Republic of Palau: Staff Report for the 2001 Article IV Consultation

This 2001 Article IV Consultation highlights that the Republic of Palau faces a number of development challenges. Substantial improvements in human and physical infrastructure are needed to sustain higher growth rates. About 80 percent of the land area is on the Babeldaob Island, which is virtually inaccessible now, but it is expected to develop rapidly after the completion of a Japan-funded bridge in 2002 and a United States-funded island access road in 2004. Asset balances have been declining as a result of drawdowns to finance fiscal deficits, as well as recent investment losses.

Abstract

This 2001 Article IV Consultation highlights that the Republic of Palau faces a number of development challenges. Substantial improvements in human and physical infrastructure are needed to sustain higher growth rates. About 80 percent of the land area is on the Babeldaob Island, which is virtually inaccessible now, but it is expected to develop rapidly after the completion of a Japan-funded bridge in 2002 and a United States-funded island access road in 2004. Asset balances have been declining as a result of drawdowns to finance fiscal deficits, as well as recent investment losses.

I. Background

1. The Republic of Palau has depended on external assistance for decades. Japan used the islands as a military base from 1914 and developed basic infrastructure. In 1947, the islands became a strategic Trust of the United Nations, administered by the U.S. In 1981, Palau established a constitutional government and commenced discussions with the U.S. on an association agreement that was concluded in 1994, ten years after similar agreements with the Federated States of Micronesia and Marshall Islands. The Compact of Free Association provides grants totaling nearly $600 million over 15 years in exchange for U.S. defense control (Box 1).

2. Compact grants were front-loaded in the first two years, intended to provide investment income and to finance budgetary spending until domestic revenue-raising capacity is strengthened. Nearly three fourths of the cash grants were received during the first seven years of the fifteen-year agreement. The upfront cash grants for current operations and capital projects have been largely spent, enabling budget deficits averaging 9 percent of GDP (after grants) during the past six years, without domestic or foreign borrowing.1 In addition, in-kind Compact grants were provided, in the form of various federal services and direct financing of a road project. A Compact Trust Fund (CTF) of $70 million, established to generate an income stream in the long run, has almost doubled in nominal terms despite sizeable losses in FY2001.2 Over the past six years, non-Compact grants (from the U.S., Japan, and Taiwan Province of China) have averaged 11 percent of GDP annually.

Summary of Compact Grants

($ million, unless otherwise indicated)

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3. Although per capita GDP is high ($6,180) in comparison with other Pacific Island countries, primarily because of very large U.S. grants, the economy faces several challenges common to other small island economies. The main challenges include a narrow productive base, a shortage of skilled labor, a small domestic market, inadequate infrastructure, and vulnerability to external shocks and natural disasters. The service sector constitutes a large proportion of GDP, with total grant aid exceeding one fourth of GDP annually, supporting the government sector. Tourism and fishing are the main private sector activities. A large share of the active workforce (36 percent) is engaged in the public sector, accounting for almost 50 percent of all wages paid in 1999. This partly reflects the demands of the communal system and the requirements of staffing a modern bureaucracy (Box 2).

4. As with other small Pacific Islands, significant financial resources are needed to address geophysical challenges. About 80 percent of the land area is on Babeldaob Island that is virtually inaccessible, but is expected to develop rapidly after the completion of two off-budget capital projects—the Japan-funded Koror-Babeldaob Bridge (in 2002) and a U.S.-funded Babeldaob Island ring road (in 2004). The 250 islands and their marine environment are fragile and could be destroyed by irresponsible development. The islands are home to a large variety of birds and unique vegetation, which are threatened by soil erosion and pollution from construction. The surrounding waters contain a diverse marine life and coral reefs, which are vulnerable to storms and climate change that could jeopardize income from tourism and fishing. Environmental protection has required significant budgetary resources to develop local agencies and expertise.

II. Recent Developments and Prospects3

5. Economic activity has been weak in the last two years and inflation is low (Figure 1 and Table 1). Following a 5½ percent decline in FY1999, real GDP is estimated to have expanded by only 1 percent annually in FY2000 and FY2001 (years ending September). Tourist activity—the main source of income—has not recovered since the Asian crisis, and its impact on overall growth has only been partially offset by project-related construction. Price inflation remains modest (2½ percent in FY2001) and slightly lower than in the U.S. Public and private sector wages have remained stable since 1996.

Figure 1.
Figure 1.

Republic of Palau: Selected Economic Indicators, 1993-2002 1/

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

Source: Data provided by Palauan authorities; and Fund staff estimates.1/ Preliminary estimates for 200/01.2/ Inflation data are not available for Palau. Nominal GDP is deflated by inflation in the United States.
Table 1.

Republic of Palau: Selected Economic and Financial Indicators, 1993/94-2001/02 1/

Nominal GDP (2000): US$118.2 million

Population (2000): 19,129

GDP per capita (1999): US$6,179

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Sources: Data provided by the Palauan authorities; and staff estimates.

Fiscal year beginning October 1.

On a calendar year basis. The column 1995/96 refers to 1996, and so forth.

U.S. CPI is used as GDP deflator for 1995 to 1999. Palau began compiling CPI from June 2000, therefore, the GDP deflator for year 2000 is the average of U.S. deflator and Palau CPI. For 2001, Palau CPI is used as deflator.

Covers operations of the Trust Fund from 1994/95.

Usable reserves estimated as government assets (total reserves) plus annual drawable amounts from the CTF less the balance of (project-related) capital grants.

Staff estimate of the unused balance of grant receipts. Capital and current balance do not add to total because of valuation losses in 2001.

uA01fig01

Fiscal Indicators

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

Source: Palauan authorities.

