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

30 term is expected to come from expansion in other sectors of the economy. Fish production is anticipated to expand following additional investment in the Soltai tuna cannery s productive capacity from The production and demand for other major export commodities is expected to expand as the world s economic recovery leads to increased prices and demand. CHART 11: HISTORIC AND PROJECTED GDP GROWTH 15 Per cent (Source: IMF) 2. FISCAL Over the next five years, annual growth in domestically-sourced revenue is expected to be around 12 per cent with, at the same time, an increase in government spending (refer to Chart 12). The IMF forecasts real revenue growth over the medium term projected to be 3 per cent per annum. CHART 12: HISTORIC AND PROJECTED REVENUE AND EXPENDITURE GROWTH (SI$billion) 6 $Billion Domestically-sourced revenue Externally-sourced revenue Total expenditure 24

31 Lower revenue from logging is expected to be replaced from mining, particularly from 2014 when it is expected that the Gold Ridge mine will start generating profits and therefore commence paying company tax. 3. MONETARY POLICY CSBI is operating monetary policy with a view to controlling inflation. The IMF projects inflation to be 5.25 per cent for Inflation is expected to be around 6 per cent per annum over the medium term with a CPI of around 6 per over the period due to expected increasing costs of fuel and food. 4.4 Economic indicators, risks and thresholds The IMF and World Bank use a standard framework, the Joint World Bank/IMF Debt Sustainability Framework (see Annexure III) to carry out debt sustainability analysis. The World Bank uses the assessment of the risk of external debt distress from this analysis to determine the share of grants and loans in its assistance program. The key economic indicators used in the Joint World Bank/IMF Debt Sustainability Framework for Low-Income Countries are summarised in Table 7. The volume of debt, expressed as a proportion of GDP, is used as a measure of debt sustainability. Debt affordability is usually expressed as the debt servicing cost in relation to domesticallysourced revenue. Debt sustainability is a longer-term measure than debt affordability. If a government cannot afford to make debt repayments, it will go into arrears and even default on payments, which will cause a loss of investment in the country and a failure of the financial systems. So, irrespective of the debt to GDP ratios, it is critical that debt is affordable. Exports indicate the ability of a country to generate foreign income. Solomon Islands, with an economy based on commodities, is very exposed to external factors that influence export earnings, such as global demand and prices. The IMF and World Bank express debt in terms of the Present Value (PV) (or Net Present Value, NPV) of debt. This allows the thresholds to be applied irrespective of the term structure, grace periods or concessionality of the debt and also allows comparisons to be made between countries and time periods. The PV of debt is the stream of future debt service payments discounted by a rate 13 which represents the alternative cost of borrowing. 13 IMF applied a rate of 4 per cent to Solomon Islands 25

32 TABLE 7: THRESHOLDS FOR A WEAK POLICY COUNTRY 14 PV of External Debt in per cent of External Debt Service in per cent of GDP Revenue Exports Revenue Exports Stress testing The baseline is a reference point for looking at the effect of shocks, or risk scenarios on the state of the economy in the future. Economic modelling is not concerned with upside risks the likelihood that conditions will be better than expected, but only with downside risks. For example, what would happen if there were a global financial shock similar to the one in 2009? Stress testing involves deciding on realistic problems (downside risks) that the country might face, and looking at how they are likely to affect the country s future economy. Stress testing is an important part of a debt sustainability analysis, where the effect of downside risks on the ability of a country to continue to make debt repayments is examined. As the SIG s Medium Term Fiscal Strategy highlights 15, the medium term risks to economic growth and prosperity in Solomon Islands remain extremely high. It is therefore important that stress testing captures the likely risks to debt sustainability and affordability so that even if there is another global economic crisis or if forest resources are exhausted sooner than anticipated, for example, debts can continue to be repaid. Stress testing helps decide on prudent levels of debt over the medium term. Although the focus of a debt strategy is the medium term (around five years), concessional loans typically have a grace period of ten years, when no principal payments are made, and maturities of up to 40 years. SIG needs to ensure that the government is able to make loan repayments at the end of the grace period, but it is very difficult to make predictions about the state of the economy such a long way into the future. Modelling by ERU extends to five years only. The approach taken in a debt management strategy must be conservative and assume that the future will not be any better than the past. Financial models use conservative estimates by assuming that present conditions will continue (for example, current interest rates and exchange rates will continue) and by using the least favourable value when there is a choice. 14 Solomon Islands has been assessed as a weak policy country by the World Bank s Country Policy and Institutional Assessment by looking at the country s structural policies, public sector management, policies for social inclusion and economic management. 15 Available at 26

33 This is a way of making sure that there will be funds available to make statutory debt repayments. Economic modelling and sustainability analysis should be able to be performed by local staff without reliance on data collection or manipulation from outside sources. The stress tests must be simple to perform and robust. Stress tests involving a decrease in revenue, GDP and export earnings, and depreciation in the SBD will be examined by DMU each year as part of the budget process to assess SIG s ability to maintain debt levels at sustainable and affordable levels over the borrowing horizon, and to determine an annual borrowing limit. Note that these are not worst case scenarios but events similar to those that have occurred historically, and which are reasonable. What follows are examples of factors that will be considered in conducting the debt sustainability analysis for 2012, and in determining the borrowing limit for the 2013 budget. 1. FALL IN REVENUES The Government needs to make sure that debt is affordable, even if revenue is less than expected. Donor funding cannot be assumed. In recent years, ten per cent of domestically sourced revenues has been set aside for debt servicing. This has made sufficient funds available for debt repayments. Forecast debt payments must therefore be maintained at a level that is less than that set aside for debt servicing. This must be based on a conservative projection of revenue, for example, by allowing for a decline in forest reserves, a decrease in logging revenues caused by a decrease in demand and allowing for times when revenue collection may fall for various other reasons. Examples include shocks such as a global financial crisis (as occurred in 2009). The following scenarios were examined: 1. Assuming a sustainable logging regime 16 ; 2. No revenue from logs; 3. Revenue declines by one standard deviation 17 (for the period ) in year 2014; 4. A revenue shock (decrease in revenue) similar to that during the Global Financial Crisis of The lifespan of logging operations is unclear, but these resources are expected to be substantially reduced by around In its revenue modelling, ERU identifies revenue from logs, so estimated data for this stress test is available. 16 SKM (2012). Solomon Islands National Forest Resources Assessment 2011 Update. Report to RAMSI Economic Governance Pillar. 17 Standard deviation is a measure of the amount of variability. 27

