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Government of Barbados

Cari AA- (Regional Scale Foreign Currency) USD 300 million Debt Issue Cari AA (Regional Scale Local Currency) (Notional) bb AAA (Barbados National Scale)

RATIONALE SUMMARY Analytical Contacts:

Arjoon Harripaul Caribbean Information and Credit Rating Services Limited

Tel: 1-868-627- 8879 (CariCRIS) has reaffirmed its ratings on the debt issue E-mail: [email protected] (notional) of the size of USD 300 million of the Government of Sherry Ann Persad Barbados of Cari AA- (Foreign Currency Rating) and Cari AA Tel: 1-868-627- 8879 (Local Currency Rating) on its regional scale . The ratings

E-mail: [email protected] indicate that the level of creditworthiness of this obligation, 1 adjudged in relation to other obligations in the Caribbean is

high.

The reaffirmation of Barbados’ ratings is based on the return to

some measure of stability in its macroeconomic performance in

Disclaimer : CariCRIS has taken 2011 as evidenced by positive growth in real gross domestic due care and caution in compilation of data for this product (GDP) and a narrowing of the fiscal deficit. Real GDP product. Information has been obtained by CariCRIS from grew by 1% in the nine months to September 2011 relative to sources which it considers reliable. However, CariCRIS does not 0.2% in the corresponding period of 2010. The fiscal deficit guarantee the accuracy, adequacy or completeness of any narrowed to 5.3% of GDP from 9.6% for the same period in information and is not responsible for any errors or omissions or for 2010. Unemployment levels also seem to have stabilized the results obtained from the use around 11% in the last twelve months. of such information. No part of this report may be published / reproduced in any form without CariCRIS’ prior written approval. CariCRIS is also not responsible for any errors in transmission and 1 The term Caribbean as used here covers the following countries: Bahamas, especially states that it has no Barbados, Belize, Costa Rica, Dominican Republic, Guyana, Haiti, Jamaica, Panama, financial liability whatsoever to Suriname, Trinidad and Tobago and the following countries in the OECS: Anguilla, the subscribers/users/ transmitters/distributors of this Antigua & Barbuda, Dominica, Grenada, Montserrat, St. Kitts & Nevis, Saint Lucia product . and St. Vincent & the Grenadines. Refer www.caricris.com for a more detailed explanation on CariCRIS ratings and rating definitions.

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CariCRIS has a practice of keeping all its ratings under continuous surveillance and ratings are revised as and when circumstances so warrant. For the latest rating information on any instrument of any company rated by CariCRIS, please contact CariCRIS at +1 868 627 8879

The external current account deficit increased marginally to 9% of GDP partially reflecting the upward trend in food and commodity prices. These higher import prices also impacted the inflation rate which up to July 2011 was estimated at 7% compared to 5.3% in September 2010. Moreover, the 2010 outturn was more or less in line with CariCRIS’ forecasts on which the 1-notch downgrade was assigned last year. Furthermore, the macroeconomic outlook for 2012 is moderately positive with growth in output projected to be around 1-2% contingent on the recovery of its main tourism markets as well as the improved performance of the other key sectors driving growth: construction and financial services. CariCRIS projects a marginal narrowing of the fiscal deficit over 2011 resulting from the uptick in economic activity. Unemployment levels are expected to fall to around 9-10%. Also providing a much needed boost to economic activity as well as to foreign direct investment (FDI) inflows is the expected resumption of the Four Seasons project and the commencement of The Merricks Resort Show Village and H Barbados boutique hotel in 2012.

CariCRIS believes that the near-term growth prospects remain challenging as economic recovery of any significance is not likely until late 2012/13. CariCRIS expects a parsimonious approach to fiscal management supported by the revenue generating initiatives announced in the last two budgets and tighter expenditure controls. Nevertheless, the fiscal situation is likely to remain tenuous in the near term in the face of a weak macroeconomic environment in Barbados and the lethargic recovery of its key markets. Even though the fiscal deficit is projected to narrow, general government gross debt is expected to rise to around 120-130% of GDP by the end of 2011. CariCRIS’ expectations are that the external current account deficit will expand further to around 10-11% of GDP and unemployment levels to be around 11-12% in 2011.

CariCRIS has noted the authorities’ commitment to fiscal consolidation and debt reduction with the development of a medium term fiscal strategy (MTFS) which has been reassessed to reflect the longer than expected recessionary conditions. The preservation of Barbados’ high creditworthiness is highly dependent on the authorities’ success at fiscal consolidation and stabilization of the public debt to a sustainable level. However, the risks are tilted to the downside and a slower-than-expected fiscal consolidation could lead to a downward adjustment of the ratings.

The ratings on Barbados reflect its long history of strong governance and political stability manifested in the quality of its underlying institutions: political, legal and economic as well as its monetary and exchange rate stability underpinned by a long- standing, fixed exchange-rate regime. Excellent human development indicators,

reflected in high per capita income and high standards of education and health care, are a key rating strength. Also supporting the rating is the diversity of its revenue sources which offers government a fair amount of financial flexibility. These strengths are tempered by persistent fiscal deficits, high and rising public sector debt levels and increasing debt-servicing costs. In addition, its weak external sector is characterized by persistent current account deficits and low reserves. Not dissimilar to many of its Caribbean neighbours, Barbados has a small open economy with limited resources and few growth prospects outside of tourism and financial services.

