Solomon Islands

AMID NOW FOR PUSLRO USE/t

EBS/81/101

CONFIDENTIAL

May 6, 1981

To:

Members of the Executive Board

From:

The Secretary

Subject:

Solomon Islands - Request for Stand-By Arrangement

Attached for consideration by the Executive Directors is a request from Solomon Islands for a stand-by arrangement equivalent to SDR 1.6 million. A draft decision appears on page 16. This subject has been tentatively scheduled for discussion on Friday, May 29, 1981.

Att:

(1)

CONFIDENTIAL

INTERNATIONAL MONETARY FUND SOLOMON ISLANDS Request for Stand-By Arrangement Prepared by the Asian Department (In consultation with the Exchange and Trade Relations, Legal, and Treasurer's Departments) Approved by P.R. Narvekar and Manuel Guitian May 5, 1981

I.

Introduction

In a letter dated April 24, 1981, a copy of which is attached, the Government of Solomon Islands requests a stand-by arrangement for a period of one year in an amount equivalent to SDR 1.6 million, or 50 per cent of quota. The letter describes the economic and financial policies of the Government that provide the basis for this request. The requested stand-by arrangement would be the first such arrangement with Solomon Islands. In April 1979, Solomon Islands purchased the equivalent of SDR 1.05 million under the compensatory financing facility; the amount was repurchased in December 1979. Fund holdings of Solomon Islands dollars currently amount to 77.5 per cent of quota. Assuming that the full amount of the requested stand-by arrangement is purchased, Fund holdings of Solomon Islands dollars in the credit tranches would increase to 50 per cent of quota at the time of expiry of the stand-by arrangement.

II.

Background and Recent Developments 1/

Solomon Islands is a small open economy; agriculture, fishing, and forestry are the principal economic activities. The economy has made considerable progress in recent years, both in terms of aggregate output growth and diversification. The main sources of growth have been the expansion of export production 2/ and high levels of private and public investment financed by capital inflows and foreign aid. Real GDP grew 1/ A detailed description of recent economic developments is available in "Solomon Islands--Staff Report for the 1980 Article IV Consultation" (SM/80/234, 10/15/80) and associated Recent Economic Developments report (SM/80/244, 10/24/80). 2/ Exports accounted on the average for nearly 50 per cent of GDP during 1978-80.

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at an average annual rate of about 8 per cent during 1973-79. Over the same period, fish and palm oil developed into major export items, diversifying the traditional export base of copra and timber. The development of irrigated rice production was another important achievement, allowing the country to become a net exporter instead of a net importer of rice. In addition, near self-sufficiency has been achieved in beef production. The Government has played a key role in inducing and coordinating the major investments by the private sector that have made possible this record of development. The rapid growth has been achieved with reasonable domestic price stability and was accompanied through 1979 by an accumulation of international reserves. In 1980, economic performance suffered a setback. The volume of copra exports fell by 20 per cent, owing to a temporary work stoppage on the largest coconut plantation, a disruption of inland transportation, and smallholders' supply response to a reduction of producer prices following a fall in international prices.l/ The fish catch declined by 8 per cent, due to exceptionally cool ocean temperatures in the first half of the year. On the other hand, the production of palm oil, rice, and timber continued to expand. Nevertheless, because of the relative importance of copra output and the extent of its fall, real GDP declined by 4 to 5 per cent according to staff estimates. While investment continued to increase, real consumption expenditure is estimated to have declined 2/ as. a consequence of a fall in agricultural incomes and a reduction in real wages in the government sector, the largest employer in Solomon Islands. Rural incomes were adversely affected by the decline in the production and price of copra, the principal cash crop. 3 / After being frozen in 1979, nominal wages in the public sector were allowed to rise only by between 7 to 10 per cent in 1980. At the same time, inflation, which was 10 per cent during 1979, accelerated to 16 per cent during 1980, reflecting movements in import prices. Fiscal developments during 1979-80 were characterized by a relatively rapid growth of expenditures owing to the transfer of functions from colonial to national authorities and the enlargement of the government administration following independence,4/ and to stepped-up development efforts 1/ The marketing of copra is conducted by the Copra Board which cushions producer prices against export price fluctuations. In 1979, when world prices were high, the Board accumulated large surpluses. In 1980, when the average export price fell by 22 per cent (20 per cent in terms of SDRs) the average producer price was reduced by 8 per cent. The difference was financed by drawing upon the accumulated surpluses of the Copra Board. 2/ In the absence of national income data on consumption and investment, this estimate is based on an analysis of developments in household incomes and movements in imports of consumer and capital goods. 3/ Income from copra sales, which represents nearly 90 per cent of rural household income in the monetized sector, fell by 15 per cent in 1980. 4/ Solomon Islands gained full independence from the United Kingdom in July 1978.

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aimed at exploiting the country's natural resources (Table 1). Although domestic revenue has also risen significantly, partly as a result of tax measures, the fiscal deficit as a ratio of GDP increased from less than 1 per cent in 1978 to about 3 per cent in 1980. The deficits during the past two years were financed by concessional external project loans and domestic nonbank borrowing; net recourse by the Government to the domestic banking system actually declined. Solomon Islands was part of the Australian monetary system until October 1977, when a national currency was introduced by the Solomon Islands Monetary Authority (SIMA). Although the SIMA has been entrusted with the usual credit control powers of a central bank, until recently, it had refrained from using these powers, preferring to place no restraint on domestic credit expansion to the private sector other than the commercial banks' criteria on the quality of lending. Therefore, the growth of credit to the private sector, which still goes mostly to a few large firms, has been determined primarily by loan requests deemed creditworthy by banks. In 1980, total domestic credit expanded by 55 per cent, following an almost tripling of such credit in 1979 when economic activity was buoyant and foreign private companies began to use local banks to meet their borrowing requirements (Table 2). Broad money (excluding the deposits of the Copra Board with commercial banks) declined by about 5 per cent during 1980, reflecting principally the drawing down of accumulated bank deposits by a few large companies. These developments in credit and broad money were accompanied by a fall in net foreign assets, since the credit expansion to and the use of deposits by the companies served mostly to finance the importation of equipment and capital goods. During the first two months of 1981, there was a further 11 per cent decline in broad money. This was due mainly to a bunching of import payments financed by a drawdown of company deposits with banks and a temporary transfer of funds abroad in anticipation of a depreciation which took place in early March. It is expected that a large part of the funds transferred abroad will be repatriated and that company deposits will be rebuilt to more normal levels following the depreciation. After an exceptionally good year in 1979 when the terms of trade improved by nearly 40 per cent and the volume of exports rose by 30 per cent (see Basic Data in Appendix II), the balance of payments position weakened considerably in 1980 due to a 6 per cent deterioration in the terms of trade, a fall in the volume of exports, an increase in service payments, After nearly and a decline in net private capital inflows (Table 3). doubling in 1979, export earnings grew by only 5 per cent (in terms of SDRs) in 1980, as the reduction in the volume of copra and fish exports was compounded by sharp declines in the average export prices of cocoa, copra, and palm oil (Table 4). Export performance would have been even weaker had it not been for an increase in fish prices and continued expansion in the volume of palm oil and rice exports. Overall, the volume of exports declined by 1 per cent and the average export unit value increased

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Table 1.