34 2. DECREASE IN GDP The ratio of debt to GDP measures the ability of a country to generate income to make debt payments over the long term. Factors that cause the growth in the economy to slow or even reverse (such as the global financial crisis) have flow-on effects that make debt unaffordable. Historical evidence suggests that a Debt to GDP ratio of below 30 per cent, even under stress, is required for debt distress to be prevented for a country like Solomon Islands. The following scenarios were examined: 1. No contribution from logs; 2. Sustainable logging, plus no contribution from mining; 3. GDP declines by one standard deviation (for period ) in 2014; The most conservative scenario is one where there is no contribution from logging or mining. It is unclear when forest resources will be exhausted, but logging is expected to decline in around A more realistic stress test is logging at sustainable levels with no contribution from mining. Mining operations could be interrupted by, for example, issues surrounding landownership. Both the IMF and ERU separate out the contribution by logging and mining to GDP growth, so data for these stress tests is available. 3. DECREASE IN EXPORTS Exports determine the capacity of the country to generate foreign exchange receipts. The following scenarios were examined: (i) Assuming a sustainable logging regime (ii) No revenue from logs; (iii) Exports decline by one standard deviation for period ) in 2014; 4. DEPRECIATION OF CURRENCY A 30 per cent depreciation (1SBD=USD10.4) is the most commonly used shock to currency exchange rates in scenario analyses and equates to the shock experienced by the SBD at the end of the tensions period. A future depreciation of the currency would lead to an increase in the foreign debt to GDP ratio (see Table 8) and increase the cost of servicing debt (because it increases the value of foreign currency denominated liabilities of Solomon Islands). Similarly, a negative terms of trade shock (a fall in the relative price of the exports) would also lead to an increase in the debt to GDP ratio (as it reduces the real income) and would thus require a larger trade surplus adjustment to avoid an unsustainable increase in the debt to GDP ratio. At the same time, a depreciation of the SBD would also increase revenues (through taxes on fuel). The overall effect is, however, to reduce debt sustainability and affordability. 28

35 A 30 per cent depreciation of the SBD would be roughly equivalent to a 3.5 per cent increase in interest rates on the debt stock. Thus the advantages of low interest rates with concessional loans are easily overwhelmed by foreign exchange movements. TABLE 8: EFFECT OF A 30 PER CENT DEPRECIATION ON DEBT STOCK AND SERVICING COSTS (SI$million) (Assuming no new borrowing) Debt stock 1,154 1, Debt Servicing cost Debt stock after 30 per cent depreciation 1,414 1,315 1,216 1, Debt Servicing cost after 30 per cent depreciation FUTURE GROWTH It is difficult to make projections about growth, since future sources of growth are unclear at present (except for Gold Ridge mine, which has a limited life span) and income from logs is forecast to be lost over coming years as forests are depleted. The simplest and most conservative approach is not to assume any growth. In their 2011 Article IV report, the IMF considered the key near-term risk of current financial turmoil in Europe and the United States causing the global recovery or Asian growth to falter. This would lead to a sharp contraction in investment and demand for commodities from Asia, and a deterioration of the terms of trade. The IMF suggest that a 20 per cent decline in gold and log prices in compared to the baseline, a sharp drop in logging exports, and delays in gold production would lower GDP growth by around 4 per cent to 2 per cent and double the size of the current account deficit in Political instability within Solomon Islands could possibly have a similar effect. 4.6 Results of the IMF Debt Sustainability Analysis Solomon Islands is at moderate risk of external debt distress according to this World Bank-IMF Low-Income Country (LIC) Debt Sustainability Analysis (DSA). The debt profile is sensitive to shocks to non-debt creating flows, export growth, and financing terms. Containing the risk of debt distress will require continued efforts to rebuild fiscal buffers, establish a multi-year budget framework to provide fiscal discipline, and implement structural reforms that are essential to promote broad-based growth. The Joint World Bank/IMF Debt Sustainability Analysis, using the Joint World Bank/IMF Debt Sustainability Framework for Low-Income Countries, and conducted in 2011 as part of the IMF 29

36 Article IV deliberations 18 placed Solomon Islands as being at moderate risk of debt distress (Annexure VI). All external debt indicators remain below the threshold levels summarized in Table 7. The risk of debt distress was assessed by subjecting the baseline data to many standard stress tests or shocks. Under all scenarios, debt servicing costs remain below the thresholds shown in Table 7. However, debt sustainability is vulnerable to shocks, in particular to: 1. A temporary growth shock (real growth at historical average minus one standard deviation over one year); and 2. Net non-debt creating flows 7 at the historical average minus one standard deviation for one year. As shown in the charts in Annexure VI, the thresholds are broken for these shocks. The Joint World Bank/IMF Debt Sustainability Framework for Low-Income Countries applies relatively large shocks to the Solomon Islands economy. This is because historical averages and standard deviations are calculated over ten years, thus including the period of civil unrest. Therefore, the recovery from low levels of economic activity and government finances after the end of the ethnic tensions means that the shock applied in the analysis is relatively large because the standard deviation (the measure of variability) is large and the average is relatively low. The second issue in the methodology is that net non-debt creating flows 19 are negative (inflows) not only because logging exports are projected to decline, but also because large foreign investment is anticipated Current transfers (exports less imports plus foreign aid) plus net Foreign Direct Investment 30