DETAILED RATIONALE

Long history of strong governance and political stability reflecting mature institutions and broad policy stability

As the third oldest democracy in the Western Hemisphere, Barbados has enjoyed a long history of social and political stability. Starting in 1639, Barbados has had one of the longest uninterrupted traditions of parliamentary practices as a British colony. This form of representative government and well-entrenched parliamentary practices has been maintained since its independence in 1966. This stability has facilitated the development of mature political, legal and economic institutions and good social delivery services. In CariCRIS’ opinion this social and political stability has led to broad macroeconomic policy stability across administrations. After serving fourteen successive years in opposition, the Democratic Labour Party (DLP) won elections in January 2008, enjoying an overwhelming majority in the Parliament (20 of the 30 seats), which enables it to comfortably execute its legislative agenda. The opposition Barbados Labour Party (BLP) holds the remaining seats in the House. There are only subtle differences in economic and ideological philosophies between the two parties and these pertain mainly to some elements of fiscal policy.

Underpinning this social and political stability is the strong social cohesion that exists in Barbados which lends to a broad-based consensus on most economic issues, particularly an unwavering commitment to the maintenance of the fixed exchange rate; a critical contributor to the country’s high creditworthiness. In CariCRIS’ opinion this strong social partnership together with a conservative culture are contributing factors to the non-militant approach to trade unionism practiced in Barbados. Disputes between labour and management are typically resolved through discussion rather than through an antagonistic or legal approach. To this end, the last work stoppage that lasted more than two days in Barbados occurred in 1981/82. This strong social pact also facilitated the establishment of a tripartite protocol among government, business and trade unions;

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an agreement that came into existence in 1998 coinciding with a period of economic difficulty in Barbados. These protocols which link moderate wage increases to commitments to share profits and improve productivity have been renewed upon expiration on each occasion. This tripartite relationship could come under increased scrutiny as the economic recovery remains weak with implications for employment levels and if the business community’s perception of increased public sector’s bureaucratic controls is not assuaged. Notwithstanding, CariCRIS believes this relationship which has underpinned social stability and prudent economic policies over the years is unlikely to change significantly in the short to medium term.

There were momentous changes to the political landscape in October 2010; the Honourable Prime Minister (PM) David Thompson passed away on October 23, 2010 and his successor, the former Deputy Prime Minister, the Honourable Freundel Stuart was appointed PM later that same day. The Honourable Mia Mottley was replaced as Opposition Leader on October 18, 2010, a post she held since 2008, as the majority of the opposition parliamentarians voted former PM, the Honourable Owen Arthur, as her successor. A by-election was held on January 20, 2011 for the St. John constituency; the seat held by the late Mr. Thompson for twenty three years. Mrs. Mara Thompson, the widow of the late PM, won by a landslide victory allowing the DLP to keep the seat. In spite of these developments, CariCRIS did not observe any material deviation in economic policies geared towards the achievement of the stated medium term objectives. Furthermore, given Barbados’ long history of political stability, no major disturbances occurred in the last year or are expected in the near term.

Compared to its regional peers Barbados has low levels of crime which is critical to its vibrant tourism industry which attracted over half million visitors annually since 2003. However, in the last two years there has been a notable increase in crime particularly robberies and murders but it has not yet impacted the tourism industry in any significant way. As such, its major tourist markets, United Kingdom (UK), United States of America (USA) and Canada, have not issued any adverse travel advisories.

Excellent human development indicators, reflected in high per capita income and high standards of education and health care systems

The quality of underlying institutions has led to the development of a well educated, highly skilled labour force, generally low levels of poverty and a high standard of living. Barbados’ human development indicators compare very favourably on both a regional and international scale. In 2010, Barbados ranked 47 th out of 187 countries on the United

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Nations Development Programme (UNDP) Human Development Index (HDI), making it the highest ranked country in the Caribbean well ahead of second-placed Bahamas (53 rd ) and third-placed Antigua and Barbuda (60 th ). In the wider Latin America region, Barbados ranked third behind Chile (44 th ) and Argentina (45 th ). Barbados’ per capita GDP in 2010 was the third highest in the English-speaking Caribbean at US $15,434, following Bahamas (US $22,259) and Trinidad and Tobago (US $15,512). Barbados’ poverty rates are among the lowest regionally and internationally reflecting the vast progress made in reducing poverty and improving the quality of life in turn transforming the island into an upper middle-income country.

The education system is modelled on that of the British; primary and secondary education is free and compulsory for children ages 5 to 15 years, while tertiary education is also state-funded. The adult literacy rate 2 of 99.7% positioned Barbados at 5th place out of a total of 179 countries 3. This ranking is the highest in the English- speaking Caribbean and well ahead of its closest peers Guyana and Antigua and Barbuda at 20 th and Trinidad and Tobago at 47 th .

Barbados’ health care systems are of a high standard with a World Health Organisation (WHO) ranking of 46 th out of 190 countries, second to Dominica (35 th ) in the English- speaking Caribbean. The UNDP’s estimate of life expectancy of 77 4 years places Barbados just behind Dominica (77.5 years) in the English-speaking Caribbean. The infant mortality rate is 10 per 1,000 live births and is among the lowest in the Caribbean.

The authorities’ prudent economic management and substantial investment in health, education, and infrastructure makes Barbados a model country among small developing countries and an attractive investment and tourist destination.

Monetary and exchange rate stability underpinned by a long-standing, fixed exchange-rate regime

The fixed exchange rate regime established since 1975 (at the rate of Bds $2.00 to US $1.00) continues to underpin investor confidence, price and monetary stability. Additionally, the peg to the US dollar resulted in a substantial real effective depreciation of the currency in the last couple of years mitigating concerns about the loss of external competitiveness. This fixed parity to the US dollar has contributed to the maintenance

2 Persons 15 years and older 3 Source: United Nations Development Programme (UNDP) Report 2009 4 Source: United Nations Population Fund 2011

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of low inflation rates averaging 4.7% for the period 2004 to 2007. However, inflation peaked at 8.1% in 2008 fuelled mainly by the rise in commodity prices, the implementation of a cess on imports and increased demand for imports. Reflecting weak demand and lower international fuel prices average inflation fell in 2009 to 3.6%; but picked up again and averaged 5.8% in 2010. Given the rising energy and commodity prices inflation is expected to end the year around 7-8%; as at July 2011 it was 7%.