6. In spite of fiscal consolidation efforts, the overall fiscal deficit (including grants) increased to 15 percent of GDP in FY2001 from 4 percent of GDP in the previous year (Table 2). This larger deficit stems mainly from a sharp decline in the income from U.S. invested assets through lower dividends and realized losses (6½ percent of GDP), and lower external grants (10 percent of GDP). Current expenditures declined by 9 percent of GDP, reflecting fiscal consolidation efforts after the November 2000 election. Capital spending increased slightly to accommodate reconstruction following damage from Storm Utor. Improvements in administration yielded nearly 3 percent of GDP in tax and nontax revenue as a number of measures were introduced ahead of the passage of the tax reform act.

Table 2.

Republic of Palau: National Government Budgetary Operations, 1994/95-2001/02

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Sources: Reports on the Audit of Financial Statements; and data provided by the Palauan authorities. Fiscal year runs from October to September.

At the time the budget was passed, Congress also, separately, reduced “sin taxes”, reducing revenue by $1.2 million.

Includes reduction in GRT relating to the impact of the events of September 11 and changes to import tax regime and introducing excise duties.

Represents monies to be reimbursed (from reimbursable grants), changes in accounts payable/receivable, and other unidentified items.

This is the change in government assets (NTFA).

Estimates of annual disbursements out of total project cost of $125 million for the road; $24.7 million for the bridge and $14 million for the airport.

Reasons for Widening Deficit in FY2001

(In percent of GDP)

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Represents amounts to be reimbursed (from reimbursable grants) and changes in accounts payable/receivable.

7. Government asset balances have been declining, reflecting drawdowns to finance operational deficits as well as recent investment losses. The fiscal deficits have been financed mainly by withdrawals from government financial assets excluding the CTF (non-Trust Fund Assets or NTFA).4 Since a large part of the NTFA balance, which now stands at only $44 million, is associated with specific capital projects, freely usable official assets are estimated at $8 million (less than one month of imports). The market value of the CTF, which had grown at an average annual rate of over 13 percent during the period FY1995–FY2000 (to $162 million), declined by 17 percent in FY2001 (to $135 million), as about 60 percent of the Fund’s assets are invested in U.S. stocks.

uA01fig02

Government Assets (NTFA) and Usable Reserves

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

Source: Palauan authorities.

8. The external current account deficit has widened in recent years as project-related capital goods imports have increased and tourist receipts have fallen (Table 3). The worsening external position suggests that Palau’s competitiveness continues to deteriorate. The real effective exchange rate (REER) has appreciated by 25 percent since 1995.5 Tourism competitiveness began to decline after the Asian crisis reflecting the lagged effect of a strong U.S. dollar and large real depreciations in the currencies of competing Asian destinations. Moreover, airfares are high as they are determined by a single carrier servicing Palau, and hotels have been reluctant, until recently, to adjust their prices in the face of weaker demand.

Table 3.

Republic of Palau: Balance of Payments, 1994/95–2000/01

(In thousands of U.S. dollars)

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Sources: Data provided by the Palau authorities; and staff estimates.

Includes direct financed aid project imports and other tax-exempt imports.

Includes realized investment gains and losses.

Includes estimated profit repatriation by foreign fish and garment exporters until 2000/01, and interest payment.

Contribution to international and regional organizations.

Includes $13 million in 1997/98 for K-B bridge settlement and excludes grants-in-kind.

Staff estimates on investments in new hotels/resorts.

Large error and omission in 1994/95-1998/99 reflect underreporting of imparts prior to April 1999 when new customs system was implemented. In addition, net private current inflows are underestimated as inflows are only reported by one bank in Palau.

Usable reserves calculated as NTFA (government assets excluding Compact Trust Fund) minus amounts related to capital projects.

uA01fig03

Current Account, Imports and Tourist Receipts

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

Source: Palauan authorities.

9. The capital account was boosted in FY2000 by a grant and loan from Taiwan Province of China, both to finance infrastructure; however, an expected grant in FY2001 did not materialize. External debt, which is all long term, remains low at 16 percent of GDP. Outstanding debt had been repaid by 2000, before contracting a $20 million concessional loan to finance the new Capital building. Foreign investment is impeded by current regulations and by unclear land use rights (See Box 2).

uA01fig04

Real Effective Exchange Rate and Tourist Arrivals

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

Source: Palauan authorities; Information Notice System; and staff calculation.

10. Banking operations continue to be characterized by large outflows of deposits to U.S. banks. There is no central bank or regulatory body. Five pieces of financial legislation have been introduced in June 2001, in advance of Palau’s review by the Financial Action Task Force (Box 3). In approving the Financial Institutions Act (FIA), Congress diluted the provisions for banking regulation and supervision. Nevertheless, the law establishes a Financial Institutions Commission (FIC) to oversee banking regulation and supervision of the 20 registered banks.

11. A large number of bills and legislative amendments have been proposed to Congress in the past 10 months to revive the previously stalled fiscal retrenchment and structural reforms. In addition to financial sector legislation, these include a foreign investment act, budget reform act, statistical act, and constitutional amendments related to streamlining the executive and legislative branches.

12. Near-term growth prospects are uncertain. Real GDP growth is projected to be around 3 percent at best in FY2002. The current account deficit is expected to widen somewhat to around 15 percent of GDP as lower investment income is offset by a slight improvement in tourism receipts. Tourism is expected to grow by 3 percent, somewhat less than forecast before the events of September 11. Since mid-September, there have been no indications of a slowdown in planned private sector investment or construction activity.