Solomon Islands: Summary of Central Government Budget, 1978-81 (In millions of Solomon Islands dollars)

1978

1979

1980 Prel.

1981 Budg.

Revenues and grants Domestic revenue Tax revenue Income taxes Individuals Companies Export duties Import duties Other tax revenue Other revenues and fees Grants

27.17 13.60 10.55 4.26 (2.15) (2.11) 2.51 3.39 0.39 3.05 13.57

31.96 19.25 15.28 4.98 (2.68) (2.30) 5.58 4.36 0.36 3.97 12.71

36.10 22.67 17.77 7.37 (3.10) (4.27) 4.45 5.62 0.33 4.90 13.43

39.01 26.82 20.54 8.50 (4.50) (4.00) 4.45 7.14 0.45 6.28 12.19

Expenditure and net lending Recurrent wages Of which: Capital Net lending Of which: GSA 1/

27.40 16.74 (6.64) 6.72 3.94 (4.14)

34.29 20.14 (11.80') 11.12 3.03 (1.64)

39.46 23.67 (13.10) 10.73 5.06 (3.22)

48.01 27.91 (15.00) 15.55 4.55 (3.00)

Overall deficit

-0.23

-2.34

-3.36

-9.00

Total financing Domestic Of which: banking system Foreign borrowing (net)

0.23 -0.19 (...) 0.42

2.34 0.30 (-0.70) 2.04

3.36 0.03 (-3.10) 3.33

9.00 3.00 (2.50) 6.00

Memorandum items: (As per cent of GDP) Domestic revenue Tax revenue Total expenditure and net lending Recurrent expenditure Capital expenditure and net lending Overall deficit

Sources: estimates. 1/

16.1 12.5 32.3 19.8 12.5 0.3

17.1 13.6 30.4 17.9 12.5 2.1

19.3 15.1 33.6 20.2 13.4 2.9

20.0 15.4 35.9 20.9 15.0 6.7

Data provided by the Solomon Islands authorities; and staff

Government Shareholding Agency.

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Table 2.

Solomon Islands:

Monetary Survey, 1978-April 1982

(In millions of Solomon Islands dollars) 1/

1978 Outstanding at end of period

1979 December

1980 Feb.

1982 1981 Apr. Dec. Aug. Program Projections

Net foreign assets

24.3

30.7

22.5

15.3

15.5

20.1

20.0

Domestic credit to: Government (net) Statutory corporations Private sector

3.9 -1.8 (--) 5.7

10.9 -2.5 2.8 10.6

16.9 -5.6 5.2 17.3

18.6 -4.0 4.8 17.8

25.8 -2.1 5.6 22.3

27.0 -3.1 6.1 24.0

30.8 -2.3 7.1 26.0

Broad money Money supply Quasi-money

27.5 8.0 19.5

41.3 11.1 30.2

37.7 15.1 22.6

33.6 14.4 19.2

40.4

46.2

49.6

Other items (net)

-0.7

-0.3

-1.7

-0.3

-0.9

-0.9

-1.2

Broad money, excluding deposits of Copra Board

22.9

33.1

31.6

28.3

28.5

30.5

33.7

Memorandum item: Average broad money/GDP ratio (in per cent)

Source:

31.4

Data provided by the Solomon Islands authorities.

1/ Data for 1978 and 1979 are not fully comparable with data thereafter because of revisions in commercial banks' reporting to the SIMA.

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Table 3.

Solomon Islands:

Balance of Payments, 1979-May 1981/April 1982 (In millions of SDRs)

1979

1980 Estimate

1981

Trade balance Exports, f.o.b. Imports, f.o.b. Of which: petroleum products

8.7 53.8 -45.1 (-5.7)

-0.3 56.6 -56.9 (-8.8)

-10.1 55.0 -65.1 (-12.2)

-9.5 59.0 -68.5 (-12.5)

Services (net) Receipts Payments Of which: profits and dividends

-15.2 4.0 -19.2 (-3.6)

-24.0 9.0 -33.0 (-11.5)

-24.2 9.5 -33.7 (-8.7)

-24.5 10.0 -34.5 (-8.2)

Transfers receipts (net) Official Private

May 1981April 1982 Projection

15.3 14.6 0.7

15.2 14.7 0.5

18.6 18.0 0.6

18.8 18.2 0.6

Current account

8.8

-9.1

-15.7

-.15.2

Nonmonetary capital (net) Private Government

4.9 3.1 1.8

2.4 -0.7 3.1

14.1 4.6 9.5

13.6 4.8 8.8

Allocation of SDRs

0.2

0.2

0.2

0.2

-8.2

-1.1

-0.9

-0.9

5.7

-7.6

-2.3

-2.3

2.3 2.3 -4.5 6.8 (5.6) (1.2)

2.3 2.3 -2.1 4.4 (2.8) (1.6)

27.7 4.3

29.8 4.3

Errors and omissions (net) Overall balance Monetary movements (net) Monetary authorities Change in foreign assets (- increase)l/ Change in foreign liabilities Of which: compensatory borrowing use of Fund credit

-5.7 -5.7 -5.7 -(--)

7.6 7.6 7.6 -() (--) (--)

Memorandum items: Gross international reserves Outstanding at end of period In months of import payments Conversion factors (SI$ per SDR) Average End period

Sources: 1/

28.1 6.2 1.12 1.13

Data provided by the Solomon Islands

23.2 4.1 1.08 1.02

1.05 1.05

1.05 1.05

authorities.; and staff estimates.

Converted at the average SI$/SDR exchange rate.

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Solomon Islands: Value, Volume, and Unit Value of Major Exports, 1979-82 1/

(Value in millions of SDRs; volume in thousands of metric tons; unit value in SDR per metric ton)

Weight 2/

Total Value Volume Unit value Fish (fresh and canned) Value Volume Unit value Fish (canned and smoked) Value Volume Unit value Cocoa Value Volume Unit value Copra Value Volume Unit value Timber Value Volume ('000 cu. m.) Unit value (SDR/cu. m.) Palm oil Value Volume Unit value Rice Value Volume Unit value Other 4/ Value Sources:

1979

1980

Projection 1981 1982

100.0

53.8 (92) (30) (48)

56.6 (5) (-1) (6)

55.0 (-3) (13) (-14)

63.6 (16) (9) (6)

19.0

13.0 (183) 23.4 (127) 556 (26)

18.3 (41) 21.6 (-8) 847 (52)

19.2 (5) 24.0 (11) 800 (-6)

20.8 (8) 26.0 (8) 800 (--)

7.0

2.1 (-3) 0.9 (--) 2,317 (-3)

3.3 (57) 1.0 (11) 3,305 (43)

3.0 (-9) 1.0 (--) 2,950 (-11)

3.1 (3) 1.0 (--) 3,140 (6)

2.0

0.6 (4) 0.3 (19) 2,023 (-11)

0.6 (--) 0.4 (33) 1,617 (-20)

0.7 (17) 0.5 (25) 1,480 (-9)

1.0 (43) 0.6 (20) 1,660 (12)

27.0

15.1 (110) 34.3 (31) 441 (60)

9.8 (-35) 27.5 (-20) 355 (-20)

7.7 (-22) 28.5 (4) 270 (-24)

8.7 (13) 30.0 (5) 290 (7)

24.0

13.2 (106) 258 (5) 51 (96)

14.2 (8) 263 (2) 54 (6)

13.4 (-6) 305 (16) 44 (-19)

17.5 (31) 365 (20) 48 (9)

13.0

5.9 (37) 12.8 (24) 461 (12)

6.1 (3) 15.6 (22) 3/ 394 (-15 )-

5.8 (-5) 15.3 (-2) 380 (-4)

6.5 (12) 15.8 (3) 410 (8)

2.0

0.9 (13) 4.2 (35) 204 (-16)

1.4 (56) 5.1 (21) 274 (34)

1.6 (14) 5.0 (-2) 320 (17)

1.8 (13) 5.5 (10) 330 (3)

6.0

3.0 (58)

2.9 (-3)

3.6 (24)

4.2 (17)

Data provided by the Solomon Islands authorities; and staff estimates.