37 5. DEBT MANAGEMENT STRATEGY There are four components to the Debt Strategy 1. Maintain debt at sustainable and affordable levels. 2. Ensure that any new borrowing follows fiscal responsibility guidelines for a fit purpose; from an allowable source; and with acceptable terms and conditions. 3. Develop the domestic debt market. 4. Introduce and consolidate fiscal, legal, institutional and operational measures that ensure that the above three objectives are met Maintain debt at sustainable and affordable levels a) Pursue grant funding and budget support; b) Where grants are unavailable, or where a loan element of grant funding for priority development projects is mandatory, limited concessional borrowing may be sought; c) Borrowing must be limited to concessional loans from multi- or bilateral donors or development partners, as defined by the IMF and as required by the 2011 MOU with the IMF; d) The criteria for considering concessional financing shall be a grant element of 35 per cent or more. This is in line with international debt management practice and as recommended by the IMF and World Bank. It is also a requirement under the IMF Standby Credit Facility Agreement and is also likely to be a requirement in any replacement agreement with the IMF. The IMF definition of the grant element is explained in Annexure IV paragraph 23, but essentially is the difference between the face value and the market value of a loan expressed as a percentage of the face value of the loan. The grant element must be independently verified by the Debt Management Unit (DMU); e) Concessional debt terms and conditions must be appropriate for the project being financed. For example, standard IDA terms applicable for Solomon Islands for the year beginning 2011 are: 40 years maturity, 10 years grace period, 0.75 per cent interest rate ( service fee ) with the loan currency either in XDR or USD. These terms are suitable for long-term infrastructure projects, but projects with a shorter life must have loans with a comparably shorter time to maturity. Also, a 10 year grace period could be too long for projects where a revenue stream is forecast to commence in less than 10 years; f) Preference shall be given to loans firstly in SBD,; g) Currency exposure should be diversified, but consideration will also be taken of potential volatility of the currencies relative to SBD; h) Projected debt servicing cost, not allowing for grace periods, must be less than 8 per cent of forecast domestic sourced revenues, assuming no growth in revenue; i) Debt servicing shall be sequenced to avoid large peaks in repayment expenses at certain times of year. For example, as Chart 6 shows, June and December are currently months with large repayment volumes. SIG revenues tend to peak in July and January, so where semi-annual payments are to be made, these months should be targeted. 31

38 j) As part of the budget process, an annual borrowing limit will be set such that debt levels will not cause thresholds to be exceeded in the Joint World Bank/IMF Debt Sustainability Framework for Low-Income Countries (see Table 7 and Annexure III); k) As a general rule, and to maintain debt at its current (affordable and sustainable) levels or below, the cumulative new issuance should not exceed the cumulative principal repayments made since in 2010 (when the Solomon Islands Government went from red to yellow light status); l) Debt levels must be lower than any thresholds stipulated in the Public Finance Act; m) Debt levels used in monitoring and analysis will be total public debt, including SOE debt; n) Guarantees will not be issued until SIG has the resources to assess the risks of proposed guarantees and negotiate means to mitigate these risks, and monitor and report on guarantees; o) Any additional fiscal surplus arising from buoyant revenues will be used to retire domestic debt. (This is also a requirement under the MOU with IMF.) IMF Article IV report 2011 Going forward, while resuming concessional borrowing after completing the Honiara Club Agreement is important to tap resources to finance large development needs, such as the hydro power project, this borrowing should still be prudent to safeguard external stability. The joint IMF-World Bank DSA shows that the debt distress remains at a moderate risk level, even after transitioning toward external concessional loans, if borrowing remains on check. 5.2 Ensure that any new borrowing follows legal and fiscal responsibility guidelines New borrowing must comply with legislative requirements in the Public Finance and Audit Act 1996 and the Government Loans and Securities Act 1996 and any other relevant legislation. New borrowing must be recommended by a Debt Management Advisory Committee and approved through the proper legal channels. It must comply with the conditions contained within the MOU with the IMF for the use of the IMF Standby Credit Facility. New borrowing must be: for a fit purpose; from an acceptable source; and with favourable terms and conditions. Concepts such as intergenerational equity are also important. Future citizens should not pay the bills for living citizens. These requirements and standards are included in fiscal responsibility provisions proposed for amendments to the Public Finance Act. Parallel to the work on strengthening the Public Finance Act, the Government will prepare a policy document for SOE debt and issuing guarantees. These documents will align with this 32

39 strategy but provide clarification around, for example, borrowing by SOEs, the processes to be followed, the circumstances under which borrowing may be approved and reporting requirements. 1. ENSURE THAT ANY NEW BORROWING IS FOR A FIT PURPOSE (i) Borrowing must be for the following types of projects Investing in the productive capacity of Solomon Islands; Funding priority core infrastructure and development initiatives; Specific purposes (projects) identified as a high priority in SIG s National Development Strategy; Preference should be given to projects with high rates of return or projects such as investing in hospitals or schools that generate a high social rate of return that help Solomon Islands reach its Millennium Development Goals. With investment projects cash flows need to be clearly identified as sufficient to make debt repayments and the cost of any contingent liabilities and obligations such as tied procurement must be factored into the cost and risk of debt. When lending for revenuegenerating enterprises, the rate of return must be sufficient to make debt servicing payments and contribute to the future capital requirements of the enterprise. (ii) Borrowing must not be used for: Funding shortfalls in recurrent expenditure. SIG is committed to delivering fiscally responsible, and fully funded, budgets. Funding losses of SOEs. 2. ENSURE THAT ANY NEW BORROWING IS FROM AN ACCEPTABLE SOURCE Acceptable and unacceptable funding sources should be prescribed in the Financial Instructions (as part of the Public Finance Act). For the duration of this Debt Strategy (five years) borrowing should be restricted to concessional sources of finance from multilateral or bilateral donors. Such financing generally comes with greater scrutiny and oversight, making sure that funding is used for the purposes it was provided and decreasing reputational risk. It is also a requirement under the MOU with IMF signed by the Solomon Islands Government (see Annexure IV). Concessional lending is available through multilateral agencies like the ADB and World Bank and bilateral donors (including various EXIM banks around the world). The DMU must independently verify that any proposed loan is concessional. 33

40 Loan amounts will depend on the specific projects to be funded and donors funding allocations for Solomon Islands. The denomination of the loan currency will also influence the acceptability of the source (loans in SBD have no exchange rate risk). Acceptability of source will also depend on the individual characteristics of the loan, limitations and conditions on the loan (as itemised in Section below). Terms of potential multilateral sources of finance and their financial characteristics are summarized in Table 9. Lending from bilateral partners is linked to specific projects and terms and conditions depend on the project. Interest rates are at or below LIBOR. There is usually limited flexibility on the choice of terms. There may be hidden costs, such as various transaction charges and conditions attached to the loan including disbursement penalties, tied procurement (requiring recipients to use or procure goods and services exported by the creditor country). Loan disbursement may also be highly dependent on the progress of the project. In the future (and beyond the timeframe of this Debt Strategy) a third potential source of funding is through domestic securities. The IMF restriction on borrowing does not apply to any SI$-denominated treasury bill and bond holdings and Bokolo bonds held by non-residents (see Annexure IV paragraph 26). Domestic securities have many advantages, which are discussed in Section 7.3 below. However, at present Solomon Islands does not have a credit rating and has a poor international reputation because it defaulted on Treasury Bonds in the past. Therefore, any debt raised through domestic securities would be relatively expensive (for example the interest on 182 day Treasury Bills is about 3 per cent) and have an unacceptable level of refinancing risk. There is also currently no capacity or systems for issuing debt by this means. SIG needs to work to develop its domestic securities market (see Section 7.3 below) before it can contemplate issuing debt through this means. 34