III. Report on the Policy Discussions

13. The discussions focused on: (i) the FY2002 Budget; (ii) the steps needed to achieve fiscal sustain ability and maintain adequate reserves (in the form of freely usable government assets); and (iii) structural reforms to foster growth. In the face of declining external grants, Palau needs to act promptly to reduce its fiscal imbalances on a sustained basis and achieve surpluses in the second half of the decade. Palau’s growth performance since the Asian crisis is one of the lowest among Pacific Island economies, underscoring the need to continue with infrastructure development while accelerating the implementation of the government’s structural reform agenda aimed at boosting domestic and foreign investment.6

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Average Real Growth Rates of Pacific Island Countries 1998-2003

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

14. To frame its discussions, the team prepared with the authorities medium-term scenarios. The team noted that future returns on U.S. stocks and bonds are likely to be much smaller than in 1995-2000. Thus, the income from the CTF alone could not be relied on to replace lost Compact grants from FY2010 onwards on a sustainable basis. Early withdrawals would further weaken the CTF’s financial position.

A. The FY2002 Budget

15. At the time of the mission, Congress was debating the FY2002 Budget that targeted an overall fiscal deficit of 6½ percent of GDP.7 The budget focused primarily on cutting current expenditure (by about 5 percent of GDP)—by reducing transfers to enterprises and goods and services—while increasing capital expenditure (by 3 percent of GDP). Additional grants were expected from Taiwan Province of China for capital projects and storm-related reconstruction. However, this budget was based on an optimistic projection for GDP growth and did not include specific revenue measures. The authorities explained that some further tax administration improvements were being implemented and that the tax reform legislation was expected to be approved by the end of FY2002.

16. The mission recommended that the overall fiscal deficit (including grants) for FY2002 be brought down to below 5 percent of GDP. Events since the U.S. terrorist attack suggested that nominal GDP growth would be modest, and thus revenue shortfalls would emerge. The team advised against delaying tax reforms until the end of FY2002 and urged the authorities to move ahead with reforms to reduce exemptions, broaden the tax base, introduce excise taxes, rationalize the import tax regime, and simplify the income tax regime. If such measures could not be introduced in a timely manner, further expenditure cuts would be needed. The mission stressed that continuation of a wage and hiring freeze and the initiation of streamlining measures were necessary to contain personnel expenses as proposed in the budget. Moreover, additional measures were needed in order to fund an Emergency Contingency Reserve Fund (ECRF), as approved by Congress, without dipping into freely usable reserve assets.8 The authorities broadly agreed with the mission’s recommendations, and indicated their intention to propose additional measures to Congress early in the year if revenue targets appeared at risk.

17. However, after the mission’s departure, Congress approved a FY2002 Budget that would effectively yield a deficit of around 7½ percent of GDP. This budget reduced current expenditure by more than ½ percent of GDP, but also reduced import duties on alcohol (1 percent of GDP) and did not take into account the expected decline in domestic revenues stemming from the economic slowdown (1 percent of GDP).9

18. The government then indicated it wanted a lower deficit than Congress had approved and to that end submitted a tax reform package on October 31, that is expected to be approved by Congress and become effective in January 2002. In consultation with the staff, the authorities developed a tax package that could yield 4 percent of GDP on an annual basis. The package would include (i) reducing the 4 import duty bands (0–150 percent range) to a flat 5 percent rate; (ii) limiting import duty exemptions; (iii) calculating import duties on the CIF, instead of FOB, value of imports; and (iv) introducing excise taxes on tobacco, alcohol, fuel, boats, and vehicles. In addition, by reversing the earlier reduction of duties on alcohol, revenue would increase by about 1 percent of GDP. The overall fiscal deficit for FY2002 would be reduced to 3½ percent of GDP, if the package is approved in full and implemented by January 2002.

B. Fiscal Sustainability and Related Structural Reforms

19. The team emphasized the need to develop a medium-term fiscal consolidation plan consistent with the scheduled phasing out of grants, in accordance with the present Compact and realistic assumptions on future CTF returns and to take into account the need to build an adequate level of reserves.

20. Accordingly, fiscal policy should target a containment of current expenditure to less than the total of domestic revenue and current Compact grants, since the majority of capital expenditure is grant-financed. In spite of the decline in current expenditure from 61 percent to 52 percent of GDP in FY2001, and a further planned decline to 46 percent of GDP in FY2002, it remains excessively high compared to similar countries (Box 4). Recent expenditure cuts should be reinforced through accelerated public sector reforms in order to make room for much needed human and physical capital improvements. Current expenditure should be targeted to decline by 5 percent of GDP by FY2005, while capital expenditure remains above 12 percent of GDP. At the same time, domestic revenue should be further increased by 5 percent of GDP following implementation of the next stage of tax reform—including the introduction of a simplified income tax and a sales tax—which the authorities intend to present to Congress in FY2003. Undertaking these reforms in the next three years would allow small fiscal surpluses to emerge from FY2005 onward, and to reach a level by FY2009 that could compensate for the reduction in grant aid. The authorities confirmed their intention to contain current spending below domestic revenue and annual Compact grants while raising revenue as a percent of GDP by the end of the Compact period, although they were constrained by often-conflicting demands by Congress that could prevent them from achieving these goals.

21. The mission endorsed the public sector reform initiatives aimed at streamlining government operations and improving service delivery. In particular, staff welcomed measures taken in January 2001 to introduce a hiring freeze, and reactivate the National Planning Committee to oversee governmental reorganization. Since January, the President had also submitted a proposed constitutional amendment that would reduce the legislative branch from two houses to a single house. Revised public service system regulations were drafted in October 2001 that include provisions for staff re-training, transfer, and redundancy payments, as well as strengthening performance evaluation and standardizing benefits. A separate law is being drafted to adjust compensation schemes during 2002 with the aim of improving merit-based incentives. The authorities described a number of additional initiatives, including the passage by Congress in July 2001 of a law initiating a “performance management system” that aims to eliminate duplication of services and ensure productive use of public funds. Legislation is also being prepared to reduce governmental operations by outsourcing services and privatizing some maintenance and operational functions. Finally, the authorities are undertaking a study to further improve the efficiency of education and health care expenditures, including reforms aimed at moving to a self-financed health system (Box 5).