All stakeholders in the economy are strongly committed to maintaining the fixed exchange rate at its current level. Although the peg to the US dollar has provided a valuable anchor, it leaves the sovereign with much less monetary policy flexibility. In CariCRIS’ opinion decisive fiscal adjustment is needed to safeguard the viability of the peg and maintain the real effective exchange rate.

The financial system in Barbados comprises both onshore and offshore activities. The offshore operations are insulated from the domestic banking system limiting the risk of contagion. Growth in the offshore industry has been propelled by low tax rates (1-2.5%) and the signing of bilateral tax treaties with key markets (Canada, USA, UK and Switzerland) 5. The industry could be negatively affected by changes in the USA and Canadian tax policies and regulations. Barbados has been identified as a “suspect jurisdiction” by the USA and the impending passage of the “Stop Tax Haven Abuse Act” will have downside risks as this proposed legislation would limit the tax arbitrage opportunities Barbados offers to US entities. Additionally, Canada has commenced negotiations for a number of new double taxation avoidance treaties (DTATs) with some of Barbados’ competitors in the region which may eliminate or at least reduce certain tax advantages Canadian companies now enjoy in Barbados. Notwithstanding, Barbados was the only independent Caribbean offshore centre to be included on the ‘white list’ released by the Organisation for Economic Co-operation and Development (OECD) in April 2009. In November 2011, the Global Forum of the OECD identified Barbados as a jurisdiction that is still not transparent with respect to international tax co-operation.

The financial sector remains broadly sound and sensitivity analysis suggests that the onshore banking industry would be resilient to most market shocks 6, but capital levels may be at risk in more extreme events. Accordingly, the turbulence in the global financial markets has had little impact on the industry as there was minimal direct

5 Barbados has signed double taxation treaties (DTTs) with 34 countries, 15 of which are OECD members. In the last two years DTTs were signed with the Republic of Panama, Spain and the Czech Republic. Currently negotiations are underway with a further 24 countries, 7 of which are OECD members. It has recently signed a Tax Information Exchange Agreement (TIEA) with the Kingdom of Denmark, and will shortly ratify TIEAs with Germany and France. 6 As reported in the IMF Financial System Stability Assessment Report dated February 2009.

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exposure to the financial market in the USA. Barbados holds the highest ranking for the soundness of its banking system in the English-speaking Caribbean region at 11 th position (out of 142 countries) with Trinidad and Tobago at a distant 30 th position ranking second 7 and within the wider Caribbean and Latin American region ranked 2 nd after Chile at 6 th position.

The performance indicators for the banking sector were mixed in 2010. Commercial banks’ capital adequacy, which has risen steadily since 2006, remained strong at 17.4% in 2010, well above the regulatory minimum requirement of 8%. However, non- performing loans (NPLs) to total loans have steadily risen in the last three years; following a decade-low of 2.9% in 2007. In 2010 it climbed to a decade-high of 10.8% from 7.9% in the prior year. NPLs remained high in 2011 at 10.3% in July 2011 from 10.6% in July 2009. CariCRIS expects further deterioration in asset quality and this remains a key credit concern as economic activity remains sluggish and unemployment levels rise. Provisioning levels remain adequate averaging around 42.2% of NPLs in the last three years; comparable to its peers in the region. There have been no financial sector crises or bank failures in the recent past. In the event of such a crisis, the Central Bank of Barbados (CBB), as lender of last resort, has a number of facilities available.

The authorities have indicated that progress is being made with the IMF’s Financial Sector Assessment Program (FSAP) 2008 Update recommendations with legislation being drafted for the aggregate limits for large bank exposures, loan classification, provisioning and connected lending. Additionally, the authorities enacted the legislation for the establishment of the Financial Services Commission (FSC) at the end of 2010. The FSC, which commenced operations in April 2011, is mandated to provide regulatory and supervisory control over the non-bank financial sector 8. CariCRIS believes this initiative would further improve Barbados’ financial services regulation and institutional strengthening in line with international best practices.

Monetary policy has eased in the last three years with the CBB’s reduction in the minimum deposit rate, discounts rates 9 (to 7% from 10%), the foreign exchange reserve requirement (to 2% from 4%) as well as the introduction of reserves requirements for

7 Source: World Economic Forum 2011/2012 Report. 8 The FSC is responsible for regulatory functions that were previously undertaken by the Securities Commission under the Securities Act; the office of the Supervisor of Insurance and Pensions under the Insurance Act and the Exempt Insurance Act. It will also be in charge of Pensions under the Occupational Pensions and Benefit Act and Regulation of Credit Unions. 9 The discount rate is the rate payable by banks and other eligible financial institutions on temporary advances from the Central Bank.

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Part III institutions 10 . These measures were intended to lower borrowing rates, stimulate economic activity and increase the supply of foreign exchange reserves available to the commercial banks. The minimum deposit rate, now at 2.5%, was reduced on three occasions by a total of 1.5 percentage points between October 2008 and August 2009. Lending rates, which are market determined, mirrored the decline and trended downwards to around 9.07% by June 2011 from a decade high of 10.87% in 2006. Nevertheless, the unfavourable economic conditions dampened credit demand growth which declined sharply to 0.7% in 2010, the lowest since 2005; credit grew marginally by 0.2% in the first nine months of 2011. As a result of low credit demand liquidity levels remained high and in September 2011 excess cash reserves to deposits was 3.7%. Going forward, CariCRIS believes there is little room for further easing of monetary policy given that the minimum deposit rate remains negative in real terms. CariCRIS also expects a continuation of weak credit demand and high liquidity levels in the face of subdued economic activity in the near term.

The Barbados authorities are well ahead of its regional counterparts with respect to preparations for Basel II and plan to focus on Pillar II which emphasises strong regulatory oversight and industry risk management practices.

