Resilience and Growth in the Small States of the Pacific
Chapter

Appendix 5. Palau

Author(s):
Hoe Khor, Roger Kronenberg, and Patrizia Tumbarello
Published Date:
August 2016
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Palau, an archipelago of more than 560 islands occupying 460 square kilometers, is centered on the island of Koror. Based on 2012 census data, Palau’s population was 17,500, including 4,500 non-Palauans.

Palau adopted its constitution in 1981 and became independent in 1994 after being part of a United Nations trust territory administered by the United States for 47 years. It entered into a Compact of Free Association with the United States in 1986.1 The government structure is based broadly on the U.S. model, but there are no political parties. The legislative branch comprises an elected bicameral parliament of nine senators and 16 members of congress, representing each of the country’s states. The president and vice president are elected on separate tickets for four-year terms. Per capita GDP is estimated at US$16,070 in 2014/15.

Sources of Growth and Economic Profile

Sources of growth. The main contributors to growth are tourism-related activities, including hotels and food services, and wholesale and retail trade. From the expenditure side, growth is driven by private consumption and service exports (tourism).

Production, exports, imports, and employment. GDP grew strongly at 9.4 percent in 2014/15, fueled by robust growth in tourism and construction. Reflecting the large increase in tourist arrivals and the decline in food and fuel prices, the current account deficit fell sharply to 0.5 percent of GDP in 2014/15. Tourism receipts account for about 52 percent of GDP, while goods exports are just 5 percent and largely limited to fish and reexports of fuel. Palau relies heavily on imports (55 percent of GDP), particularly of food and fuel. The labor force, 68 percent of the working-age population (including foreign labor), is mostly employed in the private sector. The unemployment rate was about 4 percent in 2011/12.

External income and development aid. Major sources of foreign income are government grants (15 percent of GDP in 2015), mainly from the United States, investment income from the Compact Trust Fund (CTF), and social security and pension funds.2 Grants are directed to budget support, infrastructure, energy, and education. Financial aid under the country’s compact with the United States, which is scheduled to provide US$229 million in grants until 2023/24, was renewed in 2010. The agreement is now pending ratification by the U.S. Congress, but Palau continues to receive advances. The CTF’s balance stood at US$184 million (64 percent of GDP) at the end of the 2015 fiscal year. Drawdowns from the CTF are governed by the compact agreement and have been US$5 million annually since 2001/02. Technical assistance from multilateral and bilateral donors is provided in various areas, including public financial management and statistics.

Government finance. The fiscal deficit excluding grants was reduced sharply in 2014/15, but further fiscal adjustment is needed. A continued reduction in the current deficit excluding grants (5 percent of GDP in 2014/15) over the medium term—0.6 percentage point of GDP annually during 2016/17–2020/21—is needed to achieve long-term fiscal self-sufficiency. Otherwise, domestic revenue and investment income from the CTF will be insufficient to maintain steady public expenditure when compact grants expire in 2023/24. Reforming the tax system and containing spending growth are critical, and plans to implement the medium-term fiscal and budget frameworks are in place.

Financial sector. The financial sector consists of five commercial banks, a development bank, finance companies, and credit unions. Among the commercial banks, three are branches of U.S. chartered banks insured by the U.S. Federal Deposit Insurance Corporation. The U.S. bank branches hold 93 percent of the banking sector’s loans and over 99 percent of the sector’s deposits. The nonperforming loan ratio remained low at 2.1 percent at the end of 2014/15. Bank profitability is low despite a large interest rate spread. Total bank lending in U.S. dollars has remained low and has been declining relative to deposits. Loans are made mainly to construction, tourist, and commercial activities, as well as to mortgage and consumer loans.

Business climate and investment. Palau has great potential to develop a vibrant private sector and there is room to improve the business climate. For example, the World Bank’s Doing Business indicators for 2016 show the difficulty in using land as collateral for securing loans, which limits access to finance. Other key obstacles include restrictions on foreign investment in certain sectors, such as wholesale and retail trade, transportation, tourism, and commercial fishing, and complex licensing arrangements.