22. The mission also emphasized the need for greater fiscal transparency and monitoring. Staff pointed to the need to strengthen fiscal accounting and monitoring by developing in-house capacity to publish consolidated fiscal accounts; requiring state governments to fully report their fiscal operations; and eliminating extra-budgetary funds. Although extensive reporting is undertaken by an external auditing firm to conform to U.S. reporting requirements, fiscal reporting is inadequate for policy assessment and formulation. Government finance data reveal large “errors and omissions” that reflect amounts that are reimbursable from grants and changes in accounts payable/receivable that result from advances or partial payments to suppliers. The mission stressed the need to identify and correct these discrepancies and to secure additional technical assistance and training if needed. The authorities affirmed their intention to continue their ongoing investigation of these issues in consultation with the staff.

23. The mission urged that measures be taken to reverse the recent increase in unfunded liabilities of the Social Security Fund (SSF) and the Civil Service Pension Fund (CSPF). A change in the retirement qualification (from age 60 to 30 years of service without reduced benefits) in July 1999 increased the unfunded liabilities of CSPF from $15 million to $24 million. In addition, an increase in benefits related to a cost of living adjustment in 2000 required a lump-sum transfer to the CSPF of $7.3 million, of which only $1.5 million was transferred in FY2001. The authorities indicated that annual lease income from one of the two internet concessions (each yielding $1.3 million) that were recently awarded to private companies will be earmarked for the CSPF. The government has proposed to Congress alternative funding plans for CSPF contemplating budget contributions, earmarked income, increased payroll contributions, and benefit reductions. While the SSF is self-financing by law, recent changes to benefits have increased its unfunded liability from $15 million to $20 million without providing for additional funding. In this connection, the mission welcomed the proposed legislation to reverse a part of this increase in benefits. However, while both funds will be able to continue to meet their current obligations for many years from current surpluses, the mission noted that the authorities need to devise plans to eliminate the unfunded liabilities of the two funds, which underscores the importance of reducing the size of the civil service and revising the contribution and benefit schemes.

C. Other Structural Reforms

24. In view of Palau’s sluggish growth performance, the mission stressed the need to proceed more vigorously with the government’s structural reform agenda. In particular, the team stressed the need for adequate financial sector regulation and supervision to promote efficient intermediation of financial savings and the elimination of impediments to private and foreign investment.

Financial sector reforms

25. The mission welcomed the passage in June 2001 of legislature aimed at combating money laundering. The FATF has since reviewed this legislation and deemed it adequate to keep Palau off the list of noncooperative countries. Moreover, the authorities had earlier forced the closure of one bank that was involved in unauthorized offshore operations. However, banking regulation and supervision remain virtually nonexistent, although there is no evidence of systemic banking problems and NPL ratios are very low (Box 6).

26. The mission also welcomed the recently passed Financial Institutions Act (FIA), which paves the way for establishing the Financial Institutions Commission (FIC) to oversee banking regulation and supervision. However, in order to ensure adequate oversight, the mission pressed for amendments in the following five areas: (i) removing potential sources of conflict of interest; (ii) clarifying the definition of regulatory capital and raising the capital adequacy requirement to international norms; (iii) requiring adequate record-keeping, reporting, and external certified auditing of all banks, not only foreign banks; (iv) clarifying the FIC’s mandate to request additional reports and conduct on-site inspections, and completing an initial evaluation of all existing banks against the new regulations; and (v) re-instating the provision that limited the type of activities undertaken by a licensed financial institution to its level of paid-up capital. The authorities indicated their willingness to amend the legislation and/or address these issues through FIC regulations before the end of 2001. They also welcomed the prospective technical assistance from PFTAC in achieving this objective.

Removing impediments to investment

27. The mission stressed the need to remove impediments to private investment, including through amendment of the foreign investment law, which is expected in fiscal year 2002, and acceleration of dispute resolution by the Land Courts, which is now underway through increased budgetary allocations to the courts. The authorities recognized that foreign investment was constrained by a cumbersome review process and restrictions on foreign participation in various activities. In addition, as discussed in the background paper, the spread of Palauan-owned “fronts” for foreign investors has reduced transparency and negatively influenced investor incentives. The authorities noted that a new foreign investment law was currently under Committee review in the Congress and that legislation was being prepared that would permit longer leases for foreign investors and broader land rights to joint ventures. The authorities were keen to resolve these investment constraints in view of the growth prospects of Babeldaob Island, and related foreign financing needs, following the completion of the Compact Road.

28. In view of the recent deterioration in competitiveness, the mission recommended that labor laws be revised. A minimum wage of $2.50 per hour for Palauans was introduced in 2000, while a head tax of $500 is levied on employers for each foreign worker. Average wages for all foreign workers are about 50 percent of those of Palauans, but wages of unskilled foreign labor are as low as $0.35 per hour plus lodging. The minimum wage legislation, in combination with the taxation of foreign labor, was intended to reduce the reliance on public sector employment by increasing private sector wages, especially for unskilled labor. However, it appears to have effectively worsened employment opportunities for Palauans, pushed up wages for foreign labor, and contributed to deteriorating competitiveness. The authorities stated that they planned to prepare a modern labor code with a view to encouraging greater private sector opportunities for Palauans.

29. A Tourism Promotion Task Force has been formed to investigate ways to boost Palau’s tourism earnings, especially through reducing the relatively high cost of air transport.10 Accordingly, officials have sought discussions with investors interested in setting up an airline that would link Palau with some of its neighbors thereby lowering noncharter airfares through increased competition and improving connections to Europe. Some other proposals under consideration involve diversification into new activities, e.g., golf courses, sports fishing, and retirement communities.