Diversified revenue sources offer some financial flexibility

Government revenue sources are well diversified and offer a fair amount of financial flexibility as there is a low dependence on import duties and higher reliance on personal and corporate taxes as well as taxes on goods and services. Current revenues declined in tandem with the contraction in economic activity falling to 27.2% of GDP in FY2010 11 from 29.9% in FY2008. Overall, earnings derived from income and profits accounted for 32% of total revenues in FY2010, of which corporation taxes contributed 12.7% and income taxes 17%. In FY2011, CariCRIS anticipates a moderate rise in revenue from income and profits as the economy is projected to grow by around 0.5-1%. The offshore industry is expected to remain under pressure, as recovery remains sluggish in the developed economies, negatively impacting revenue collection as this industry contributes around 60% to corporation taxes. Sales taxes are the largest contributor to total tax revenues accounting for 47.5% in FY2010, of which Value Added Tax (VAT) contributed 34.5%. The hike in the VAT rate to 17.5% from 15% effective December 1, 2010 is expected to generate an additional Bds $124 million in revenues and places an

10 Part III licensees include non-bank financial institutions licensed under the Financial Institutions Act such as trust and mortgage companies, finance companies and merchant banks. 11 Fiscal year runs from April 1 to March 31.

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even greater reliance on this source. The other sources of revenues in FY2010 were international trade (8.2%), property (4.9%), non-tax revenues (4.4%), special receipts (4.4%) and other taxes (0.5%).

The VAT system in Barbados is characterized by high compliance levels and an effective collection rate of around 62% making it one of the most efficient in the Western Hemisphere. Nevertheless, the authorities have focused on improving the tax collection process, efficiency and compliance rate in the last couple of years. As a result a number of initiatives were undertaken to simplify the tax system which included reductions in both corporate and personal tax rates as well as an increase in the level of personal allowances. Other tax simplification measures announced in 2010 included an increase in the VAT threshold to Bds $80,000 from Bds $60,000, the abolition of the Environmental Levy on imported goods effective December 1, 2010 and an increase in the audit threshold for businesses to Bds $2 million (gross revenues and/or assets) from Bds $1 million and Bds $4 million after December 2013.

Supporting this revenue-diversity strength has been the increase in revenues in FY2010 (Chart 1), albeit marginal. Overall, total revenues rose by 0.4% as tax revenues grew by 2.1% to Bds $2,216.9 million from Bds $2,170.3 million in FY2009. The categories which recorded growth were special receipts (53.2%), international trade (7.3%) and goods and services (6%) of which VAT rose by 5.5%. Notwithstanding, the following categories recorded declines: other taxes (17.6%), income and profits (7.3%) and property taxes (0.4%). Non-tax revenues fell by 4.7% to Bds $102 million in FY2010 from Bds $107 million in FY2009. However, a similar trend continued in 2011 and up to October total revenues rose by 7.6% to Bds $1,297.4 million of which direct taxes increased by 8.6% and non-tax revenues contracted by 22.7% to Bds $31.5 million from Bds $40.8 million year-on-year. Given the higher VAT rates, receipts increased by 21.4% to Bds $522.6 million for the period April - October 2011.

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Chart 1 Central Government Revenue, Expenditure and Overall Fiscal Balance FY2005 - FY2010

40

30

% of 20 GDP

10

0 2005 2006 2007 2008 2009 2010

-10

Central Gov't Current Revenue Central Government Current Expenditure Central Government Overall Balance

Source: Central Bank of Barbados

Given the revenue raising measures announced in the November 2010 budget CariCRIS expects some improvement in revenues in the near term. In addition to the hike in the VAT rate, excise taxes on gasoline were increased by 50% to Bds $0.5358 per litre and is expected to contribute Bds $22.7 million in additional revenues. Bus fares were increased by Bds $0.50 per ride effective January 1, 2011 as well as user fees such as private prescription drug and immigration fees will rise. Few revenue raising measures were announced in the August 2011 budget as the authorities remained constrained by the challenging environment which limits its fiscal flexibility.

In the medium term, CariCRIS expects improved efficiencies in revenue collection following the establishment of the Central Revenue Authority (CRA) in November 2011. Further supporting the revenue collection process is government’s MTFS commitment to a number of measures inclusive of a review of the tax system by the Caribbean Regional Technical Assistance Center (CARTAC), completion of the modernisation of the Customs and Excise Department as well as the VAT Department and “strengthening and modernising legislation” for collection agencies to augment their authority in enforcing compliance.

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These rating strengths are tempered by the following factors:

Persistent fiscal deficits, high and rising debt levels and increasing debt-servicing costs

Central government has consistently run fiscal deficits which has risen steadily since FY2005 reaching an 8-year high of 8.1% of GDP in FY2010 from 7.9% in the prior year. Over the past three years the deficit has widened sharply averaging 7.1% of GDP, compared to 2.9% for the period FY2005 to FY2007, amid high and rising expenditure levels and declining revenues. However, for the period April to September 2011 the fiscal deficit narrowed to 5.3% of GDP from 9.6% of GDP in the corresponding period of 2010. CariCRIS expects expenditure levels to remain high, despite the authorities’ plans to decrease it by 2.5% of GDP, as the government remains committed to maintaining employment levels in the prevailing environment. The high current expenditure levels severely limit government’s capacity for capital expenditure. CariCRIS estimates the deficit will be around 5-7% of GDP in FY2011.

In recent times the government has entered into several public-private partnerships (PPPs) arrangements utilizing the build-operate-lease and transfer (BOLTs) contracts to execute its capital development programme. The involvement of the private sector may have resulted in greater efficiencies and cost savings but these off-budget capital expenditures have served to reduce fiscal transparency and mask the true extent of the country’s fiscal position. In FY2007 the authorities included the completed projects’ assets and liabilities on its balance sheet as it adopted the accrual accounting method. In FY2009 the authorities included a number of projects which added over Bds $300 million to debt. According to the authorities there are no PPPs to be included in FY2011. The inclusion of these off-budget expenditures have served to improve the transparency of fiscal policy and streamline the budget process. As stated in its MTFS the government plans to make greater use of PPPs in the future.