Exchange rate and competitiveness. Palau uses the U.S. dollar as its legal tender, which remains appropriate given the close financial and trade links with the United States, and it maintains an exchange system free of restrictions on international payments and transfers. The U.S. dollar also provides an important nominal anchor. Annual average inflation was 2.2 percent in 2014/15 and the real effective exchange rate is broadly in line with its long-term average, indicating the country’s external competitiveness and stability.

Growth Challenges, Vulnerabilities, and Spillovers

Main growth challenges. Palau faces a number of constraints common to small islands: an undiver-sified economy, geographical remoteness, small population, and a limited resource base. Insufficient infrastructure, weaknesses in the business climate, and limited access to credit hamper private sector growth. Here, the recent implementation of the secured transactions registry in the financial sector is a positive step. Further effort is needed to diversify the economy and attract foreign direct investment, including simplifying investment processes and making land leases more secure. Continued fiscal consolidation is crucial for achieving fiscal self-sufficiency and sustaining external stability.

Main vulnerabilities. Palau’s heavy reliance on tourism, grants from the United States, and food and fuel imports carries substantial risk. Weak global growth could hurt tourism, and an increase in food or fuel prices could raise inflation, depress domestic demand, and weaken fiscal and external positions. Given the need for fiscal consolidation and the absence of monetary and exchange rate policies, Palau has limited policy space to react to any downside scenario. Palau’s tourism prospects could also be affected by global climate change and weather-related disruptions such as typhoons.

Regional and global economic spillovers. The United States has a significant economic impact on Palau through the provision of grants and opportunities to study and work abroad. The CTF is also exposed to fluctuations in U.S. assets prices. Japan, Korea, Taiwan Province of China, and, recently, China provide the largest number of tourists.

Appendix Table 5.1Palau: Selected Economic Indicators, 2010–15
Nominal GDP (FY2014): US$250.9 millionGDP per capita (FY2015): US$16,070
Main exports: Tourism, fishPopulation (FY2014): 17,708
Remoteness (GDP-weighted distance): 7,554 km
Sources: Palau authorities; and IMF staff estimates as of May 2016.Note: … = data not available.

Current balance excludes grants and capital expenditure.

Index, 2005 = 100.

Data are calendar year.

Share in total loans.

World Bank, Doing Business reports; Palau is included from 2006.

United Nations Development Programme.

GDP, GDP growth, employment, and prices
Real GDP (percent change)−0.53.83.35.03.2−2.44.29.4
Real GDP per capita (percent change)−0.44.55.37.05.2−2.03.28.3
Unemployment (percent)
Consumer prices (percent change, average)2.83.01.12.65.42.84.02.2
Shares in real GDP (percent)
Accommodation and food services8.012.09.611.612.411.912.813.6
Public administration16.015.717.115.915.315.715.614.5
Wholesale and retail trade12.212.712.612.212.513.113.112.8
Agriculture and forestry1.51.31.51.41.31.31.21.1
Contributions to real GDP growth (percent)
Accommodation and food services0.21.20.72.61.1−0.81.52.0
Public administration0.10.0−0.1−0.5−0.10.00.50.3
Wholesale and retail trade−0.20.71.70.20.70.30.50.9
Agriculture and forestry0.00.0−0.10.00.00.0−0.10.0
Sources: Palau authorities; and IMF staff estimates as of May 2016.Note: … = data not available.

Current balance excludes grants and capital expenditure.

Index, 2005 = 100.

Data are calendar year.

Share in total loans.

World Bank, Doing Business reports; Palau is included from 2006.

United Nations Development Programme.