30. The authorities fully recognize the need to preserve Palau’s fragile environment and to protect against soil erosion and have embarked on a wide range of environmental initiatives. Tourism prospects are closely tied to the success of efforts to preserve Palau’s prime diving sites, while limiting construction-related pollution. Key institutions have been formed to monitor and analyze environmental data, regulate infrastructure development, and promote preservation policies. A major part of the government’s effort is geared toward adequate safeguards ahead of the expected urbanization of Babeldaob Island. The authorities stated that a number of legislative items are being prepared to address environmental issues.

Tariff Rates in Pacific Island

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Sources: IMF Exchange Arrangements and Exchange Restrictions, 2000; and IMF Country Reports. The reported rates are for the latest available year.

Calculated as the amount of import duties or trade taxes relative to total imports.

Ranging from least restrictive (1) to most restrictive (10). The index has not yet been computed for Palau. The staff’s estimate is indicated in the table, based on low tariffs and the absence of quantitative restrictions.

There is no available estimate of the average tariff and many tariffs are specific rather than ad valorem. This is a rough staff estimate.

Trade liberalization

31. Palau’s trade regime is relatively open and the proposed tax reforms noted earlier constitute a further improvement. Most imports are subject to a 3 percent tariff rate (See Tax Summary, Recent Economic Developments, Table 15); vehicles are subject to a rate of 5 percent, in addition to specific quantity-based import levies. Some luxury items are subject to a 25 percent rate. Alcohol and cigarettes are also subject to specific levies. Exceptions apply to medicine, food, and boats for personal use, as well as grant-financed imports and goods for government use. There are no export restrictions and only fish exports are taxed. The proposed tax reform noted earlier would introduce a uniform 5 percent tariff rate and remove exemptions for food, medicine, and boats for personal use. Palau would continue to have one of the lowest tariff rates among the Pacific Islands economies.

D. Medium-Term Growth Scenarios

32. The team emphasized that improving growth prospects would require an acceleration in the pace of structural reforms, and prepared with the authorities two illustrative medium-term scenarios covering the period through 2009/10 (See Annex V). The reform scenario assumes approval by Congress in the coming months of the tax package, investment law, and expenditure management reforms. It also assumes continued implementation of the government’s strategy—as described in the MAP—which outlines sectoral priorities for infrastructure development, as well as further plans to improve the provision of public services and streamline government operations.

33. Implementation of these reforms would facilitate a rise in annual real GDP growth to 6 percent by the end of the decade, with tourism boosted by improvements in competitiveness spearheading private sector growth. Freely usable official reserves would increase to over three months of imports. Beyond 2009, the fiscal and external deficits resulting from the cessation of Compact grants could be filled by sustainable withdrawals from the CTF. In the less optimistic scenario which assumes no structural reforms, real growth would be constrained to 2 percent annually during this decade, and continued large fiscal deficits would make it impossible to compensate for the sizeable reduction in grants without substantially eroding official reserves and requiring Palau to undergo a difficult adjustment process. The authorities confirmed that Palau is keen to avoid the sharp output contractions that some other islands had experienced following the declines in grants upon which they had become reliant, as needed adjustments had been postponed.

34. Nevertheless, the authorities shared the staff’s view that even if they pursued the reforms underlying the reform scenario, there would be significant risks to the medium-term outlook associated with implementation capacity and external vulnerability. While the government’s long-term Master Development Plan issued in 1996 confirms the need to achieve fiscal and external sustainability and to do what is required, key measures have not so far been adopted on schedule. Both technical assistance requirements and political developments contributed in the past to delaying passage of legislation. Although several key reforms had been recently introduced, there remains a large agenda of pending legislative reforms. Moreover, the vulnerability of tourism to a number of factors—changes in the fragile marine environment, commercial fishing, pollution from increased levels of construction and manufacturing, and the global economic downturn—underscores the possible adverse effect on growth prospects if timely corrective action is not taken.

35. The medium-term exercise served to illustrate the extent of fiscal adjustment, averaging 1 percentage point of GDP per annum over the next 8 years, needed to prepare for the expected decline in grant aid by about 6½ percent of GDP in FY2010. Although the government’s stated objective is to refrain from CTF withdrawals before FY2010, the scenarios showed that in the absence of fiscal reforms, existing reserves would be depleted by FY2008 and CTF withdrawals would be needed. In discussing future CTF returns, the team emphasized the need to assume more modest returns than those achieved in recent years, particularly in view of the substantial stock market losses in FY2001, and to avoid withdrawals before FY2010 and limit them thereafter (Annex VI). The authorities agreed with the desirability of limiting withdrawals beyond 2010 to a level aimed at maintaining the real per capita value of the CTF.11

IV. Technical Assistance and Data Issues

36. Severe data shortcomings continue to hamper economic assessment and policy formulation. Following the recommendations of the staff team during the 1999 Article IV consultation discussions, regular GDP compilation was undertaken, a CPI index was developed, and a new customs reporting system has improved trade statistics. The authorities agreed that the next priority is a statistics law to formalize the government’s role in collecting and disseminating economic data to the public, which would also prepare Palau for participation in the GDSS. They also recognized that improvements would be needed in the balance of payments and government finance statistics.

37. As in the case of other small island economies, Palau has a dearth of economic management expertise and is dependent on foreign advice. Palau benefits from a considerable amount of PFTAC advice (see Annex H). In general, technical assistance has been effective and advice is implemented in a timely manner. The authorities are requesting additional PFTAC assistance in establishing effective banking supervision, designing financial disclosure guidelines, modifying bank taxation rules, and establishing a banking survey.

V. Staff Appraisal

38. In spite of sizeable fiscal expansion, economic activity has been weak and prospects remain poor in the absence of structural reforms. This outlook reflects the economy’s high dependence on tourism and the poor performance of that sector since the Asian crisis. Recent grant-financed infrastructure projects have only partially offset some of this weak demand. Cost competitiveness has declined due to the relative strength of the U.S. dollar. Private investment remains low reflecting rigidities in the land and labor markets, and cumbersome regulations on foreign investment.