Public sector debt levels have increased sharply reaching unprecedented highs for Barbados. Central government gross debt rose to 98.5% of GDP in FY2010 from 85.6% in the previous year and 63.6% six years earlier (Chart 2). The general government gross debt peaked at 118.4% of GDP in 2010 from 101.2% in the prior year and 83% at the beginning of the decade. This high level of debt has placed Barbados in an unfavourable position relative to its regional peers, ranking the 3 rd highest in CariCRIS’ sample with a 3-year average of 102.6% of GDP behind St. Kitts and Nevis (142.8%) and Jamaica (123.4%). The steep increase in contingent liabilities in the last eleven years, from Bds

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$189.3 million in FY1999 to Bds $1.4 billion in FY2010, has also contributed to the rise in debt levels. Notwithstanding, the government’s strong asset base placed Barbados in a comfortable net debt position. The net general government debt remained relatively low at 51.1% of GDP in FY2010, up from 44.8% in FY2009. In FY2011, CariCRIS expects debt levels to rise even further as government plans to continue borrowing in the domestic market as well as from the multilateral financial institutions, to finance its fiscal deficit and capital works programme. This was quite evident as the government raised Bds $450 million via bonds and debentures in the domestic market in the period February to October 2011.

Barbados’ debt portfolio is primarily domestic, accounting for 69.9% of total debt in FY2010, and is held mainly in Barbados dollars by local commercial banks and public entities thereby minimizing rollover risk. Further supporting the low rollover risk for the domestic debt is the proportion held by the National Insurance Scheme (NIS) and the Central Bank of Barbados (CBB). In FY2010 these two institutions accounted for 39.3% of the total domestic debt from 29.6% in FY2007 and averaging 37.4% in the last three years. In spite of the low rollover risk, CariCRIS is concerned about the sustainability of the high and increasing level of domestic borrowings over the long term. Furthermore, the high levels of domestic borrowings may lead to a partial crowding out of the private sector particularly when economic activity picks up.

With a peg and a partially liberalised capital account, fiscal policy remains the main macroeconomic policy tool available to the authorities to contain external deficits. The current administration is committed to fiscal consolidation and towards this end has developed a medium term fiscal strategy in 2010. The specific objectives’ of the MTFS are to bring public finances to a more sustainable path by achieving a balanced budget by FY2014 and reducing central government’s debt to around 70% of GDP by FY2017; the MTFS’s targets have recently been revised. CariCRIS believes achieving these targets might prove a Herculean task in light of the ongoing global recession, a weakened economy, fiscal deficits and the uncertainty surrounding the return to sustainable growth.

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Chart 2 Total Public Sector Debt 2005 - 2010

130

120

110

100

% of 90 GDP 80

70

60

50 2005 2006 2007 2008 2009 2010

Central Government Gross Debt General Government Gross Debt

Source: Central Bank of Barbados

Debt service is high and has risen sharply in the last three years consuming 56% of current revenues in FY2010 relative to 38.3% in the prior year. Interest payments accounted for 20.6% of current revenues in FY2010 rising from 15.1% in FY2008 and climbed further to 23.5% in the 7 months to October 2011. It is CariCRIS’ belief that these increasing levels of debt service is unsustainable particularly given the sluggish economic activity, prolonged recovery of its major trading partners and limited options to increase revenues in the prevailing environment. Moreover, the funding of the total debt service by borrowings is a key credit concern for CariCRIS as it may impair fiscal flexibility in the near term.

Contributing to the burgeoning current expenditure is the high proportion of transfers and subsidies which accounted for 40.4% in FY2010. Grants to public institutions accounted for 60.4% of current transfers in FY2010. In the medium term, CariCRIS expects a reduction in transfers and subsidies as government plans to place limits on transfers to statutory boards and corporations as well as government-owned institutions such as the Queen Elizabeth Hospital, Barbados Transport Board, Barbados Agricultural and Development Marketing Corporation and The University of the West Indies. Additionally, there are plans to eliminate transfers to the National Housing Corporation and Barbados Water Authority. The government’s commitment to curtail expenditure

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levels is reflected in the 10% decline in transfers and 15.2% reduction in grants to public institutions for the period April to October 2011. Wages and salaries have risen steadily since FY2003 and accounted for 27.5% of total current expenditure in FY2010. There are plans in the MTFS to focus on containing “personal emoluments cost by allowing total growth to be the equivalent of the sum that would normally be paid as increments.” CariCRIS believes once these expenditure reduction measures have been implemented they would serve to bring expenditure to more sustainable levels in the medium term.

CariCRIS expects Barbados’ fiscal situation to remain tenuous in the near term as the economic activity remains subdued and the global recovery lethargic. In the medium term, there may be some easing of the fiscal situation with the implementation of the revenue generating initiatives stated in the MTFS which includes the following: a more aggressive approach to revenue collection, “broadening the VAT base by restructuring fiscal incentives”, keeping increases in licenses and fees in line with inflation and increasing excise taxes and dividend yields from commercial government agencies. CariCRIS believes the MTFS is a demonstration of the authorities’ commitment to fiscal consolidation though it may be challenging given the uncertainty in the prevailing environment. Additionally, it must be emphasized that fiscal consolidation and stabilization of the public debt levels are critical to Barbados maintaining its high creditworthiness.