1/ Figures in parentheses are percentage rates of change. 2/ Calculated on the basis of 1977-78 average export value. S/ Includes 1,900 tons of 1979 production shipped in early 1980. 4/ Includes mainly sawn timber, gold, palm kernels, marine shells, and manufactured tobacco.

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by only 6 per cent. Owing primarily to a decline in the imports of consumer goods, the growth of imports slowed substantially (from 60 per cent in 1979 to 26 per cent in 1980) despite the increase in oil prices;l/ nevertheless, the trade balance turned from a large surplus in 1979 into a small deficit in 1980. The services account also deteriorated-largely because of an increase in remittances of profits and dividends reflecting the favorable profit situation in 197 9--so that the current account, which showed a surplus of SDR 9 million in 1979, recorded a deficit of about the same amount in 1980. At the same time, the private capital account, which normally shows a net inflow, registered a net outflow, as the Government encouraged local financing in preference to external financing of certain private sector investment and allowed the joint-venture fishing company to use local borrowing to repay part of an external loan at a time when reserves were still relatively high. Overall, the balance of payments recorded a deficit of nearly SDR 8 million in 1980, compared with a surplus of almost SDR 6 million in 1979. The deficit was financed by use of international reserves.

III.

The Economic Program

Largely because of a decline in export prices, Solomon Islands is confronted with a projected 23 per cent deterioration in the terms of trade in 1981. To cope with this situation, the policy response of the authorities has been a combination of adjustment measures and reliance, for the first time, on external borrowing in commercial markets. In addition to measures designed to expand the volume of exports, the adjustment policies include measures aimed at increasing the mobilization of domestic resources and restraining consumption in order to moderate the growth of imports. To this end, the authorities introduced in early 1981 several important revenue measures, including a 20 per cent increase in all non-oil import duties; decided to maintain the policy of wage restraint followed during the past two years; and depreciated the Solomon Islands dollar by about 6 per cent. These, as well as other measures that the authorities have taken or plan to take in support of the program, are described below. The program envisages a rate of growth of 5 to 6 per cent and, taking into account the domestic price effect of the depreciation and the increase in import tariffs, a rate of inflation of 12 to 14 per cent. The overall balance of payments deficit is projected to decline to about SDR 2.3 million in 1981. Economic growth in 1981 is expected to come from an increase in the volume of exports and investment; disposable income and consumption are expected to decline in real terms. The program contains the following performance criteria: (a) phased ceilings on total domestic credit with a subceiling on net credit to 1/ The price-induced increase in the oil import bill accounted for 26 per cent of the increase in total imports.

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Government; (b) limits on the contracting of public and publicly guaranteed external borrowings; and (c) the standard commitment with regard to exchange restrictions and practices. 1.

Investment and energy policies

Solomon Islands has considerable potential for export growth in agriculture, forestry, and fishing, and for import substitution in the energy sector. The major ongoing investment programs include the construction of a hydropower project and new investments in the palm oil, timber, cocoa, and fishing industries. With the exception of the hydropower project, most of the projects are joint ventures between the Government and foreign investors and produce almost entirely for export. In most cases, the Government is a sizable minority shareholder, giving it important board representation while responsibility for management is left with the foreign partners.l/ The Government's investment program is being financed principally by foreign grants from bilateral sources, mainly the United Kingdom, Australia, and Japan, and by concessional loans from multilateral institutions, i.e., the Asian Development Bank, the European Development Fund, IDA,2/ and the OPEC Fund. In the palm oil industry, the Government plans to expand the area under cultivation by about 15 per cent during 1981-82. This expansion, together with the coming into full production of earlier plantings, will ensure continued growth of palm oil production during the coming years; palm oil production is projected to increase by about 40 per cent between 1980 and 1986. Ongoing investment in the timber industry is projected to increase the volume of timber exports by an average of nearly 20 per cent per year in 1981-82. Further, the authorities are studying the possibility of licensing new areas for exploitation if this proves to be consistent with the objectives of long-term forest management. Based on the success of cocoa plantings on a limited scale in the early 1970s, the Government has now undertaken an extensive cocoa planting program that is expected to develop cocoa into a major export item by the second half of this decade. The program to expand the fishing fleet also continues, with the objective of nearly doubling the fish catch over the next five years. The construction of a new cannery during 1981-83 is expected to triple the production of canned fish, which will enable Solomon Islands to earn a higher value-added on fish exports; at present, Solomon Islands exports mostly frozen fish for canning abroad. 1/ The Government's participation in joint ventures is carried out through the Government Shareholding Agency (GSA). The twin objectives of the GSA are to acquire for the Government a substantial part of the ownership of major commercial operations and to promote development in accordance with national priorities. These objectives recognize Solomon Islands' human resource constraint and therefore the important role of expatriate managerial and technical expertise, as well as the need for direct finance provided by foreign investment in the development strategy. GSA's equity share has not exceeded 49 per cent in commercial operations. 2/ World Bank Group operations in Solomon Islands are described in Appendix III.

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A major goal of the Government's development policy is to increase the involvement of village communities in the economy by expanding the opportunities for earning cash income. To this end, the Government continues to strengthen and expand the operations of the Development Bank of Solomon Islands, which is the only source of long-term finance for small- and medium-sized projects. With assistance from the IBRD, the Government is preparing a multi-sector project which aims at improving education and infrastructure in village areas. The bulk of Solomon Islands' energy supply comes from imported oil. In 1980, imports of petroleum products represented 15 per cent of total imports, of which nearly a third was used by the fishing fleet. To encourage conservation, the Government's policy has been to raise domestic energy prices in line with the import prices of oil. In early 1981, the taxes on petroleum products were substantially increased. To reduce oil dependency, the Government has undertaken the construction of a hydropower project near the capital city of Honiara, on the Lungga river. When completed, this project will have the capacity to meet the expected electricity demand of Honiara and the surrounding region up to the end of this century.l/ The first phase of this project is expected to be completed by 1985 and will result, at present oil prices, in a saving equivalent to about 20 per cent of the current oil import bill. 2.

Fiscal policy

The main objectives of fiscal policy in 1981 are to increase the mobilization of domestic resources and to restrain the growth of current expenditures in order to support the development effort. Total domestic revenue is projected to increase by over 18 per cent in 1981, or by about 1 percentage point as a ratio of GDP. This increase takes place against the background of a reduction in receipts from the company income tax, reflecting the less-favorable profit situation in 1980,2/ and a sharp fall in the export duties on copra because of a decline in the average copra export price; the fall in copra export duties in 1981 is equivalent to about 2 per cent of total domestic revenue. Revenue measures taken in 1981 include a 20 per cent increase in nominal import duties on all non-oil imports; a substantial upward adjustment in fees and charges for almost all government services, most importantly for sea transport on which the charges were raised by 50 per cent; and the introduction of ad valorem taxation of petroleum products to replace a system of specific taxes, a change that more than doubled the average rate of taxation on petroleum products to a range of 10 to 20 per cent. The addition to revenue from these measures is estimated at about 7 per cent of total domestic revenue (about 1.4 per cent of GDP) in 1981. 1/ See Appendix III for further details on the hydroproject. 2/ Since most of the large companies operating in Solomon Islands are engaged in export business, company profits are sensitive to variations in exports.

