Inflation has been rising in the Pacific islands on the back of strong increases in commodity prices.
Even though commodity prices have declined from recent peaks, food and fuel prices are still above historical levels and remain a concern in the islands, as most have only limited social protection systems.
Headline inflation in the islands has picked up since end-2007 beyond most central banks’ comfort zone (chart). The inflation seems largely imported: local fuel prices have increased steadily since December 2007. Food price inflation has also increased substantially.
Rising fuel and food costs put pressure on household budgets. The food share in total household spending is on average 50 percent for these islands—about twice as much as in the emerging markets.
There are also signs of homegrown demand pressures. Credit growth remains high and excess liquidity pervasive in Papua New Guinea and the Solomon Islands. Fiscal policies appear to have turned expansionary in the Solomon Islands, Timor-Leste, and Vanuatu.
Higher input costs (of animal feed and fertilizer, in addition to energy) have created pressures on prices. Wage pressures are mounting, notably in Papua New Guinea and the Solomon Islands.
Inflation pressures are rising in the Pacific islands on the back of strong increases in commodity prices.
Sources: National authorities; and IMF staff estimates.
The impact of the higher commodity prices on the Pacific islands’ domestic and external balances has been uneven. Most of the islands rely heavily on imports—mostly of food and fuel—while their export base remains narrow. As a result, their external balances are vulnerable to commodity price spikes. The Pacific island countries rely almost exclusively on oil-based fuel for their energy needs, limiting the scope for substitution in production and consumption.
Net food and oil importers such as Fiji, Kiribati, Samoa, and Tonga have been hit the hardest, and these countries are currently facing wider current account deficits.
By contrast, commodity producers such as Papua New Guinea (an exporter of oil, metals, and agricultural products) and Timor-Leste (an oil and gas producer) have benefited from a positive terms of trade shock. These countries still have a window of opportunity to convert the windfall gains into benefits for the economy as a whole, but they remain vulnerable to commodity price volatility.
Because most of the islands are either dollarized or have a pegged exchange rate regime, the exchange rate has a diminished role in curbing imported inflation. The weakening of both the Australian and New Zealand dollars has generated terms of trade losses for those countries whose exchange rates are pegged to these currencies.
The recent decline in commodity prices from record highs in mid-July may provide some respite. However, inflation is likely to decline only gradually in the Pacific islands as high transportation costs continue to feed through with a lag.
Commodity exporters still face an opportunity to increase their medium-term growth prospects. Despite declines, oil prices remain elevated. In Papua New Guinea and Timor-Leste, the oil sector is for the most part foreign owned and relies little on local inputs.
Most of the linkages to the domestic economy are via the income tax and other revenues to the budget, as in Papua New Guinea, or to the petroleum fund, as in Timor-Leste. The benefits from high oil prices will depend critically on how revenue windfalls are utilized.
High food and fuel prices pose special challenges to low-income countries such as the Pacific islands. The authorities have to strike a balance between protecting the poor from price increases—especially food—and supporting demand to enhance growth.
Ideally, targeted transfer programs—as part of an integrated social safety net—could reach the poor efficiently. In the absence of effective safety nets, a package of measures building on existing programs such as school feeding programs, cash transfers to the most vulnerable populations, reduced education and health fees, and public transport subsidies could be identified.
A more effective approach would include targeted demand and supply responses, combined with donor support. The Pacific islands should continue to allow full pass-through of higher food and fuel prices to domestic prices, while allowing for some time to adjust.
Donor support—preferably grants—would also help limit the harm to real incomes. A more flexible exchange rate regime would also help to cushion inflationary pressures in the commodity-exporting countries. In the islands that have full dollarization or a pegged exchange rate regime, the need for fiscal restraint to facilitate the external adjustment and offset any increase in fuel and food subsidies is clearly heightened.
IMF Asia and Pacific Department