39. Palau needs to undertake large fiscal adjustments to prepare for the decline and subsequent cessation of U.S. Compact grants, without depleting government assets. Although the authorities believe that some amount of grant assistance will continue to be forthcoming from other sources, it is prudent to assume that future support will be much less than is now available. Consequently, fiscal deficits on the scale of those incurred over recent years will not be financeable.

40. In moving to fiscal sustain ability, the authorities should target a marked reduction of the overall government deficit in FY2002 to below 5 percent of GDP, and a balanced budget by FY2005, when the unspent balance of capital grants is expected to be depleted. However, in view of the recent budget passed by Congress that yields a deficit of 7½ percent of GDP, it is important that additional revenue and expenditure measures be approved to achieve the intended deficit target in FY2002 and beyond.

41. To this end, the tax package currently under review in Congress should be implemented as soon as possible. This package focuses appropriately on streamlining the import tax structure, introducing excise taxes, reducing exemptions, and broadening the import duty tax base. In FY2003, the authorities should move ahead with plans to shift to a more efficient and equitable tax structure by introducing a simplified income tax and a sales tax, as well as continuing to adjust fees on public services.

42. Fundamental structural reforms are essential to achieve long-term fiscal sustain ability while fostering growth and building reserve assets. As such, the new administration’s reform program is pointed in the right direction by focusing on revenue mobilization, public administrative reform, human capital development, financial sector development, investment promotion, and environmental protection. If these reforms are elaborated and initiated in the coming year, Palau would be much better prepared to absorb future external shocks and the prospective reduction in U.S. grant assistance. Given the low level of freely usable reserves, there is a need to build a buffer against adverse external shocks, while continuing to avoid withdrawals from the CTF. In developing future policy options, it is important to adopt more conservative assumptions on CTF’s future returns. The establishment of an Emergency Contingency Reserve Fund is a welcome step and every effort should be made to commence its funding in FY2002.

43. The planned curtailment of current government expenditures by advancing civil service reform should be continued. The salary and hiring freeze should be enforced until the size of the civil service is reduced through attrition and existing posts are linked strictly to skill and performance requirements. It is important to proceed expeditiously with plans to reorganize the government by reducing the number of offices and removing some layers of government. In particular, there is merit in the administration’s aim to consolidate state government activity into a more unified central administration and to establish a unicameral legislature. At the same time, fiscal monitoring capacity must be strengthened by recruiting qualified staff, requiring state governments to report their fiscal operations, eliminating extra-budgetary funds, and developing in-house accounting, forecasting, and reporting capacity.

44. The government should emphasize the intended shift in its role from being the main employer to one of supporting private sector investment and entrepreneurship. Reform initiatives aimed at right-sizing government and improving service delivery are welcome. The new “performance management system,” if successfully implemented, could eliminate duplication of services and ensure productive use of public funds, while outsourcing or privatizing some maintenance and operations services.

45. Palau’s growth prospects will depend critically on its ability to develop tourism by attracting foreign investment and nurturing domestic entrepreneurship. The government’s structural reform agenda recognizes the need to remove impediments to Palau’s growth and is broadly appropriate. Nevertheless, implementation has been slow in the last seven years suggesting that concerted efforts are needed to expedite the current initiatives to remove restrictions of foreign investment and delays in resolving land disputes, which have discouraged investment. Success in removing these impediments will require: (i) Congressional support for the initiatives outlined in the MAP; (ii) prioritization and sequencing of the broad range of initiatives; and (iii) timely elaboration of specific strategies, related legislation, and implementation procedures.

46. While the recent passage of financial legislation is welcome, continued efforts are needed to establish a viable supervisory framework in Palau. Although there are no signs of immediate systemic risk, it is essential that Palau develop a financial sector that is capable of intermediating savings and providing credit for viable projects. Weaknesses in the regulatory and supervisory framework must be addressed by amending the legislation and establishing a strong Commission that is capable of ensuring its effective implementation. Moreover, the financial disclosure of audited bank reports will lead to strengthened accounting and disclosure practices of businesses which would, in turn, encourage bank lending.

47. Weaknesses in data continue to hamper the assessment of economic developments and policy formulation. With the exception of recent improvements in trade data, other components of balance of payments statistics are weak and incomplete. Fiscal accounting is extensive, but improvements are needed in developing consolidated reports to guide policy formulation and in removing remaining discrepancies. Efforts are also needed to compile quarterly GDP indicators, a GDP deflator, and monetary statistics.

48. The next Article IV consultation with Palau is proposed to take place on the 24-month cycle.

Republic of Palau: The Compact of Free Association

The Compact of Free Association (the “Compact”) is a 50-year political, strategic, and economic treaty between the Republic of Palau and the United States. Under the Compact, Palau conducts its own domestic and foreign affairs, while the United States retains control of defense and security matters as well as exclusive strategic access to the land adjoining the Airai Airfield and a part of Malakai Harbor. Under the Compact, the United States is to pay the government of Palau a specified sum of money in the first 15 years of the Compact. The Compact took effect on October 1, 1994, as Palau became a sovereign nation in free association with the United States.

The Compact payments are not entirely economic aid. Rather, they are a combination of rent and aid, which amounts to nearly $600 million in total direct payments. About three quarters of the cash amounts have been disbursed in the first seven years. Under the Compact, citizens of Palau may enter the United States and establish residence as nonimmigrants, and accept employment. The terms of the Compact and its related agreements are subject to review by both parties at specified intervals during its 50-year life.