41 TABLE 9: EXAMPLES OF MULTILATERAL LOAN TERMS Multilateral World Bank 20 ADB Interest rate 0% 1% first 8 years then 1.5% Interest type Fixed fixed Time to maturity 40 years 32 years Currency SDR XDR Structure Amortizing Amortizing Grace period 10 years 8 years Transaction fees/costs 0.75% Added benefits Advisory services Project management Flexibility to negotiate terms None (i) Unacceptable funding sources: It is proposed that borrowing from the central bank or commercial lenders will be explicitly prohibited in the amended Public Finance Act. Servicing loans from commercial lenders is expensive and prohibited by IMF programs. Loans from the Central Bank (CBSI) are unacceptable Borrowing from the central bank either through requiring direct participation in the primary market, through advances or through an overdraft facility is prohibited because it: Compromises CBSI s independence; Conflicts with CBSI s monetary policy objectives; Distorts the market; Is inflationary, and will typically lead to a higher general level of interest rates; Impedes the price discovery process, hindering the development of an efficient government bond market. Private sources are prohibited Borrowing from private sources such as commercial banks is prohibited for the following reasons: Cost interest rates are high; Interest rate risk with variable interest rates, costs can increase;

42 Rollover risk loans tend to be short-term; Requires assets to be offered as collateral; Lack of transparency. The MOU signed with the IMF (see Annexure IV) also effectively prohibits long and short term borrowing on commercial terms for any purpose. 3. ENSURE THAT TERMS AND CONDITIONS ARE ACCEPTABLE The terms and conditions associated with any debt proposals must be examined carefully. Loans will be subject to a cost risk analysis by the DMU and acceptability will be assessed by the Debt Management Advisory Committee (see Section below). The following factors will be examined: 1. Grant/ concessional element: Preference should be given to debt with a large grant component. However, the project still needs to be for a fit purpose. 2. Debt sustainability and affordability: The volume and cost of debt must not have a negative impact on debt sustainability and affordability. All economic indicators must be below the thresholds (see Table 7) when subject to stress tests (see for example Section 4.5 above) and using conservative estimates of economic variables. Hidden costs, such as fees (transaction, commitment, agency or underwriting), requirements for the Solomon Islands Government to fund maintenance or project management expenses beyond the current year must be included in the analysis. The analysis must extend out 20 years using conservative estimates of economic variables and be verified using the Joint World Bank/IMF Debt Sustainability Framework. 3. Currency and exchange rate risk: Despite offering very low interest rates, concessional loans still carry foreign exchange risk. The benefit of very low or even zero interest rates could be negated by depreciation of the Solomon Islands dollar against the loan currencies. For example, 30 per cent depreciation is equivalent to 5.5 per cent increase in interest rates on a semi-annual amortizing bond with a ten year term. Stress tests used in the above analysis must assess the impact on affordability and sustainability of foreign exchange movements. Preference should be given to debt denominated in SBD. 4. Interest rate: Debt with a lower interest rate will have a lower cost. Fixed interest rates have a lower risk than variable interest rates where the future cost of debt is not known. 5. Tenor: Concessional loans have a standard long time to maturity (32 or 40 years). However, the term of the loan should be more closely aligned to the cash flows of the project. The advantages of very long term loans (such as the impact of inflation on the value of the loan) and very low repayment amounts can be outweighed by accumulating large amounts of debt over many generations. Very long term loans may encourage fiscal irresponsibility, because if the project fails, it is future generations that must bear the cost. By using up the 36

43 borrowing envelope now, it might restrict the ability of future generations to borrow, and they will be servicing debt for projects that were completed before they were born and for which they receive no tangible benefit. 6. Grace period: Debt sustainability analysis must extend beyond grace periods. The standard long grace periods of eight or ten years offered by multilaterals such as the World Bank and ADB may not be appropriate. The length of the grace period should be assessed in terms of factors such as the revenue stream from the project, its duration, inter-generational equity and the time value of money. 7. Repayment risk: SIG must be able to afford the debt repayments over the life of the loan and repayments must be timed for months with lower repayment volumes or where SIG has peaks in cash collection. 8. Conditions: Preference should be given to debt with positive characteristics such as project administration or management and advisory services. Negative characteristics such as tied procurement, the requirement to use particular companies or nationalities for project implementation, future expense commitments (such as auditing expenses or maintaining equipment) need to be factored into assessments of the cost of debt. 9. Concentration risk: If the volume of the loan is large, it may contribute to concentration risk. If an institution or bilateral partner has a large concentration of debt it could use this as a means of exerting undue political influence or bargaining for favours (for example tax concessions, access to resources). The behaviour of the lender needs to be assessed. 10. Legal risk: Borrowing proposals must be examined for potential legal risks. They must not contravene any Solomon Islands legislation. In addition, SIG must be certain that it is able to comply with all legal requirements such as conditions attached to the loan and including ability to repay. All loan contracts must first be cleared with the Attorneys General Office before signing. 5.3 Develop the domestic debt market A domestic government securities market is made up of tradable debt instruments with a time to maturity up to one year (Treasury Bills, which are discount instruments) and Treasury Bonds which have a time to maturity of more than one year. Currently, the primary SIG market is limited to Treasury Bills with a time to maturity of up to 182 days. The current market is limited because of SIG s history of default and poor investor confidence, as well as limited systems for issuing and recording debt. At present, yields (interest rates) on longer term Treasury Bonds are likely to be unacceptably high, given poor investor confidence in Solomon Islands and the absence of a credit rating. For short to medium term Treasury Bonds the high refinancing risk also precludes their use for infrastructure funding. However, in the future, Treasury Bonds may be a cheaper or at least less risky source of financing, since they are not subject to foreign exchange risk. 37