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In the attached letter, the authorities have indicated their intention of undertaking a general review of the import tariff system in 1981. The main purpose of the review would be to support resource mobilization in the 1982 budget. Taking into account the recent adjustment in tariff rates, the average ratio of import duties to imports is estimated at just over 10 per cent. This relatively low ratio reflects the fact that most intermediate imports and items of machinery enter duty free. Foodstuffs are either not taxed or bear rates that do not generally exceed 20 to 25 per cent. Nonluxury consumer goods are taxed at rates generally ranging from 25 to 40 per cent and most durable luxury goods at 50 per cent. There is, therefore, scope for raising additional revenue from further increases in import duties. Given the adjustments in income tax rates made in 1980 1/ and the need to maintain incentives to undertake new investments and to attract expatriate managerial and technical expertise, an upward revision of income taxes is not now regarded by the authorities as a productive way to mobilize resources. In order to contain the growth of budgetary expenditure, salary increases for permanent employees in the public sector have been limited to 8 to 12 per cent for 1981. The wage awards are inversely related to rank, and the average increase of 11 per cent, as compared with the projected rise in prices, implies a decline in real salaries for the third consecutive year. Contrary to government intentions, temporary employees were recently awarded a 15 to 18 per cent increase by an independent arbitration tribunal. Although the wage bill for these employees is relatively small, a reduction in the number of temporary workers to offset the larger award is under consideration as a step to demonstrate the Government's determination on its wage policy. While the decision to restrain wages will limit the growth of the wage bill to less than 15 per cent, other current outlays will rise more rapidly, owing primarily to the need to provide a more adequate level of public services. Nevertheless, total current outlays are projected to grow by about the same amount as domestic revenue. Reflecting the implementation of development projects, capital expenditure and net lending are projected to rise by 27 per cent. This includes relatively large expenditures on the hydropower projects and on the expansion of the fishing fleet. As a result, the fiscal deficit is projected to expand to nearly 7 per cent of GDP.2/ Given that all project loans from multilateral development institutions and governments transit through the budget, the rise in the overall deficit is largely accounted for by the growth in expenditures financed 1/ In 1980, the company income tax rate was raised from 30 to 35 per cent and the personal income tax rates were raised from a range of 11 to 40 per cent to a range of 15 to 45 per cent. The maximum marginal income tax rate is reached at SI$20,000 of taxable income. 2/ The projected expenditure on the hydropower project and associated housing is equivalent to over 60 per cent of the increase in the budget deficit.

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from this source, which will cover two thirds of the deficit. Most of the remaining deficit will be financed from net domestic bank borrowing which is projected at SI$2.5 million, or about 7 per cent of total liquidity at the end of 1980. This use of bank resources reflects to a large extent the liquidation of an unusual buildup of government deposits with the banking system in the last quarter of 1980, partly resulting from disbursements of foreign aid. The rest of the deficit will be financed from domestic nonbank borrowing, mainly from the National Provident Fund and private companies. 3.

Monetary and credit policy

Consistent with the liquidity needs of the economy based on the growth and price targets, broad money is projected to increase by 23 per cent during 1981 and by about 7 per cent during January-April 1982, i.e., at about the same annual rate as during 1981. This expansion in broad money takes into account the rebuilding of company deposits to more normal levels following the sharp drop in such deposits during the first two months of 1981. Despite this rebuilding, the average ratio of broad money to GDP is expected to decline from about 34 per cent in 1980 to 31 per cent in 1981 (Table 2). Taking into account the balance of payments target, the program allows for a total domestic credit expansion of 60 per cent during 1981 and for an annual rate of growth of 48 per cent during January-April 1982. This relatively rapid growth rate reflects the fact that, in the past, domestic credit has provided only a small part of the liquidity needs of the economy, which have been satisfied mostly by the external sector.l/ Reflecting the impact of the expected pattern of the Government's receipts and disbursements on its financing requirements, net credit to Government is projected to rise by SI$3.5 million during the first eight months of 1981, but is forecast to decline by SIS1 million during the last four months of the year; it is expected to rise again, but more moderately, during January-April 1982. Given the liquidity position of commercial banks, it is expected that the SIMA will have to lend to banks to satisfy the credit needs of the economy. This will be implemented by the Government borrowing on external commercial markets and depositing the proceeds of the borrowing with the SIMA, which will onlend the funds to banks for the financing of selected private sector projects.2/ 1/ Despite a rapid expansion in domestic credit since Solomon Islands introduced its own currency, total domestic credit still represents only about 12 per cent of GDP. Comparable figures for some selected countries in the Asian region are 48 per cent for Korea, 34 per cent for Malaysia, 33 per cent for the Philippines, 22 per cent for Fiji, and 17 per cent for Papua New Guinea. 2/ Government deposits with the SIMA of the proceeds of external borrowings for the purpose of onlending will not affect net bank credit to the Government as defined under the program.

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In an effort to strengthen its control over credit expansion, the SIMA introduced in January 1981 a 5 per cent reserve requirement on commercial banks. At the same time, the SIMA issued, as a precautionary step, guidelines inviting banks to regulate personal advances with a view to curbing credit for import purposes; avoiding financing excessive inventories; and taking all necessary steps to reduce leads and lags with respect to import payments and the repatriation of export proceeds. Interest rates on bank deposits in Solomon Islands range from 3.5 per cent on savings deposits to 6.5 per cent on 180-day time deposits. These rates are relatively low compared with those prevailing in major trading partners and, at the present rate of inflation, imply fairly substantial negative real interest rates on deposits. Bank lending rates in Solomon Islands have been generally similar to Australian rates and presently average about 11 per cent. This implies a sizable spread between deposit and lending rates. The authorities stated that, despite this spread, banking business had not been profitable until recently because of the small scale of operations and the low level of charges on services associated with foreign exchange operations. The authorities believe that a significant upward adjustment in lending rates would be counterproductive at the present stage of development because it would deter new investment. The authorities recognize that the level and structure of interest rates will be affected by government policy later in the year when the SIMA starts its lending to banks. Accordingly, the question of interest rates, as well as the modalities of the SIMA's lending, are now under study by the authorities. The Government continues its efforts to strengthen and build up the financial system. In March 1981, the National Bank of Solomon Islands (NBSI) was established as a joint venture between the Commonwealth Bank of Australia and the Solomon Islands Government. Among the priorities of the NBSI are to bring banking services to rural areas and to train local staff in banking. In order to strengthen monetary management over the longer term, the authorities are exploring the possibility of gradually transferring the deposits of the Copra Board from commercial banks to the SIMA, which would become the sole depository. Such an arrangement would ensure that the surpluses of the Copra Board would not lead to an excessive expansion of the credit base and that an accumulation of surpluses would be matched by an increase in official international reserves. 4.