The main goal of the Compact funds is to establish an infrastructure that would enable Palau to become self-sustaining by the end of the 15-year period. Among the conditions of the Compact’s approval by the U.S. Congress was the formal adoption by the Palauan government of an economic development plan (EDP), which outlined particular goals and methods to achieve these goals. In addition, the government of Palau is required to report annually to both the President and Congress of the United States “on the implementation of the plans and on its use of the funds” made available under the Section 211 Grant (as detailed in Table 4). The Compact funds comprise the following elements:

  • One portion, Section 211(f) amounting to $70 million, is set aside for a Trust Fund, which is to provide a stream of income over the long run.

  • Another large element of grant assistance provides front-loaded grants in the first year of the Compact for current and capital improvements that are lowered in the second year and further reduced from the fifth year.

  • Assistance is also provided in the form of an in-kind grant amounting to $ 149 million for the construction of the Compact Road on Babeldaob Island. This project is planned for completion by summer 2004.

  • In addition to economic assistance, the United States has made available to Palau under the Compact services and programs of agencies such as (i) the Federal Deposit Insurance Corporation (FDIC), the Small Business Administration, the Economic Development Association, the Rural Electrification Administration, the Job Training and Training Act, Job Corps; (ii) postal services; and (iii) services relating to tourism and marine resource development of the Department of Commerce.

In addition to Compact support, Palau continues to be eligible for other U.S. assistance, based on direct proposals to grantor agencies, which have amounted to an additional $7 million annually in recent years.

Table 4.

Republic of Palau: Selected Social Indicators, 1995 and 2000

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Sources: 1995 and 2000 Census of Population and Housing from the Office of Planning & Statistics; and Social Security Office.

Republic of Palau: Tribal Influences and Land Rights

Like other Pacific Island economies, cultural factors permeate and influence economic and political processes. The traditional tribal system is intertwined with the demands of a modern government and has resulted in a large public service where resources are allocated in a manner in which collective decision-making remains an important element.

The large size of the public sector stems partly from the need for consensus-building and tribal representation. The system of government is modeled after the U.S. and comprises 16 states which have their own constitutions, legislature, and elected governor and are represented in the two houses in the National Congress—known in Palauan as Olbiil Era Kelulau (OEK). Although the tenets of modem democracy and the traditional tribal system have been skillfully blended, reconciling the differences between a communal and private enterprise system has been more challenging, as it has been throughout the Pacific. Tribal leaders continue to play a role in decision-making.

A major constraint on economic development has been the uncertainty over property rights, in particular title and rights to land. A communal land tenure system appears to raise transaction costs for undertaking commercial agriculture, tourism, mining, and other activities. Nonmarket allocation rules, along with shortcomings in the demarcation and registration of plots, give rise to disputes over access to land. Foreigners cannot legally own land, nor enter certain industries. Restrictions on the use of land as collateral also hinder credit growth. The constitution prohibits the taxation of land.

The concentration of land approvals in the hands of a relatively small number of influential Palauans also creates the potential for corruption and misuse of resources. Much of the land in Palau is owned by clans and can only be given or sold to a Palauan individual by the unanimous consent of clan members. At the same time, Japanese occupation during WWII and the subsequent redistribution of land created much confusion about land ownership. There are also difficulties in gaining access to land for public purposes, such as for the provision of telecommunication services.

Recognizing the consequences of such uncertainties, the government has taken steps to make the land market more predictable without changing the fundamental institutional construct which reserves freehold land for Palauans only. All lands have been required to be surveyed and registered with the Land Court by 2005. Less than 10 percent of land had been registered by the mid-1990s. However, the number of litigations has increased, slowing down the process and making it difficult to acquire land that is suitable for development. Even after titles are granted, there are still individual-to-clan disputes. Courts have recently increased their capacity to handle the litigation, but only 50 percent of cases have been resolved.

To facilitate foreign investment, Palau allowed in 1995 leasing of land for up to 50 years (with a further 59 years extension). Foreign concerns seeking long-term land access tend to take local partners, especially landowners, or obtain fixed-term leases on lands for which titles have been obtained and registered in the Land Court.

It will be important to continue making progress on:

  • accelerating the process of land surveying and registration;

  • clarifying procedures for government land acquisition for infrastructure and public use; and

  • further strengthening the capacity of the Land Courts.

Republic of Palau: Initiatives to Combat Money Laundering

Reports that offshore banks in Palau and other Pacific Island economies were involved in large-scale money laundering activities prompted in late-1999/early-2000 a few large international banks to place a ban on U.S.-dollar denominated transactions involving Palau, Nauru, and Vanuatu. In response, Palau established a National Banking Review Commission to investigate these allegations. Composed of representatives of the government and members of the business sector and chaired by the Attorney General, the Commission was given broad powers to determine the accuracy of reports by the international banks that had imposed the bans. The Commission issued a report declaring that there is no credible evidence that any financial institution in Palau had engaged in activities that would justify the accusations.

The U.S. Department of State has raised concerns over Palau’s bank licensing procedures. The Money Laundering and Financial Crimes Report, 2000 notes that a few shell banks had been established through a mechanism in which entities in Palau applied for certification of incorporation and business licenses in a local (in lieu of national) level jurisdiction. None of these were ever given foreign investment approval or any approval to do business in Palau. Nonetheless, a few of these were reported to have handled almost $2 billion in suspicious transactions with foreign financial entities.

Palau has sought assistance from the United States, the Pacific community, the U.N., and the IMF in its efforts to develop an anti-money laundering regime and has participated in international meetings and conferences on financial crime. Palau is also a signatory to the anti-money laundering initiatives of the Pacific Island Forum and has made significant advances to comply with the Honiara Declaration (which calls for the implementation of the FATF 40 Recommendations).

In June 2000, FATF listed some Pacific Island Forum members, but not Palau, as “noncooperative jurisdictions”. These countries were regarded as having detrimental rules and practices, which obstruct international cooperation against money laundering and allow criminals to escape the effect of anti-money laundering measures. Palau was not reviewed at that time.