44 Sovereign governments aim to have a liquid market in government securities because they: offer flexibility in funding; are denominated in domestic currencies and are therefore not exposed to exchange rate movements (and are therefore potentially a lower cost funding source; allow diversification of the Government s debt financing base; improve the functioning of the finance sector by enabling the creation and transfer of liquidity via interbank trading; and serve as a price benchmark by providing a risk-free reference rate. For example, in its 2011 Article IV report, the IMF stated that the lack of a domestic secondary market for equity and debt instruments makes it difficult to value higher-risk equity stakes and real estate investments. This is of particular concern for the superannuation provider, NPF. Developing such a market should be a long-term goal of the Solomon Islands Government. The first step is strengthening and extending the market, which can be done within the timeframe of this Debt Strategy. 1. STRENGTHEN CURRENT MARKET Improve investor confidence through maintaining accountability and transparency. This will be achieved by: Continuing to ensure that auction calendar and results are published on CBSI website (see Section (ii) below); Encouraging participation through market liaison meetings held at least quarterly; Making early part repayments of principal to domestic bond holders. 2. EXTEND CURRENT CAPABILITIES As a first step SIG should consider issuing one year Treasury Bills. Preliminary market discussions indicate that this would be well received; A recommendation will be made for the Treasury Bill issuance volume cap to be increased by SI$10 to SI$20 million to allow for issuance of one year Treasury Bills; When a one year Treasury Bill is introduced, the rediscounting provision needs to be reintroduced so that investors can break the one-year Treasury Bill if they need to. The discount rate needs to be sufficiently prohibitive to deter investors gaming SIG and Depending on the strength of demand for a one year Treasury Bill, SIG should make preparations for, in the medium term, introducing short-term Treasury Bonds. 38

45 5.4 Introduce and consolidate fiscal, legal, institutional and operational measures that ensure that the above three objectives are met Fiscal, legal, institutional and operational measures are needed to strengthen debt management and establish a borrowing framework. These measures also need to increase transparency and accountability so as to restore credit worthiness through rebuilding reputation. The Public Finance Act will be reviewed during 2012 to incorporate an effective borrowing framework. The World Bank, Commonwealth Secretariat and United Nations all advocate these measures, which are recognised world-wide as essential factors in sound debt management. DMU will be assessed regularly as to how well it performs its functions. 1. FISCAL MEASURES The Solomon Islands Government must continue its commitment to balanced recurrent budgets and debt should not be used for recurrent spending 21. SIG will continue to set aside a percentage of domestically sourced revenue equivalent to the ratio of forecast debt servicing payments to forecast domestically sourced revenue plus a buffer of 2% for contingencies (such as weak revenue, currency devaluation) into a Debt Servicing Account. This account is not to be used for any purpose other than debt servicing. Cabinet approval should be given to change the arrangements surrounding this account. Annual borrowing limits will be set as part of the budget process to keep debt at sustainable and affordable levels, based on conservative forecasts of macro-economic factors, and in line with the Government s Medium Term Fiscal Strategy. 2. LEGAL MEASURES Essential aspects of debt management contain these elements: Definition of debt to include loans, borrowings, guarantees and on-lending; Clear authorization by Parliament to the Minister of Finance to approve borrowings and loan guarantees on behalf of the government; A requirement that all borrowing proposals (including guarantees) are reviewed by a Debt Management Advisory Committee and recommendations submitted to the Minister of Finance before borrowing and loan guarantees can be approved on behalf of the government; Decisions surrounding borrowing made as part of the budget process so that projects can be compared on merit, and appropriations are made for borrowed funds; 21 There may be special circumstances when the Government needs to raise funds for the recurrent budget such as in a genuine emergency or crisis. 39

46 Clear authorization from the Minister of Finance to the debt management entities to undertake borrowing and debt-related transactions and to manage loan guarantees; Clear debt management objectives, including that the cost of the debt is minimized from a medium/long-term perspective, the risks in the debt portfolio are kept at acceptable levels, and that development of the domestic debt market is promoted; A requirement to review and update the Debt Strategy annually which will serve as an operational strategy and will provide a framework for how the government will achieve its debt management objectives; and As part of the annual update of the Debt Strategy, mandatory reporting on progress since the last review, covering an evaluation of outcomes against stated objectives. 3. INSTITUTIONAL FRAMEWORK (i) Process for recommending borrowing proposals to Cabinet As outlined in section above, there needs to be clear delegation of responsibilities for recommending and approving debt, where debt includes loans, borrowings, guarantees and onlending by both central Government and SOEs. The proposed process for approving debt to be incorporated into the revised Public Finance Act is as follows: 1. Borrowing proposals are recommended by the Ministry of Development, Planning and Aid Coordination (MDPAC) and forwarded to the Debt Management Advisory Committee for consideration. The projects identified for debt financing shall be consistent with the Development Strategy and limited to those projects that add to capital formation, contribute to foreign exchange earnings, job creation and/or GDP growth, or are investments in essential social infrastructure (hospitals or schools for example). New borrowing will be prioritized projects with high rates of return or key infrastructure for achieving Millennium Development Goals. Cash flows from investment proposals need to be clearly identified and be sufficient to make debt repayments. The cost of any contingent liabilities and obligations such as tied procurement are factored into the cost and risk of debt. The implications for the recurrent budget should also be quantified, for example, maintenance of buildings or other assets acquired through the proposal. 2. Borrowing proposals are assessed by the Debt Management Advisory Committee. The Committee shall propose a methodology for evaluating projects for debt financing consideration. This methodology will include evaluating the cost /risk tradeoffs of the proposal. (See the box below.) 3. The DMAC will recommend and rank acceptable proposals; 4. Proposals that have been recommended by the DMAC can then be submitted and incorporated as part of the budget approval and appropriation process. 5. The Finance Minister has sole authority to approve loans. Therefore borrowing will not be legal unless it has been signed off by the Finance Minister. 40