Relatively weak external sector characterized by high and persistent current account deficits

The ratings reflect increasing vulnerabilities arising from high and persistent current account deficits and lower reserve coverage. The worsening fiscal position, falling tourism receipts and declining merchandise exports have exacerbated the deficits on the current account. The current account deficit averaged 8.1% of GDP for the period 2008- 2010 compared to an average of 5.6% for the period 2001-2003. The savings/investment gap emphasises the country’s heavy reliance on foreign savings and leaves it vulnerable to a reversal in private capital flows. The current account deficit fluctuated between a sizeable 10.1% of GDP and 5.6% in the last three years. In 2011 the deficit continued to widen reaching 9% of GDP in September relative to 8.7% the year-earlier. CariCRIS expects the current account deficit to be around 10-11% of GDP in 2011 as tourism receipts decline and the import bill increases as energy and commodity prices rises.

Barbados recorded its second successive balance of payments surplus of just below 1% of GDP in 2010 (Chart 3). However, the surplus on the capital and financial account of

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7.9% of GDP was not sufficient to finance the growing current account deficit. This trend did not continue as the BOP recorded a deficit of Bds $57.3 million in September 2011 relative to a surplus of Bds $75.4 million in September 2010. CariCRIS expects a deficit in 2011 as private capital inflows remain tight, way below the pre-crisis levels, and the current account deficit is projected to widen.

Chart 3 Overall External Balance 2006 – 2010

15.0

Current Account 10.0 Balance

5.0

% of Capital & GDP 0.0 Financial Account Balance

-5.0

Overall External -10.0 Balance

-15.0 2006 2007 2008 2009 2010 Year

Source: Central Bank of Barbados

Import cover has been maintained at just over 6 ½ months in the last two years, above the international benchmark of 3 months, as Barbados’ stock of international reserves rose marginally to Bds $2,355.2 million in 2010 from Bds $2,292.6 million in 2009. In September 2011 reserves provided coverage for about 18.9 weeks of imports.

Despite the comfortable reserves position, the Barbados economy continues to be highly vulnerable to adverse external developments, particularly the uncertain and lethargic recovery of its key tourism markets, adversely impacting foreign exchange (FX) earnings 12 and placing greater strain on its external liquidity position. Additionally,

12 For the period 2004-2008 it is estimated that the tourism industry contributed an average of 52% to foreign exchange earnings.

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Barbados’ FX earning capacity is also impacted by the performance of the offshore sector, which has been adversely affected by the global recession, as it is second to tourism in terms of contribution to FX earnings.

The external deficits have been partially financed by external debt which averaged 26.3% of GDP for the period 2008-2010. The external public debt peaked at 28.3% in 2009, the highest since 2002. Notwithstanding, Barbados’ 3-year average compares favourably with its regional peers ranking the 5 th lowest in CariCRIS’ sample after Trinidad and Tobago (6.2%), Bahamas (8%), Anguilla (11.7%) and Antigua and Barbuda (22.8%). Foreign Direct Investment (FDI) inflows have been largely directed towards tourism and tourism related infrastructure but have virtually disappeared since the financial meltdown in the last quarter of 2008. In 2009 FDI inflows declined by 40.2% to Bds $319.4 million, less than half of 2007’s inflows, from Bds $534.4 in the prior year reflecting the tight credit conditions in a weak global environment. These weaker FDI inflows places even greater pressures on Barbados’ external position. CariCRIS expectations are FDI inflows will continue to be way below pre-crisis levels as uncertainty in the global marketplace lingers on, credit conditions continue to be tight and investor confidence remains low. The commencement of construction of The Merricks Resort Show Village and H Barbados boutique hotel (formerly the Allamanda Beach Hotel) in November 2011 will provide a much needed boost to FDI inflows as well as employment. CariCRIS expects a further uptick in FDI inflows with the planned resumption of the Four Season project in 2012.

Small, open economy with limited resources and few growth prospects

Barbados’ small, open economy with limited resources is highly dependent on tourism, construction, and the financial services industries for growth. Services, particularly tourism and financial services, account for around 86% of GDP and an estimated 80% of exports. Tourism will remain the key economic driver in Barbados for some time yet, as growth has been hampered by low rates of private investment and the sluggish performance of manufactured and agricultural exports. This dependence leaves the economy highly vulnerable to external shocks including the economic performance of its main markets, UK, USA and Canada which accounted for 34%, 25.4% and 13.6% respectively, of tourist arrivals in 2010. This was clearly evident as both stay-over arrivals and tourism value added contracted in 2008 and 2009, reflective of the recessionary conditions in its key markets. However, despite the 2.6% increase in arrivals and the 2.9% growth in value added in 2010, tourism expenditure continued to decline and is estimated to have fallen by around 13.5% in the first quarter of 2011.

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Arrivals continued to grow and for the first eight months of 2011 rose by 8.7% with increases from Brazil (186.9%), Germany (30.7%), Trinidad and Tobago (26.9%), Other Europe (14.5%), UK (10.2%), USA (7.8%); but declined in Canada (2.3%) and Other countries (7.8%). Additionally, there has been deterioration in some key tourism performance indicators; hotel occupancy rates have fallen from 64% in 2008 to 57% in 2010 and to 53% for the period January to October 2011. Average length of stay fell to 4.7 days in September 2011 from 5.5 days in 2010.

The tourism industry continues to be plagued by reduced seat capacity/airlifts on its international routes with the use of smaller aircrafts by Virgin Atlantic and British Airways since 2008. The introduction of daily year-round flights by JetBlue and US Airways in October 2009 and WestJet in 2010 provided a much needed boost. These initiatives were further supported by the penetration into non-traditional markets with GOL Airlines’ offering a weekly flight out of Brazil which commenced in June 2010. The foray of REDjet, a low fares airline, in the intra-regional market has increased seating capacity and resulted in a lowering of fares by other players. The routes currently serviced by REDjet include Barbados, Jamaica, Trinidad, Guyana and Antigua with plans to extend its routes and fleet in the near term.