External policies

An important element of external policy has been the depreciation of the Solomon Islands dollar by about 6 per cent effective March 3, 1981. Since October 1979, the Solomon Islands dollar, which had been previously pegged to the Australian dollar, has been pegged to a basket Between October 1979 and of currencies of four major trading partners. December 1980, the trade-weighted real effective exchange rate for the Solomon Islands dollar appreciated by about 6 per cent. The depreciation is expected to moderate the demand for imports and mitigate the impact

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of the decline in world commodity prices on the profitability of exports. At the time of the depreciation, the authorities changed the relative weights of the four currencies in the basket to reflect settlement rather than trade patterns. Because of the prospective sharp deterioration in the terms of trade, the current account deficit is projected to increase from SDR 9 million (about 8 per cent of GDP) in 1980 to about SDR 16 million (12 per cent of GDP) in 1981. This implies substantial external adjustment--equivalent to more than 5 per cent of GDP--since the increase in the current account deficit which would be due to the deterioration in the terms of trade alone (approximately 10 per cent of GDP) is more than twice as large as the projected widening of the deficit. The adjustment will be achieved mainly by a 13 per cent growth in the volume of exports. Despite the growth in volume, export earnings are forecast to decline by 3 per cent, as the average unit value of exports is projected to fall by 14 per cent.l/ Import payments are projected to grow by 14 per cent. This growth is due almost entirely to an increase in prices, 2/ since the total volume of imports is expected to virtually stagnate; while the volume of imports of development goods will expand, that of consumer goods is projected to decline, owing to a reduction in household incomes, mainly in the rural sector.3/ The bulk of the current account deficit will be financed by mediumand long-term capital inflow which is projected to increase substantially (a) an increase in private capital inflow; the policy of in 1981 due to: the authorities will be to ensure, through credit policy and suasion, that a substantial part of the financing of private sector investment is met from external sources; (b) an increase in concessional borrowing associated with development projects; and (c) borrowing by the Government in commercial markets. The Government intends to contract a loan of about SDR 20 million in the Euro-currency market, of which approximately half is expected to be drawn in 1981. The overall balance of payments deficit is projected at SDR 2.3 milin 1981. The deficit is to be financed by use of Fund credit and compensatory external borrowing. Gross international reserves are projected to rise by SDR 4.5 million in 1981; this implies that reserves will reach the equivalent of about four months of import payments at the end of 1981, In view of the lumpii.e., about the same level as at the end of 1980. ness in balance of payments flows inherent in the functioning of a small 1/ The average export price of copra is projected to fall by 24 per cent, timber by 19 per cent, cocoa by 9 per cent, fish by 6 per cent, and palm oil by 4 per cent (Table 4). 2/ Non-oil import prices are projected to increase by 10 per cent and oil prices by 15 per cent. 3/ Income from copra sales is projected to decline by about 6 per cent, as a 4 per cent growth in output is expected to be offset by a 10 per cent reduction in the average producer price. This implies some cushioning of the producer price by the Copra Board against the fall in the export price.

- 15

economy and given the dependence of exports on a few primary commodities, the prices of which are subject to wide fluctuations, the authorities regard a level of reserves equivalent to at least four months of import payments as necessary for efficient management. During the progam period (May 1981-April 1982), the same balance of payments trends as in 1981 are projected to prevail (Table 3), except that export performance is expected to improve beginning in early 1982 as a result of an anticipated upturn in export prices. During 1982 as a whole, exports are forecast to increase by 16 per cent; the volume of exports is projected to rise by 9 per cent and the average export unit value by 6 per cent (Table 4). The volume of all major exports is projected to increase, with the volume of cocoa, timber, and fish expected to record the fastest growth. Because of the availability of foreign grants and loans on concessional terms, Solomon Islands' external public debt is equivalent to only about 6 per cent of GDP, and the external public debt service ratio is less than 1 per cent. The authorities have undertaken to limit to SDR 40 million the contracting of new public and publicly guaranteed external loans with maturities between 1 to 12 years during the program period. No borrowing is intended with maturities of 1 to 5 years. The SDR 40 million includes, in addition to the Euro-currency loan, a loan of SDR 10 million from the Commonwealth Development Corporation for the partial financing of the hydropower project and associated housing and SDR 10 million for other development projects. Drawings under these loans will be phased over several years. The external public debt service ratio is not expected to rise significantly in 1981 and is projected to be about 3 per cent in 1982.

V.

Staff Appraisal

The impressive progress achieved by Solomon Islands in recent years has been the result of determined efforts on the part of the Government to expand and diversify export production in agriculture, forestry, fishing, and import substitution in food. Solomon Islands has large underutilized natural resources, and one of the major objectives of the authorities is to draw these resources into production. The high priority attached by the authorities to continued promotion of export production should help ensure a broad-based improvement in living standards, as well as a viable balance of payments over the medium term. After several years of balance of payments strength, Solomon Islands' external position weakened considerably in 1980, as a deterioration in the terms of trade was compounded by a fall in the production of copra and fish. The weakening of the balance of payments was reinforced by an increase in remittances of profits and dividends and a net outflow of private capital. Despite a substantial slowdown in the growth of imports, both the current and the overall balance of payments registered large deficits.

- 16 -

In 1981, Solomon Islands is faced with a further sharp deterioration in the terms of trade, owing largely to a decline in commodity prices. To cope with this situation, the authorities have focused on measures to encourage the mobilization of domestic resources and to restrain domestic demand. The revenue measures introduced in 1981 are a significant step toward improving domestic resource mobilization through the budget. The decision to maintain the policy of wage restraint followed over the last two years will contribute to moderating domestic demand. The depreciation of the Solomon Islands dollar should help restrain imports and alleviate the impact of the decline in commodity prices on the profitability of exports. Finally, the steps taken to increase the control of the Solomon Islands Monetary Authority over credit expansion will strengthen short-term demand management. The authorities' intention of reviewing the import tariff system in the context of the 1982 budget is welcome. It is also important that interest rates be set at levels that would encourage mobilization of savings. An opportunity to revise interest rates will be provided to the authorities when the Solomon Islands Monetary Authority is expected to start lending to banks later this year. The current account deficit of the balance of payments is projected to increase in real terms during 1981, but the increase is equivalent to less than half of the deterioration in the current account due to the decline in the terms of trade, which implies substantial external adjustment. The adjustment will be achieved mainly by a growth in the volume of exports and a decline in consumption, rather than a slowdown in investment. Balance of payments prospects for 1982 depend importantly on developments in commodity prices. The authorities recognize that if the expectation of an improvement in these prices in early 1982 does not materialize, further adjustment measures will be needed. The staff believes that the present program represents a substantial effort to cope with the balance of payments situation faced by Solomon Islands. Accordingly, the following draft decision is proposed for adoption by the Executive Board: 1.

The Government of Solomon Islands has requested a

stand-by arrangement equivalent to SDR 1.6 million.

In the

letter attached to EBS/81/101, the Government of Solomon Islands states the objectives and policies that it will pursue. 2.

The Fund notes the objectives and policies stated in

the letter and approves the stand-by arrangement in accordance with the request.

- 17 -

APPENDIX I

Fund Relations with the Solomon Islands

Date of membership:

September 22, 1978.

Quota:

SDR 3.2 million

Article VIII status:

The Solomon Islands Government accepted the obligations of Article VIII, Sections 2, 3, and 4.

Trust Fund:

Not eligible

Use of Fund resources:

None outstanding. A CFF drawing was repurchased in December 1979.

Fund holdings of Solomon Islands dollars (as of March 31, 1981): SDR holdings (as of March 31, 1981):

SDR 2.47 million, or 77.48 per cent of quota.

SDR 1.18 million, 181.28 per cent of net cumulative allocation of SDR 654,400.

Exchange rate system:

Since October 1979, the Solomon Islands dollar has been pegged to a weighted basket of currencies of four of its major trading partners: the U.S. dollar, the Australian dollar, the Japanese yen, and the pound sterling. Effective March 3, 1981, the Solomon Islands dollar was depreciated by about 6 per cent. The representative rate of the Solomon Islands dollar established with the Fund is the rate for the U.S. dollar obtained on the basis of the midpoint between buying and selling rates for the Solomon Islands dollar against the Australian dollar and the representative rate for the Australian dollar.