47 Debt Management Advisory Committee will assess the volume and risk characteristics of debt to ensure that: Debt 1. Management Debt is sustainable Advisory and Committee affordable; will assess the volume and risk characteristics 2. Debt below of debt the to thresholds ensure that: established in the Debt Strategy and 1. Debt annual is Borrowing sustainable Plan; and affordable; Debt is below from an the acceptable thresholds source; established the Debt Strategy and annual 4. Borrowing Debt is within Plan; legislative guidelines (including Public Finance and 3. Debt Audit is Act) from and an other acceptable legal obligations source; (such as the IMF Facility); Debt is within for a good legislative purpose guidelines and the project (including is a Public high priority Finance in and the Audit National Act) Development and other legal Strategy; obligations (such as IMF Facility); Debt is for not a for good funding purpose recurrent and the expenditure; project is a high priority in the 7. National The project Development has a positive Strategy; NPV or helps achieve MDGs and the 6. Debt implication is not for funding recurrent recurrent expenditure expenditure; is clearly quantified; Project The cost has of any a positive contingent NPV or liabilities helps achieve and obligations MDGs; such as tied 8. The procurement cost of any are contingent factored into liabilities the cost and and obligations risk of debt; such as tied 9. procurement Cash flows from are project factored can into be the identified cost and that risk will of be debt; able to be used 9. Cash for repaying flows from the loan. project can be identified that will be able to be used 10. for Loan repaying terms and the conditions loan. are acceptable and achieve the best cost 10. Loan and risk terms outcome. and conditions are acceptable and achieve the best cost 11. and Borrowing risk outcome. aligns with the Medium Term Fiscal Strategy. 11. Borrowing aligns with the Medium Term Fiscal Strategy. (ii) Functions and responsibilities of the Debt Management Unit The functions and responsibilities of the DMU will be incorporated into legislation through the Financial Instructions and will include: 1. Make debt payments on time and for the correct amount; 2. Keep timely, comprehensive and accurate records of outstanding government debt, guarantees, contingent liabilities and new borrowing in a single debt database; 3. Publish, in a timely manner, monthly (and quarterly) reports showing the status of outstanding debt, debt payments, and projected debt payment obligations; 4. Prepare, review and update the Debt Strategy; 5. If required, prepare an annual borrowing plan; 6. Prepare and publish auction calendars for issuance of domestic securities (Treasury Bills and Treasury Bonds); 7. Assess the risks in issuing any guarantees, and prepare reports on the method used for each assessment and the results thereof for the attention of the Finance Minister; 41

48 8. Monitor and advise on all debt servicing obligations of the government; 9. Prepare forecasts on government debt servicing and disbursements as part of cash management and the yearly budget preparation; 10. Work closely with Treasury to improve cash management using tools such as Treasury Bills; 11. Store all original loan contracts and debt administration records in a safe place; 12. Oversee the loan contracting and issuance process and be responsible for determining the loan structure and for negotiating reasonable terms and conditions for all new borrowing; and 13. Produce operational guidelines, document procedures and approval processes for domestic and external borrowing. (iii) Debt Management Advisory Committee The Debt Management Advisory Committee will evaluate borrowing proposals (see Section above). The Debt Management Advisory Committee will be chaired by the Permanent Secretary, Ministry of Finance and Treasury with membership from DMU, ERU, CBSI and MDPAC. This committee will be an extension of the 4M 22 committee. DMU will act as Secretariat for the Committee. The Committee will make recommendations to the Finance Minister as to whether borrowing should or should not proceed. (iv) Liaison with CBSI 1. The DMU will maintain a close working relationship with CBSI, including quarterly liaison meetings. The areas of cooperation include, but are not limited to: 2. Debt recording and maintaining the Commonwealth Secretariat Debt Recording and Management System (CS-DRMS) database; 3. Issuance of debt securities; 4. Co-ordination concerning early repayment or retirement of domestic debt to ensure that liquidity injections do not lead to excessive credit growth; 5. Debt payments from the Government s account; 6. Publishing debt data; 7. Ensuring that foreign reserves are adequate for external debt repayments; and 8. Membership on the Debt Management Advisory Committee. 4. OPERATIONAL FRAMEWORK Accurate records and reports are necessary for maintaining and building SIG s accountability and transparency, and thus credibility. These are all important factors in improving investor confidence which will reduce the cost of borrowing in the future. Accurate records are needed for analysis, for example cost and risk analysis and for assessing performance against the Debt 22 Monthly Monitoring and Management Meeting 42

49 Strategy. An outline of what is required will be incorporated into the Financial Instructions. Operational guidelines, procedures and approval processes for domestic and external borrowing also need to be documented. (i) Debt recording The DMU will maintain accurate and up-to-date records of all debt (including guarantees, on-lending and contingent liabilities) and investments, which can then be reported. DMU also needs to keep records on liabilities of SOEs. The DMU s debt recording system is CS- DRMS, which is a Commonwealth Secretariat system. Records and information on the details of holders of government securities will be maintained by the CBSI. (ii) Debt reporting DMU will publish monthly reports on the status of SIG s total debt including loans, guarantees, contingent liabilities and payment arrears. The report will include details of new borrowing and issuance of Government guarantees, as well as debt repayments, rescheduling, write-offs, and retirements. Quarterly debt bulletins indicating debt levels and cost, debt sustainability and affordability and actual and projected debt service costs over the medium term will be published on both the CBSI and Ministry of Finance and Treasury websites. An Annual Report will be produced showing changes in the debt status over the year, details of any new borrowing and debt repayments, key events in the management of debt and the DMU, and a review of progress and performance against the Debt Strategy. The Debt Strategy and reports will be published on the Ministry of Finance and Treasury website. Reports will be published in a timely manner, so that stakeholders have access to up-to-date information. The results of auctions of domestic securities (Treasury Bill and Treasury Bonds) will be published on the CBSI website 23 before the end of each week. A monthly calendar indicating issuance volumes and target maturities of domestic debt securities will be published on the CBSI website in a timely manner. (iii) Debt Strategy Every year the DMU will review and update the Debt Strategy. The Debt Strategy will provide a framework for ensuring debt financing decisions are consistent with SIG s broader fiscal and development strategies and that the level of borrowing fits within the debt sustainability/affordability thresholds defined in legislation or any other official documents and with achieving macroeconomic objectives