Furthermore, the Caribbean travel industry was affected by the introduction of the UK Airline Passenger Duty (APD) 13 in November 2009. This environmental tax increased the cost of travel to the Caribbean by a higher rate than travel to the USA and could have a detrimental impact on countries that have a high dependence on UK travellers, like Barbados. The second tranche of the APD increase became effective November 1, 2010. The German authorities introduced an airline levy adding €45 (US $57) to Caribbean destination prices effective September 3, 2010 and imposed on all flights out of the country from January 1, 2011. The USA also introduced US $10 tax per ticket which became effective in October 2010. Tourism remains highly susceptible to the vagaries of external factors specifically world events as was evidenced with the volcanic eruption in Iceland which grounded flights out of UK and much of Europe for the period April 14-20, 2010 and resulted in the loss of 4,450 seats for Barbados.

Barbados is increasingly becoming a high cost tourist destination. In response to the changing circumstances the authorities have shifted their strategic focus towards the

13 All Caribbean countries have been placed in “Band C” because their capitals are between 4,001 and 6,000 miles from London. However, the whole of the United States of America (including California, Alaska, even Hawaii) has been placed in “Band B” because Washington DC is less than 4,000 miles from London. The percentage increases for passengers travelling in Premium Economy and Business Class are +25% from November 2009 and +94% from November 2010. For example, a tourist travelling in Economy Class who previously paid £40 in tax will pay £50 from November 1, 2009, and £75 from November 1, 2010.

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high value niche market. The tourism product now being developed includes condominiums and villas versus the traditional hotel rooms and facilities which offer golf courses and polo grounds. However, in the current weak global economic environment travellers are opting for the middle range facilities and there has been a slowdown in demand for the condominiums and villa type facilities.

To provide some cushion against the impact of the global recession the authorities established a “Tourism Industry Relief Fund” in 2009 to provide financial support for hoteliers and providers of ancillary services. Around Bds $25 million was allocated on the condition that employment levels were maintained in the industry; this facility was not offered in 2010. Other support measures provided to the industry included financial incentives to airlines, US $60 million loan guarantee for the Four Seasons project and increased marketing initiatives in both traditional and non-traditional markets. Notwithstanding the above, the pressures have mounted for the industry as operating costs rose with hikes in water and electricity rates. Also adding pressure on operating margins has been the heavy discounting, up to 60%, offered in order to boost occupancy levels.

Additional support measures directed towards the tourism sector included an increase in the marketing budget to Bds $16 million from Bds $10 million, the establishment of a “Tourism Loan Guarantee Facility” in January 2011 for working capital borrowings and a grant for “Small Hotels Refurbishment Programme” of Bds $20 million to improve the quality of the standard rooms stock. Despite all these measures the outlook for this industry remains weak as the economic recovery of its source markets remains lethargic. As such a marginal growth in arrivals is projected for 2011.

Since 2008 economic activity has slowed markedly in response to the global recession with contractions in real GDP for two consecutive years and a decade-high contraction of 3.8% in 2009. A marginal growth of 0.2% was recorded in 2010 and for the nine months to September 2011 1% relative to 0.2% in the same period of 2010. Even though most of the industries grew it was minimal with mining and quarrying recording the largest at 9.4% followed by tourism at 2.9%. The industries which declined were sugar (19.7%), construction (9.9%), manufacturing (4.3%) and non-sugar agriculture (1.1%). For the first nine months of 2011, the tradable industries contracted by 2.4% while the non-tradable industries grew by 1.9%. Economic activity is projected to grow by around 1% in 2011.

As a result of the recession unemployment has been on the rise, climbing to 10.8% in 2010 and further to 11% by September 2011, from a decade low of 7.4% in 2007. As

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economic conditions remain depressed CariCRIS expects unemployment levels to be around 11-12% in the near term. In order to maintain employment levels the government announced in the November 2010 budget a tax credit of 10% on businesses’ wage bill for those increasing their profits and workforce by at least 10% over a period of three years starting from 2011.

In a Caribbean context, Barbados is a high-cost production centre. There is very little opportunity for growth in manufacturing as manufacturers face extremely high fuel, electricity, land, labour and raw material costs. In the last two years manufacturers’ costs increased further with the rise in water rates, a sharp 60%, and electricity rates placing them in an even more disadvantageous position. As such, the manufacturing industry in Barbados is small (3-year average contribution to GDP of 5%) and is highly protected. The removal or reduction in duty protection will present further challenges for manufacturers. CariCRIS expects the cost of manufacturing to remain high and uncompetitive compared to its regional peers in Trinidad and Tobago. Since 2006 the manufacturing industry has generated negative growth. In 2010 the sector contracted by 4.3% following a contraction of 12.2% in 2009; the sharpest in the last eight years.

The growth in the construction industry was reversed in the period 2008 to 2010. The stoppage/slowdown of tourism related projects contributed to a 9.9% contraction in 2010 on the heels of a 13.7% decline in 2009; the sharpest in the last decade. CariCRIS expects this industry’s performance to remain weak as FDI inflows remain scarce in the near term. However, there may be some increased activity in the industry once the Four Seasons and Merricks Resort Show Village projects commence in 2012.

The government has initiated the process for its foray into the offshore oil and gas industry as it awarded two off-shore blocks to BHP Billiton for exploration. However, the current maritime dispute with Venezuela could prove to be a hindrance to these efforts. At this point it is not clear what potential may exist in this industry, but if substantial discoveries are made they could have a significant impact on Barbados’ economic growth.

Rating Sensitivity Factors • Significant changes in the fiscal stance • Significant changes in the external liquidity situation • Significant changes in domestic output

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ABOUT THE SOVEREIGN

Barbados is the most easterly island in the Caribbean chain and is part of the Lesser Antilles. It lies approximately 160.9 kilometres (kms) to the east of its nearest neighbour, St. Vincent and the Grenadines and is approximately 463 kms north-east of the South American mainland. The island is approximately 34 kms long and 23 kms wide with an area of 431 square kilometres. Its far eastern location in the Atlantic Ocean puts it just outside the hurricane belt of the Caribbean region.