Technical assistance:

The Fund is currently providing two experts under the CBD Technical Assistance Program, serving as Chairman and as Banking Manager of the Solomon Islands Monetary Authority.

Last Article IV consultation:

October 29, 1980 (SM/80/244); staff discussions were held during September 1-14, 1980.

APPENDIX II

- 18 Basic Data

Area:

28,896 square kilometers

Population (1979):

221,000

GDP per capita (1979):

SDR 409 1978

1979

1980 Est.

1981 Proj.

5.6 9.2

11.2 9.7

-4.5 15.8

4.0-5.0 12.0-Ob0

Money and credit (annual rates of change in per cent): 1/ Broad money Total domestic credit Credit to private sector 2/

40.7 5.6 3.6

50.2 179.5 135.1

-8.7 55.1 67.9

22.6 59.8 33.8

Public finance (annual rates of change in per cent): Domestic revenue Current expenditure Capital expenditure and net lending Total expenditure

23.1 18.9 66.0 34.3

41.5 20.3 32.7 25.2

17.8 17.5 11.4 17.5

18.3 17.9 27.5 21.7

11.0 -10.0 -16.0 -22.0

30.0 48.0 46.0 9.0 36.0

-1.0 6.0 12.0 13.0 -6.0

13.0 -14.0 l. II. -23.0

28.0 7.2 6.2 4.3 6.7 28.3 -0.3 3.7 11.5

53.8 15.2 13.1 5.9 15.1 45.1 8.7 8.8 5.7

56.6 9.7 14.1 6.2 21.5 56.9 -0.3 -9.1 -7.6

55.0 7.6 13.3 5.8 22.2 65.1 -10.1 -15.7 -2.3

Output and prices (annual rates of change in per cent): Real GDP Consumer prices

Foreign trade (annual rates of change in per cent): Export volume Export unit value Import volume Import unit value Terms of trade Balance of payments (SDR million): Exports (f.o.b.) Of which: Copra Timber Palm oil Fish Imports (f.o.b.) Trade balance Current account balance Overall balance

APPENDIX II

- 19 -

Basic Data (concluded)

1978

1979

1980 Est.

1981 Proj.

Gross international reserves (end of period): In millions of SDRs In months of imports

22.1 7.8

28.1 6.2

23.2 4.1

27.7 4.3

Selected financial ratios (in per cent): Current account surplus or deficit/GDP Government sector deficit/GDP External debt/GDP 3/ External debt service ratio 3/ Oil imports/total imports

5.0 0.3 1.2 -11.3

8.8 2.1 2.8 0.1 12.6

-8.3 2.9 5.6 0.2 15.5

-12.3 6.7 12.4 1.7 18.7

Sources:

Data provided by the Solomon Islands authorities; and staff estimates.

1/ Data for 1978 and 1979 are not fully comparable with data thereafter. 2/ Includes statutory corporations. 3/ Refers to external public debt only; no data is available on external private sector debt.

APPENDIX III

- 20 -

World Bank Group Operations in Solomon Islands Summary

Project Status

Date of Approval

Purpose

Amount US$ mn.

Terms

1.

Approved

February 1981

Development Bank of Solomon Islands (DBSI)

Relending

1.5

IDA

2.

Proposed

October 1981 (estimated)

Government of Solomon Islands

Hydropower

2.0

IDA

3.

Proposed

February 1982 (estimated)

Government of Solomon Islands

Multisector

5.0

IDA

Beneficiary

Project Description 1.

The project will assist the DBSI in providing finance for investments in the agricultural, industrial, commerce, transportation, and service sectors for the period 1981-82. The project is expected to benefit about 500 sub-borrowers whose total fixed investment cost is estimated at US$8.4 million and help increase the involvement of the indigenous population in the economy. Cofinancing with AsDB.

2.

The proposed project of hydropower development will provide for a dam across the Lungga gorge, which will form a reservoir to be developed in two stages with an ultimate capacity of 155 million cubic meters and a power capacity of 21 mw. Power output in the first stage will amount to 7.5 mw. The project is large (US$30.5 million of foreign exchange costs) in relation to economy; however, substantial foreign exchange savings will be realized by its implementation. Cofinancing with AsDB.

3.

The proposed project is likely to consist of two components: education and transportation. The education component would assist the Government to help provinces and communities increase access to primary schools by creating new and upgrading established facilities, provide training to raise the quality of teachers, assist in the development of more relevant curricula, and improve management. The aim of the proposed transportation component is to provide sea access to isolated areas with agricultural potential located on coastal plains and in river valleys. Construction of jettys, feeder roads, and copra storage sheds are included.

- 21 -

ANNEX I

Solomon Islands--Stand-By Arrangement

Attached hereto is a letter dated April 24, 1981 from the Minister of Finance of Solomon Islands requesting a stand-by arrangement and setting forth the objectives and policies that the authorities of Solomon Islands intend to pursue for the period of this arrangement. To support these objectives and policies, the International Monetary Fund grants this stand-by arrangement in accordance with the following provisions: 1. For a period of one year beginning , 1981, Solomon Islands will have the right to make purchases from the Fund in an amount equivalent to SDR 1.6 million, subject to paragraphs 2, 3, and 4 below, without further review by the Fund. 2. Purchases under this arrangement shall not, without the consent of the Fund, exceed the equivalent of SDR 0.8 million until September 30, 1981 and the equivalent of SDR 1.2 million until January 31, 1982, but none of these limits shall apply to a purchase under the stand-by arrangement that would not increase the Fund holdings of Solomon Islands' currency in the credit tranches beyond 25 per cent of quota. 3. Solomon Islands will not make purchases under this arrangement that would increase the Fund holdings of its currency in the credit tranches beyond 25 per cent of quota: (a)

during any period in which the data at the end of the preceding period indicate that the limits on total domestic credit of the banking system or the limits on net credit from the banking system to the Government referred to in paragraph 13 of the attached letter are not observed; or

(b)

if Solomon Islands (i)

imposes or intensifies restrictions on payments and transfers for current international transactions, or

(ii)

introduces multiple currency practices, or

(iii)

concludes bilateral payments agreements which are inconsistent with Article VIII, or

(iv)

imposes or intensifies import restictions for balance of payments reasons, or

(v)

fails to observe the limits on the contracting of new public and publicly guaranteed external borrowings described in paragraph 14 of the attached letter.

- 22 -

ANNEX I

When Solomon Islands is prevented from purchasing under this arrangement because of this paragraph 3, purchases will be resumed only after consultation has taken place between the Fund and Solomon Islands and understandings have been reached regarding the circumstances in which such purchases can be resumed. 4. Solomon Islands' right to engage in the transactions covered by this arrangement can be suspended only with respect to requests received by the Fund after (a) a formal ineligibility, or (b) a decision of the Executive Board to suspend transactions, either generally or in order to consider a proposal, made by an Executive Director or the Managing Director, formally to suppress or to limit the eligibility of Solomon Islands. When notice of a decision of formal ineligibility or of a decision to consider a proposal is given pursuant to this paragraph 4, purchases under this arrangement will be resumed only after consultation has taken place between the Fund and Solomon Islands and understandings have been reached regarding the circumstances in which such purchases can be resumed. 5. Purchases under this arrangement shall be made in the currencies of other members selected in accordance with the policies and procedures of the Fund, and may be made in SDRs if, on the request of Solomon Islands, the Fund agrees to provide them at the time of the purchase. 6. Solomon Islands shall pay a charge for this arrangement in accordance with the decisions of the Fund. 7. (a) Solomon Islands shall repurchase the outstanding amount of its currency that results from a purchase under this arrangement in accordance with the provisions of the Articles of Agreement and decisions of the Fund, including those relating to repurchase as Solomon Islands' balance of payments and reserve position improves. (b) Any reductions in Solomon Islands' currency held by the Fund shall reduce the amounts subject to repurchase under (a) above in accordance with the principles applied by the Fund for this purpose at the time of the reduction. 8. During the period of the arrangement, Solomon Islands shall remain in close consultation with the Fund. These consultations may include correspondence and visits of officials of the Fund to Solomon Islands or of representatives of Solomon Islands to the Fund. Solomon Islands shall provide the Fund, through reports at intervals or dates requested by the Fund, with such information as the Fund requests in connection with the progress of Solomon Islands in achieving the objectives and policies set forth in the attached letter.