50 The DMS will be reviewed by the Debt Management Advisory Committee (see above). The key elements of the Debt Strategy will be incorporated into the MTFS and approved by Parliament as part of the annual budget process. (iv) Borrowing Plan When required, DMU will prepare a borrowing plan. (v) Debt Sustainability Analysis DMU will prepare a debt sustainability analysis, using data from the Ministry of Finance in addition to using the Joint World Bank/IMF Debt Sustainability Framework, as appropriate. (vi) Integration with Cash Management The DMU will continue to work with Treasury to integrate cash and debt management. Cash management ensures that SIG has sufficient funds to meet its obligations as an when they fall due. Use of cash management tools depends on reliable cash forecasting. For example, Treasury Bills can be issued to fund forecast cash shortfalls, with maturity timed to coincide with periods of forecast cash surplus. Similarly, excess cash can be invested in term deposits or similar instruments to earn SIG reasonable rates of return, with term deposits maturing at times of forecast cash shortfall. (vii) Compliance Where staffing levels permit, the DMU will move toward an office organization with separation of back, middle and front office duties so that work can be monitored and verified. DMU will also work with Treasury toward greater integration of the cash management task. (viii) Capacity Building Capacity building will continue at all levels, with assistance from RAMSI funded staff on secondment from AOFM and from other organisations such as the World Bank and Commonwealth Secretariat. DMU will update its capacity development plan annually in line with the Ministry s Corporate Plan. (ix) Business Continuity and Disaster Recovery Business continuity will be strengthened by documenting procedures for all key processes. A register will be kept of key spreadsheets and documents, and these will be backed up regularly. DMU will continue to work in close partnership with CBSI. DMU will ensure that backups of key documents and spreadsheets are kept off-site, and will develop a disaster recovery plan. Parallel copies of the data base in CS-DRMS should be maintained by CBSI and DMU and Commonwealth Secretariat. 44

51 ANNEXURE I: IMF DEFINITION OF DEBT GUIDELINES ON PERFORMANCE CRITERIA WITH RESPECT TO FOREIGN DEBT Excerpt from Executive Board Decision No (79/140), as revised on August 31, (a) For the purpose of this guideline, the term debt will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows: (i) loans, i.e., advances of money to the obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans and buyers credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements); (ii) suppliers credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and (iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property. (b) Under the definition of debt set out in point 9 (a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt. 45

52 ANNEXURE II: SOLOMON ISLANDS TOTAL DEBT ATTRIBUTED BY CREDITORS AS AT 29 FEBRUARY

53 ANNEXURE III: JOINT WORLD BANK IMF DEBT SUSTAINABILITY FRAMEWORK FOR LOW-INCOME COUNTRIES The Joint World Bank IMF Debt Sustainability Framework for Low-Income Countries Low-income countries (LICs) have often struggled with large external debts. Debt burdens have been reduced, thanks in large part to international debt relief initiatives. As part of the Millennium Development Goals (MDGs), the IMF and the World Bank have developed a framework to help guide countries and donors in mobilizing the financing of low-income countries' development needs, while reducing the chances of an excessive build-up of debt in the future. The joint World Bank International Monetary Fund (IMF) Debt Sustainability Framework (DSF) was introduced in April 2005, and is periodically reviewed, to address this challenge. Strategic approach in order to reach goals The framework is designed to guide the borrowing decisions of low-income countries in a way that matches their financing needs with their current and prospective repayment ability, taking into account each country s circumstances. This also provides guidance for creditors lending and grant-allocation decisions to ensure that resources are provided to low-income countries on terms that are consistent with both progress towards their development goals and long-term debt sustainability. It also improves the World Bank and IMF assessments and policy advice in these areas and helps detect potential crises early so that preventive action can be taken. Under the DSF, debt sustainability analyses (DSAs) are conducted regularly. They consist of: an analysis of a country s projected debt burden over the next 20 years and its vulnerability to external and policy shocks baseline and shock scenarios are calculated; an assessment of the risk of debt distress in that time, based on indicative debt burden thresholds that depend on the quality of the country s policies and institutions; and recommendations for a borrowing (and lending) strategy that limits the risk of debt distress. Assessing debt to avoid risks The DSF analyzes both external and public sector debt. Given that loans to low-income countries vary considerably in their interest rates and length of repayment, the framework focuses on the present value (PV) of debt obligations. This ensures comparability over time and across countries. To assess debt sustainability, debt burden indicators are compared to indicative thresholds over a 20-year projection period. A debt-burden indicator that exceeds its indicative threshold suggests a risk of experiencing some form of debt distress. There are four ratings for the risk of external debt distress: External Relations Department Washington, D.C Telephone Fax Factsheet URL:

54 low risk, when all the debt burden indicators are well below the thresholds; moderate risk, when debt burden indicators are below the thresholds in the baseline scenario, but stress tests indicate that thresholds could be breached if there are external shocks or abrupt changes in macroeconomic policies; high risk, when the baseline scenario indicates a protracted breach of debt or debt-service thresholds but the country does not currently face any repayment difficulties and alternative scenarios or stress tests also show protracted threshold breaches; or in debt distress, when the country is already having repayment difficulties. Low-income countries with weaker policies and institutions tend to face repayment problems at lower levels of debt than countries with stronger policies and institutions. The DSF, therefore, classifies countries into one of three policy performance categories (strong, medium, and poor) using the World Bank's Country Policy and Institutional Assessment (CPIA) index, and uses different indicative thresholds for debt burdens depending on the performance category. Thresholds corresponding to strong policy performers are highest, indicating that in countries with good policies debt accumulation is less risky. Debt Burden Thresholds Under the DSF PV of debt in percent of Debt service in percent of Exports GDP Revenue Exports Revenue Weak Policy Medium Policy Strong Policy Integrating debt issues into policy advice The DSF has enabled the IMF and the Bank to integrate debt issues more effectively in their analysis and policy advice, through improved frequency and quality of the analysis. It has also allowed comparability across countries. The DSF is important for the IMF s assessment of macroeconomic stability, the long-term sustainability of fiscal policy, and overall debt sustainability. Furthermore, debt sustainability assessments are taken into account to determine access to IMF financing, as well as for the design of debt limits in Fund-supported programs. The World Bank uses the assessment of the risk of external debt distress from the DSF to determine the share of grants and loans in its assistance to each low-income country. The effectiveness of the DSF in preventing excessive debt accumulation hinges on its broad use by borrowers and creditors. The IMF and the Bank encourage low-income countries to use the DSF or a similar framework as a first step toward developing medium-term debt strategies. Creditors are encouraged to take into account the results of debt sustainability assessments in their lending decisions. In this way, the framework should help low-income countries raise the finance they need to meet the Millennium Development Goals, including through grants when the ability to service debt is limited. More Information about the DSF: or THIS INFORMATION IS CURRENT AS OF SEPTEMBER 2010