The population of Barbados is estimated to be 276,302 (December 31, 2010) making it one of the most densely populated countries in the world, with an average population density of 641 persons per square km. The majority of the population is of African descent (90%), the remaining are European (4%) and others of mixed descent (6%). The population growth rate has averaged 0.22% for the period 2006-2010; with an average life expectancy of 77 years. The official language is English. The education system is modelled on the British system and is free and compulsory for children between the ages of 5 and 15.

Barbados has transformed itself from a low income economy dependent upon sugar production into an upper middle-income services driven economy. Overall, the services sector contributed around 86.4% to GDP in 2010, with Wholesale and Retail accounting for the largest component with 21.7%. The main sectors driving economic growth are Tourism (14.7%), Business and General Services (18.9%), Construction (6.5%) and Manufacturing (4.7%). The labour force comprises around 145,500 (June 2011) with an unemployment rate of 10.8% as at the end of 2010 and further to 11% by September 2011. The private sector presence in the economy is not as significant as some of its Caribbean counterparts as the government accounts for roughly 40% of employment and gross capital formation.

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Table 1 Selected Economic, Social and Political Indicators 2006-2010

2010 2009 2008 2007 2006 Income & Economic Structure Nominal GDP (US $ mn.) 4,264.5 4,393.1 4,345.4 4,485.3 4,197.8 Nominal GDP Per Capita (US $) 15,434 15,933 15,782 13,605 15,321 Real GDP Growth (%) 0.2 (3.8) (0.1) 3.8 3.6 Unemployment Rate (%) 10.8 10.0 8.1 7.4 8.7 Human Development Index 47/187 37/182 37/179 31/177 31/177 Transparency Intl Corruption Perceptions Index 7.8 7.0 7.0 6.9 6.7 Transparency Intl Corruption Perception Country Rank 17/178 20/180 22/180 23/180 24/180

2010 2009 2008 2007 2006 Fiscal Accounts (% of GDP) Central Gov't Current Revenue 27.2 26.3 29.9 27.6 26.7 Central Gov't Current Expenditure 34.1 32.0 32.1 28.1 25.2 Central Gov't Current Balance (6.9) (5.7) (2.2) (0.6) 1.5 Central Gov't Capital Expenditure 1.3 2.2 3.1 3.1 4.3 Central Gov't Primary Balance (2.5) (2.9) (0.7) 0.2 1.2 Central Gov't Overall Balance (8.1) (7.9) (5.3) (3.6) (2.8) Central Gov't Gross Debt 98.5 85.6 76.6 69.4 65.3 General Gov't Gross Debt 118.4 101.2 88.1 76.9 72.1

2010 2009 2008 2007 2006 Monetary, Financial & Exchange Rate Indicators Consumer Price (end of period) 6.5 4.4 7.6 4.7 5.7 Consumer Price (annual average) 5.8 3.6 8.1 4.0 7.3 Credit to the Private Sector & NFPE (% GDP) 59.9 57.8 57.7 50.3 51.1 Credit to the Private Sector & NFPE (YOY change %) 0.7 1.3 11.0 5.1 13.2 Non-Performing Loans/Total Loans (%) 10.8 7.9 3.4 2.9 4.5 Provision for NPL (% of NPL) 33.6 39.8 53.2 40.2 34.1 Banking Sector Capital Adequacy Ratio (%) 17.4 17.5 16.5 15.9 12.3 Base Money (YOY change) 3.1 1.1 (2.0) 6.6 3.5 Broad Money or Money Supply (YOY change %) (4.8) 1.8 (3.5) 20.5 (1.0) Average Bank Deposit Rate (%) 2.7 2.7 4.1 4.8 5.1 Average Bank Lending Rate (%) 9.4 9.7 10.3 10.6 10.9 Interest Rate Spread 6.7 7.0 6.2 5.8 5.8 Nominal Exchange Rates (per US $) 2 2 2 2 2 Real Effective Exchange Rates (YOY change %) … … … 3.7 3.8

2010 2009 2008 2007 2006 External Sector Indicators Current Account Balance (% GDP) (8.6) (5.6) (10.1) (4.0) (5.9) Capital & Financial Account Balance (% GDP) 7.9 5.9 6.0 12.0 8.2 Overall External Balance (% GDP) 0.8 0.9 (5.7) 6.2 1.0 External Public Debt (% GDP) 27.7 28.3 22.8 19.2 19.6 Gross International Reserves (US $ Mn) 1,177.6 1,146.3 1,005.5 1,232.5 929.1 Net International Reserves (US $ Mn) 649.6 618.3 472.5 567.1 415.9 Gross International Reserves (in months of imports) 6.6 6.7 5.0 6.7 5.2 Debt Service (incl. STD) (% of exports of GNFS) 3.7 3.7 3.2 2.5 2.7 Total Debt Service (% of exports of GNFS) 12.7 11.7 9.5 8.4 8.5 Gross Financing Requirements / Reserves (%) 51.4 40.4 63.3 28.4 44.6

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Table 2 CariCRIS’ Projections for Key Macroeconomic Indicators

2011 Income & Economic Structure Real GDP Growth (%) 0.5-1 Unemployment Rate (%) 11-12

Fiscal Accounts (% of GDP) Central Gov't Overall Balance (5-7) Central Gov't Gross Debt 100-103 General Gov't Gross Debt 120-130

Monetary, Financial & Exchange Rate Indicators Consumer Price (annual average) 7-8

External Sector Indicators Current Account Balance (% GDP) (10-11) Overall External Balance (% GDP) 1-2 Change in Gross International Reserves (US $ Mn) 50-80 Gross International Reserves ( in months of imports) 5-6

January 4, 2012

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