- 23 -

ANNEX I

9. In accordance with paragraph 17 of the attached letter, Solomon Islands will consult the Fund on the adoption of any measures that may be appropriate at the initiative of the Government or whenever the Managing Director requests consultation because any of the criteria in paragraph 3 above have not been observed or because he considers that consultation on the program is desirable. In addition, after the period of the arrangement and while Solomon Islands has outstanding purchases in the upper credit tranches, the Government will consult with the Fund from time to time, at the initiative of the Government or at the request of the Managing Director, concerning Solomon Islands' balance of payments policies.

- 24 -

ANNEX II

Honiara, Solomon Islands April 24, 1981

Dear Mr. de Larosiere: 1. I am grateful for the Fund's prompt response to our request for consultation on financing the balance of payments requirements of Solomon Islands. We have taken the opportunity to review with the Fund staff the overall economic and financial position of our country. 2. Solomon Islands economy has achieved considerable progress in recent years. During 1973-79, aggregate output in real terms grew at an annual average rate of nearly 8 per cent; at the same time, reasonable domestic price stability was maintained. Diversification and sustained expansion of exports, as well as increased substitution of local food production for imports, provided the main stimulus to growth. Fish and palm oil exports increased rapidly, expanding the traditional export base of copra and timber. The development of irrigated rice production led from dependence on rice imports to the emergence of rice exports. In addition, near self-sufficiency has been attained in beef production. Reflecting these developments, together with a steady inflow of aid to the Government's development program, the external position remained strong during 1973-79, with the overall balance of payments recording surpluses in most years. By the end of 1979, gross international reserves had risen to a level equivalent to about six months of import payments. 3. Following an exceptionally good year in 1979, when the average unit value of our exports increased by almost 50 per cent and the value of exports nearly doubled, balance of payments performance fell back considerably in 1980. We experienced a sharp deterioration in Solomon Islands' external terms of trade, which was compounded by a decline in the volume of certain export commodities. Our export earnings grew by less than 2 per cent in 1980. The slowdown in export growth was due primarily to a fall in copra and palm oil prices and a decline in the volume of fish and copra exports, the latter caused in part by a downward adjustment in copra producer prices following international prices. Export performance would have been even weaker had it not been for an increase in fish prices and continued improvements in the production of palm oil and rice. 4. Although slowing considerably, import payments continued to increase faster than exports, owing to a large extent to the rise in oil and other import prices. Oil imports are essential for our primary industries of agriculture, forestry, and fisheries, and the oil price-induced increase in our import bill expressed in terms of the IMF Special Drawing Rights (SDR) in 1980 was SDR 3.1 million, out of an overall rise of SDR 11.8 million. In real terms, however, total imports grew only moderately, and imports of consumer goods actually declined. The trade account, which showed a substantial surplus in 1979, recorded a small

- 25 -

ANNEX II

deficit in 1980. At the same time, there was a sharp increase in remittances of profits and dividends, reflecting the favorable profit situation of the previous year; and the private capital account, which usually had shown a net inflow, recorded a deficit, partly because we made increased use of accumulated savings to finance capital investment at a time when reserves were still relatively high. Overall, the balance of payments registered a deficit of about SDR 7.6 million in 1980, which was almost entirely financed by a drawdown of international reserves. Reserves fell by about a further SDR 6 million during the first two months of 1981. This fall appears to be due to a bunching of import payments, an increase in remittances by temporary residents, and perhaps also some capital outflows in anticipation of an exchange rate adjustment. 5. The principal objective of our economic policy is to sustain investment levels that will make possible continued steady growth in an environment of financial stability. With a stock of underutilized natural resources to be drawn into production, we can undertake a continued dynamic program of development financing of investment in primary industry and some in manufacturing without aggravating price inflation or running into debt service problems. This makes the operative constraint on growth our human resources, a factor that we have explicitly recognized in our forthcoming five-year National Development Plan. Meanwhile, since we expect in 1981/82 a further decline in our export prices and therefore a continuing deterioration in our terms of trade, we have adopted a program designed to restrain consumer demand in the short run, while maintaining the tempo of the development effort in pursuit of our over-riding goal of broadening the production base of the economy. In support of this program, the elements of which are described in the following paragraphs, the Government of Solomon Islands requests from the International Monetary Fund a stand-by arrangement for a period of one year in an amount equivalent to SDR 1.6 million. In recent years, the economy has been driven by a number of large6. scale joint venture investments--including projects in the production of palm oil, timber, fish, and rice--which have significantly increased employment and incomes. Investments of this kind will remain essential for sustained economic growth, and we will continue our efforts to expand the existing projects and bring new projects through identification and finanIn the palm oil industry, our immediate objective is cing into production. to expand the area under palm oil cultivation by about 15 per cent during 1981-82. This expansion, together with the maturing of existing acreage, will ensure continued growth of palm oil production during the coming years. To improve fish exports, we will continue our program of expanding the fishing fleet toward a total catch 60 to 100 per cent higher than at present. Further, a new cannery, which will expand production of canned fish by 300 per cent, is being planned for consruction over 1981-83. Investment in the timber industry will continnued to expand on presently licensed areas, and the Government is considering the opening of new areas for exploitation. On the basis of present licences, we expect timber exports to grow by an average of about 20 per cent per year in 1981-82.

- 26 -

ANNEX II

Based on the success of plantings in the 1970s, we have undertaken an extensive cocoa planting program. Projects now in operation or due to start in 1981 will lead to production on 4,000 hectares by 1985. 7. A major objective of our development policy is to ensure that the benefits of growth are broadly shared. It is therefore important to bring economic development into the village communities which make up the bulk of our population. The expansion of opportunities for earning cash incomes in rural areas and increased involvement of the population in the economy are essential elements of our development strategy. In pursuit of these objectives, we will, with the assistance of the AsDB and the IBRD, continue to strengthen and expand the operations of the Development Bank of Solomon Islands, which is the only source of longterm finance for small- and medium-size development projects. We are also preparing a multisector project, with assistance from the IBRD, which aims at improving education and infrastructure facilities in rural areas. Infrastructure and equipment obtained under this project is designed to increase smallholder production of copra and other crops for export. In general, the development of large-scale commercial plantations also facilitates smallholder development by accelerating the transfer of improved technology into the agricultural sector, upgrading skills, and justifying the development of domestic transport systems, overseas markets and input supplies for the whole industry. 8. An important endeavor of our development policy is to diversify the sources of energy. At present, the bulk of Solomon Islands' energy supply comes from imported oil. To reduce oil dependency, we have undertaken the construction of a hydropower project near Honiara, the capital city. This project, when completed, will have the capacity to meet the expected electricity demoaid in Honiara and surrounding region up to the end of this century. The first phase of this project is expected to be in operation by 1985. In order to encourage conservation, the Government's policy has been to increase domestic energy prices in line with the rise in imported oil prices and to use the import tariff as a further deterrent to unnecessary use of imported fuel. We intend to maintain this policy. 9. The principal objective of our fiscal policy for 1981 is to moderate current outlays through continued wage restraint and to increase the mobilization of domestic resources. Wage increases for permanent employees in the public sector have been limited to between 8 to 12 per cent. Several important measures have been introduced to raise domestic revenues. These included an upward adjustment in fees and charges for government services; a 20 per cent across-the-board increase in all nominal import duties; and the replacement of a system of specific tax levies on petroleum products by ad valorem taxation, which more than doubled the average rate of taxation on these items to a range of 10 to 20 per cent. Reflecting expenditures on a number of large projects, such as the hydropower project, plantation agriculture, forestry, and fisheries projects, capital expenditures are projected to grow relatively