Share in real GDP (percent)
Private consumption61.064.064.062.863.665.664.763.5
Private investment
Public consumption33.533.136.633.631.733.333.030.3
Investment36.224.221.723.922.920.829.925.7
Exports minus imports−30.7−21.3−22.2−20.4−18.2−19.7−27.6−19.4
Contributions to real GDP growth (percent)
Private consumption−1.92.3−0.40.44.13.10.96.0
Private investment
Public consumption−1.50.2−0.3−2.0−0.32.10.60.8
Investment−4.32.12.42.70.3−1.310.0−1.2
Exports minus imports7.2−0.81.64.0−0.8−6.4−7.23.7
Public finances
Central government finance (percent of GDP)
Revenue and grants41.743.747.444.545.241.043.340.5
Total domestic revenue19.322.920.421.522.722.724.425.5
Grants22.420.827.123.022.518.418.915.0
Expenditure46.141.948.443.344.240.339.835.2
Current36.735.337.536.036.136.135.430.6
Of which: wages and salaries18.516.418.717.816.816.315.213.6
Capital9.36.610.97.38.14.34.44.6
Current balance1−17.4−12.4−17.1−14.5−13.4−13.4−11.0−5.0
Overall balance−4.31.9−1.01.31.00.73.55.9
Financing4.3−1.91.0−1.3−1.0−0.7−3.5−5.9
Assets4.0−1.8−3.81.9−4.72.7−3.9−3.0
Debt0.4−0.24.8−3.23.7−3.40.4−3.6
Of which: external−0.10.4−0.9−0.84.8−1.51.7−0.8
Public sector debt (percent of GDP)34.429.336.231.232.028.425.622.5
Compact Trust Fund balance (percent of GDP)80.877.082.273.380.282.979.464.0
Balance of payments (percent of GDP, unless otherwise indicated)
Current account including official transfers−20.5−7.7−6.7−9.2−8.7−9.3−11.8−0.5
Current account excluding official transfers−42.5−26.9−30.4−30.4−28.5−27.6−29.7−14.7
Overall balance−1.3−0.46.4−2.2−6.4−1.80.41.5
External debt service (percent of goods and services exports)4.85.16.85.55.54.64.23.9
Foreign direct investment−5.5−4.8−2.7−3.3−3.2−3.4−5.8−10.2
Sources: Palau authorities; and IMF staff estimates as of May 2016.Note: … = data not available.

Current balance excludes grants and capital expenditure.

Index, 2005 = 100.

Data are calendar year.

Share in total loans.

World Bank, Doing Business reports; Palau is included from 2006.

United Nations Development Programme.

External debt34.329.836.231.432.328.428.122.4
External income22.921.925.123.122.520.620.619.4
Government current grants18.516.119.517.616.514.814.813.6
Investment income0.10.00.00.00.00.00.00.0
Fishing license fees, others4.35.85.65.56.05.85.85.8
Contributions to external income growth (percent)
External income growth−0.23.27.70.64.8−3.39.20.2
Government current grants−1.41.68.7−1.40.8−3.76.6−1.7
Investment income0.00.00.00.00.00.10.00.0
Fishing license fees, others1.31.6−1.01.94.00.32.61.9
Exchange rate (U.S. dollar is the legal tender)1.01.01.01.01.01.01.01.0
Real effective exchange rate (period average)2122.7124.5126.1119.2122.4127.1128.0
(percent change)1.4−0.4−4.0−5.52.73.80.7
Money, credit, and financial sector3
Broad money (percent change)
Credit to private sector (percent of GDP)14.613.912.613.212.8
(percent change)−16.43.8−2.910.96.6
Bank assets (percent of GDP)54.561.160.061.670.3
Average yield on banking sector loans11.813.411.411.6
Nonperforming loan ratio5.53.33.63.4
Foreign bank market share (percent)486.088.489.189.8
Business climate indicators
Business environment rankings5
Doing business (overall)120113118120104131136
Construction permits674550525896101
Getting electricity10277808592137138
Enforcing contracts126121121124128129130
Getting credit1301711731761107179
Human development index60.80.80.80.80.80.80.8
Memorandum:
Nominal GDP (local currency)180.8227.5183.8199.9214.2228.7250.9287.4
Nominal GDP (US$ million)180.8227.5183.8199.9214.2228.7250.9287.4
Sources: Palau authorities; and IMF staff estimates as of May 2016.Note: … = data not available.

Current balance excludes grants and capital expenditure.

Index, 2005 = 100.

Data are calendar year.

Share in total loans.

World Bank, Doing Business reports; Palau is included from 2006.

United Nations Development Programme.

Sources: Palau authorities; and IMF staff estimates as of May 2016.Note: … = data not available.

Current balance excludes grants and capital expenditure.

Index, 2005 = 100.

Data are calendar year.

Share in total loans.

World Bank, Doing Business reports; Palau is included from 2006.

United Nations Development Programme.

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