IMF said the main challenge facing the country was to contain the islands budget deficit which has "reached extraordinarily high levels by international and historical standards."
"The 2008 budget continues to entail a large increase in current expenditures in an election year financed by extraordinary revenue measures with significant implementation risks," the IMF said in a public information notice released this week.
"An over 50 percent increase in the wage bill and quadrupled subsidies, mainly because of administered electricity prices, pushed up overall expenditure to nearly 70 percent of GDP (gross domestic product)."
Foreign Debt
The government was planning to finance the deficit with a "too ambitious" sale of 30 islands, and had decided in Augusts to cut expenditure by 20 percent.
The deficit was financed mainly through a large increase in private capital inflows, including foreign borrowing by commercial banks, which was then on-lend to resort developers.
As a result, external debt increased sharply to near 70 percent of GDP in 2007, increasing external risks.
IMF says "external vulnerabilities will need to be monitored carefully," due to the recent rise in external debt and debt service. Though the debt was largely due to private sector activity, a close eye should be kept on risks to the banking sector.
Inflation was projected at 15 percent for 2008 up from 7.4 percent, but IMF said the country's dollar peg could be maintained if budgets improved.Dollar Peg
"The Maldives appears to have adequate room to maintain competitiveness under the peg despite the recent rise in inflation, provided imported inflation is not exacerbated by fiscal slippages," the monetary watchdog said.
Exchange rate pegs are broken when governments use large volumes of central bank credit (printed money) to finance budget deficits.
Attempts to maintain pegs (defend the currency with foreign reserve sales) without raising interest rates could then result in a full-blown currency crisis and very high levels of inflation, as had happened in Pakistan and Vietnam in 2008.
Central banks are prevented from raising interest rates and forced to print money by finance ministries. The lack of central bank independence is known as fiscal dominance of monetary policy.
The IMF said a new central bank governor was appointed following the amendment to the Maldives Monetary Authority (MMA) law which separated the positions of finance minister and governor.
"MMA was also empowered to set interest rates and put a ceiling on the amount the government can borrow through its Ways and Means Account," the IMF said.
The government was committed to zero domestic financing of the budget. Analysts point out that any domestic financing should be conducted through the sale of bonds to the public and not the MMA to preserve the peg and low inflation.
Any MMA borrowing - even temporary - would pressure the peg and drive inflation up, undermining the long-term viability of the peg. In the past Maldives peg has been broken several times.
Fixed exchange rates also known as 'hard pegs' can be maintained indefinitely if there is no government financing or bank liquidity financing (discount window operations) by the monetary authority.
Such stable institutional frameworks, known as currency boards, are found in countries like Hong Kong, Singapore and many small islands which are financial centres, which have very high standards of living and small or effective governments.
Sustainable Budgeting
IMF said sustainable measures needed to be found to raise revenue for government, such as corporate tax and value added taxes on sales and tourism and only spend on useful areas.
IMF's executive directors in their assessment said authorities should "develop a realistic medium-term expenditure framework to prioritize spending within the available resource envelope."
The Maldives had seen more democracy in recent years, though the islands have historically reported lower levels of inflation.
Her neighbors like Sri Lanka, India have seen greater democracy, more populist vote buying spending, which has brought very high levels of inflation and abject poverty of parts of the population.
In Sri Lanka large volumes of money is spent on expanding and maintaining the civil service who are an important vote-base.
Analysts say the Maldives could be increasing vulnerable to populist spending on subsidies and civil service salaries which could result in falling living standards of especially of the poorer segments of the population.
Source: www.lankabusinessonline.com
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