- 27 -

ANNEX II

fast, leading to an increase in the overall fiscal deficit. However, most of the deficit on recurrent and capital accounts combined will be financed through drawings on external project loans, largely obtained on concessional terms, and through domestic nonbank borrowing. Preparations for the 1982 budget are about to begin. We intend to continue our policies of improving the mobilization of domestic resources and avoiding undue reliance on domestic bank borrowing to finance the budget deficit. In line with this policy, we intend to undertake a general review of the import tariff system. 10. Until recently, the Solomon Islands Monetary Authority (SIMA) had refrained from using its credit control powers, preferring to place no restraint on domestic credit expansion to the private sector other than the banks' criteria on the quality of lending. This policy has helped to strengthen business confidence in the years immediately following independence and worked well when the external environment was favorable. With the tightening of overall liquidity and reduction of our reserves to levels requiring positive management, the time has now come for the SIMA to play a more active role in the control of credit. Accordingly, we introduced in January 1981 a 5 per cent reserve requirement on commercial banks. At the same time, the SIMA issued, as a pre(i) regulate personal cautionary step, guidelines inviting banks to: advances with a view to curbing credit for import purposes; (ii) avoid financing excessive inventories; and (iii) take all neccessary steps to reduce leads and lags with respect to import payments and the repatriation of export proceeds. We intend to use credit guidelines and SIMA's control over commercial bank liquidity to ensure that credit expansion will be consistent with the objectives of our program. As part of our credit policy, SIMA plans to make funds available to banks to finance loans for high priority private sector investment projects. Funding for these credits will be obtained through government borrowing on external commercial markets. 11. The level of nominal interest rates in Solomon Islands has not changed significantly in recent years, although inflation has accelerated in the meanwhile. It is our intention to keep under review the level and structure of interest rates with a view to improving the mobilization and allocation of resources. Further, in order to improve monetary management over the longer term, we will explore the possibility of gradually transferring the deposits of the Copra Board from the commercial banks to the SIMA. This change would ensure that large movements in the deposits of the Copra Board would not automatically result in similar movements in commercial bank liquidity. 12. The Government continues its efforts to build up the financial system. In March 1981, the National Bank of Solomon Islands (NBSI) was established. The NBSI is a locally incorporated joint venture between the Commonwealth Bank of Australia and Solomon Islands Government. The important priorities of the NBSI are to bring banking services to rural

- 28 -

ANNEX II

areas and to train local staff in banking. We also plan to set up an insurance company with substantial Solomon Islands ownership. The objective is to improve the insurance services available and to progressively build up the proportion of premium payments retained and reused in Solomon Islands. 13. Credit policy during the program period will aim at providing the liquidity needs of the economy consistent with a 5 to 6 per cent rate of real growth and a 12 to 14 per cent increase in prices. Total domestic credit, which amounted to SI$18.6 million at end-February 1981, will not exceed SI$25.8 million during the period through end-August 1981, SI$27.0 million during the period through end-December 1981, and SI$30.8 million during the remainder of the stand-by arrangement. The Government's net credit position vis-a-vis the banking system, which amounted to SI$4.0 million at end-February 1981, will not fall below SI$2.1 million during the period through end-August 1981, SI$3.1 million during the period through end-December 1981, and SI$2.3 million during the remainder of the stand-by arrangement. This will not include government deposits with the banking system on account of external commercial market loans by the Government. The purchases from the Fund will be made by the Solomon Islands Monetary Authority and will therefore not affect the Government's net position vis-a-vis the banking system. 14. Since most of our external development assistance has been obtained in the form of grants or soft-term loans, Solomon Islands' external public debt service represents less than 1 per cent of exports of goods and services. Our development strategy in natural resources and energy sectors requires us now to undertake financing on a scale that cannot be matched by any combination of savings within the economy, official aid, and concessionary loans. A rapid increase in our external public debt on commercial or near-commercial terms is inevitable if we are to achieve our aims of export production and import replacement in the coming decade. Nevertheless, during the program period, we will limit the contracting of new public and publicly guaranteed external borrowing with an original maturity of more than 1 year and up to and including 12 years to an amount not to exceed SDR 40 million; drawdowns on these loan commitments will be phased over several years. We will not contract any public or publicly guaranteed external borrowing with maturities of 1 to 5 years. Within the limit of SDR 40 million, we expect that about SDR 10 million will be borrowed from the Commonwealth Development Corporation for the partial financing of the Lungga hydropower project and associated housing; up to SDR 10 million for other major development projects in a suitable mix with concessionary and equity-type finance; and SDR 20 million from commercial markets for relending for project finance and for rebuilding official external reserves. At the end of February 1981, official reserves were equivalent to about two-and-a-half months of current import payments. In view of the lumpiness in our balance of payments flows and the dependence of our exports on a few commodities, the prices of which are subject to large fluctuations, we regard a level of reserves equivalent to four months of current import payments as necessary for efficient management.

- 29 -

ANNEX II

15. Our domestic credit and foreign borrowing policies are consistent with a reduction in the overall balance of payments deficit from about SDR 7.6 million in 1980 to approximately SDR 2.3 million in 1981. This projection is based on an expected decline in our average export prices in 1981 over 1980, which will more than offset the anticipated gains in the volume of exports. Although the growth of import payments is expected to slow down, the trade deficit is projected to widen substantially, reflecting the continued deterioration in our terms of trade. The trade deficit will be financed largely by foreign grants, external public borrowings and private capital inflows. With respect to private investment, we intend to ensure that a substantial part of financing requirements are met from external sources. 16. Since October 1979, the Solomon Islands dollar has been pegged to a basket of currencies of four of our major trading partners. Effective March 3, 1981, the Government changed the exchange rate from SI$1 = A$1.062 to SI$1 = A$1.00. We believe that, in addition to moderating the immediate pressure on the balance of payments, this change will complement our longer-term efforts to expand and diversify exports and to encourage import-substitution in sectors where Solomon Islands has a comparative advantage. At the time of the exchange rate adjustment, the relative weights of the currencies in the basket were revised to take into account more accurately our transactions patterns. Recognizing the importance of exchange rate policy in promoting efficient resource allocation and in strengthening the balance of payments, we will keep under careful review the appropriateness of the exchange rate in light of price and balance of payments developments. 17. The Government of the Solomon Islands believes that the policies set forth in this letter are adequate to achieve the objectives of its program, but will take any further measures that may become appropriate for this purpose. The Government will consult with the Fund on the adoption of any such measures, in accordance with the policies of the Fund on such consultation. Yours sincerely,

/s/

Benedict Kinika Minister of Finance

Mr. J. de Larosiere Managing Director International Monetary Fund Washington, D.C. 20431 U.S.A.