55 ANNEXURE IV: EXTRACT FROM TECHNICAL MEMORANDUM OF UNDERSTANDING BETWEEN SOLOMON ISLANDS GOVERNMENT AND IMF NOVEMBER, 2011 V. EXTERNAL DEBT A. Medium- and Long-Term External Debt 19. A ceiling applies to the contracting and guaranteeing by the public sector of new nonconcessional borrowing with nonresidents with original maturities of more than one year. The ceiling applies to debt and commitments contracted or guaranteed for which value has not yet been received. This applies to private debt for which official guarantees have been extended and which, therefore, constitutes a contingent liability of the public sector. The public sector comprises the central government, the CBSI, nonfinancial public enterprises (i.e., enterprises in which the government owns more than 50 percent of the shares), and other official entities. 20. The definition of debt, for the purposes of the program, is set out in Point 9 of the Guidelines on Performance Criteria with Respect to External Debt in Fund Arrangement Executive Board Decision No (79/140), as revised on August 31, 2009 (see Annex I). 21. Excluded from the ceiling are (i) the use of Fund resources; (ii) lending from the World Bank and the Asian Development Bank; (iii) debts incurred to restructure, refinance,or prepay existing debts, to the extent that such debt is incurred on more favorable terms than the existing debt and up to the amount of the actually restructured/refinanced/prepaid debt; (iv) concessional debts; (v) any SI$denominated treasury bill and bond holdings and Bokolo bonds held by nonresidents. 22. For program purposes, the guarantee of a debt arises from any explicit legal obligation of the central government, the CBSI, nonfinancial public enterprises, or other official entities on behalf of the central government or the CBSI to service debt in the event of nonpayment by the main obligor (involving payments in cash or in kind). 23. For program purposes, a debt is concessional if it includes a grant element of at least 35 percent, calculated as follows: the grant element of a debt is the difference between the net present value (NPV) of debt and its nominal value, expressed as a percentage of the nominal value of the debt. The NPV of debt at the time of its contracting is calculated by discounting the future stream of payments of debt service due on this debt. The discount rates used for this purpose are the currency specific commercial interest reference rates (CIRRs), published by the Organization for Economic Cooperation Development (OECD). For debt with a maturity of at least 15 years, the 10-year-average CIRR will be used to calculate the NPV of debt and, hence, its grant element. For debt with a maturity of less than 15 years, the 6-month average CIRR will be used. To both the 10-year and 6- month averages, the same margins for differing repayment periods as those used by the OECD would continue to be added (0.75 percent for repayment periods of less than 15 years, 1 percent for 15 to 19 years, 1.15 percent for 20 to 29 years, and 1.25 percent for 30 years or more). B. Short-Term External Debt 24. A ceiling applies to the contracting and guaranteeing by the public sector of new nonconcessional borrowing with nonresidents with original maturities of up to and including one year. The ceiling applies to debt and commitments contracted or guaranteed for which value has not yet been received. This applies to private debt for which official guarantees have been extended and which, therefore, constitute a contingent liability of the public sector. 25. For program purposes, the definition of debt is set out in Point 9 of the Guidelines on Performance Criteria with Respect to External Debt in Fund Arrangement approved by the Executive Board Decision No (79/140), as revised on August 31, 2009 (see Annex I). 26. Excluded from the ceiling are (i) debts classified as international reserve liabilities of the CBSI; (ii) debts incurred to restructure, refinance, or prepay existing debts, to the extent that such debt is

56 incurred on more favorable terms than the existing debt and up to the amount of the actually restructured/refinanced/prepaid debt; (iii) SI$-denominated treasury bills and bonds and CBSI and Bokolo bills held by nonresidents; and (iv) normal import financing. A financing arrangement for imports is considered to be normal when the credit is self-liquidating. VI. EXTERNAL PAYMENT ARREARS 27. A continuous performance criterion applies to the nonaccumulation of external payments arrears by the public sector, comprising the central government, the CBSI, nonfinancial public enterprises, and other official entities. External payments arrears consist of external debt-service obligations (principal and interest) that have not been paid at the time they are due, as specified in the contractual agreements.

57 ANNEXURE V: DEBT STATUS AS AT 31 DECEMBER Government Debt Outstanding (SI$million) Domestic Debts Government Bonds Commercial Banks Central Bank National Provident Fund QBE Maruha Nichiro Treasury Bills Advances from Central Bank ^ Other External Debts 1, , , , , , Multilateral Creditors Bilateral Creditors Other Creditors Total Official Debt 1, , , , , , ,190.8 Explicit Informal Debts and Contingent Liabilities Loan Guarantees Other Grand Total 1, , , ,290.7 * Currency composition of external debt as at 31 December 2011 is: USD 47%, EUR 22%, JPY 17%, Other 14% * Informal debts and contingent liabilities exclude SOE debts that are not covered by an explicit Government guarantee * Data is sourced from a combination of Central Bank and MoFT records with exchange rates as at 30 December 2011 ^ Includes special securities account 2. Debt Servicing payments (SI$million) Domestic Debts Principal Interest External Debts Principal Interest Grand Total Figures represent expenditure on servicing Official Government Debt only

58 ANNEXURE VI: DSA USING IMF TEMPLATE CHARTS

59 GLOSSARY OF ACRONYMS ADB CBSI CS-DRMS DBSI DeMPA DMU EFIC EIB EC ERU EXIM FDI GDP HIPC ICDF IDA IFAD IMF MDPAC MOU NPF OPEC PV RAMSI SDR UNITAR Asian Development Bank Central Bank Solomon Islands Commonwealth Secretariat Debt Recording and Management System Development Bank Solomon Islands Debt Management Performance Assessment Debt Management Unit Australian Export Finance and Insurance Corporation European Investment Bank European Commission Economic Reform Unit of the Ministry of Finance and Treasury Export-Import Bank Foreign Direct Investment Gross Domestic Product Heavily Indebted Poor Country International Cooperation and Development Fund International Development Assistance (from the World Bank) International Fund for Agricultural Development International Monetary Fund Ministry of Development, Planning and Aid Coordination Memorandum of Understanding National Provident Fund Organization of the Petroleum Exporting Countries Present Value Regional Assistance Mission Solomon Islands Special Drawing Rights United Nations Institute for Training and Research