The FATF Plenary Meeting in June 2001 postponed a review of Palau’s status regarding “noncooperative jurisdictions”. The decision on Palau and three other countries was postponed until September as each of these countries had passed legislation in recent weeks that had not yet been incorporated into FATF’s results. More time was needed to review this new legislation.

In September 2001, the FATF review was completed and, based on the legislation passed in June, Palau was not included on the list of con-compliant or non-cooperative countries. Since June, one bank’s license was revoked. Also, the activities of several previously licensed financial institutions that do not meet the eligibility criteria under the new law, will be restricted. Palau intends to continue to implement the FATF 40 Recommendations.

There is currently no law in Palau permitting offshore banking. The Offshore Banking Act was suspended in 1982.

Republic of Palau: Comparison of Fiscal Indicators Among Pacific Island Countries

Palau’s domestic revenue is supplemented by substantial U.S. grant receipts. Combined tax and nontax revenue (excluding grants) are the second highest among the island economies in relation to GDP. Nontax revenue collections are only second to that of Kiribati which receives large sums from fishing rights. Although Palau receives substantial grants of around 25 percent of GDP, these are lower than grants received by the Federated States of Micronesia (FSM), Marshall Islands (RMI), and Kiribati.

Palau has a relatively high ratio of wage expenditure to GDP although current expenditures as a percent of GDP are in line with other island states. The government is the largest employer, accounting for about 30 percent of total employment. In 1999, public sector wages accounted for about 50 percent of all wages paid.

Source: PIC database for 1999. All indicators are in percent of GDP.

Republic of Palau: Social Services

Expenditures on health and education in Palau are in line with the average expenditures in other island economies. Education, health, and medical services are provided by the government in Palau. Outlays for these services account for 16 percent of GDP, compared with a range of 8 percent and 27 percent of GDP for other island economies.

A number of initiatives are aimed at improving cost-efficiency of public health and education services. Despite declining government transfers in recent years, the main hospital was able to provide increased medical services to patients by imposing health service fees at about 25 percent of medical cost. The demand for increased medical services was largely due to an increase in the number of foreign workers in Palau. However, much scope remains for improving the quality of education services, as about 38 percent of teachers are high school graduates who do not hold college/university degrees. Some savings can be achieved by limiting the school lunch program which currently extends to private schools.

Palau faces a shortage of skilled labor which is one of its main developmental constraints. A community college was established in 1993. The Ministry of Education records show that enrollment grew by 7 percent for elementary schools and 13 percent for secondary schools in 1998–99. The total student enrollment was 4,150 in 2000. Palau is facing a shortage of local teachers, and the student-teacher ratio increased to its highest level in 1998–99. A teacher’s certification bill is awaiting Parliamentary approval. The introduction of local certification standards will increase the number and quality of teachers.

uA01fig07

Health Expenditure

(In percent of GDP, 1999/2000)

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

uA01fig08

Education Expenditure

(In percent of GDP, 1999/2000)

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

Human Development Indicators in Pacific Island Countries

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Source: Pacific Regional Strategy, The World Bank (2000).

The Human Development Index (1 being the highest ranking) is derived from combining the average life expectancy at birth, adult literacy, gross school enrollments, and adjusted GDP per capita.

The Human Poverty Index is derived from combining the life expectancy, literacy, and standard of living indices.

Republic of Palau: Banking System

Palau has a large banking sector relative to its population. The financial sector consists of around 20 registered banks (not all of which are active), including three U.S.-based banks, a development bank, and a number of small credit unions. The branches of U.S.-based banks are insured by the FDIC and follow U.S. regulations. Local banks are not yet subject to formal regulation. As Palau uses the U.S. dollar, and given its strong links with the U.S. banking system, deposit rates in Palau tend to mirror those of the U.S. However, lending rates vary from 5-18 percent for smaller loans, and commercial loans are extended at the U.S. prime rate plus 1-4 percent.

Commercial banks lending is limited and funds have tended to flow out of the country. Foreign commercial banks have tended to pool deposits at their headquarters for investment elsewhere, as indicated by the substantial excess of deposits over loans. Lending has tended to focus on smaller consumer loans (well secured by deductions from salaries paid into bank accounts) rather than business loans. Commercial loans are viewed as more risky and the difficulties in using land as collateral has presented a problem for foreign-owned banks.

The National Development Bank of Palau (NDBP) eased this constraint by guaranteeing 90 percent of commercial loans for a fee (the NDBP can also assume the title of land in the case of default). The NDBP’s provision of loan guarantees and lending was constrained in 1998/99 by the deterioration in its balance sheet (related to poor-quality directed lending). New management was brought in to focus on loan recovery and improve monitoring and loan risk assessments. In 1999, the NDBP made news loans of only $350,000, which increased in 2000 to around $3.2 million with the recovery of its financial position and a government transfer.

uA01fig09

National Development Bank of Palau: Loans

(In thousands of U.S. dollars

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

Bank regulation and supervision in Palau is being developed following the enactment of the new Financial Institutions Act (FIA), which was approved in June 2001. While there is some concern that the final form of the legislation has resulted in the general weakening of supervision powers over financial institutions, the authorities have indicated their intention to strengthen the law through amendments and regulations. The FIA represents a step forward as several previous attempts to have banking legislation enacted have failed. The FIA will be implemented by the Financial Institutions Commission (FIC), to be overseen by five Board members who will develop regulatory guidelines and monitor banks’ compliance. Selection of the five Board members has been difficult, due to the lack of qualified individuals who are not current Bank officials. There is also a concern over the lack of appropriate funding for the FIC. Once the Board members and staff are selected, the FIC is expected to review the accounts, operations, and staffing of each of the licensed banks to determine their compliance with the new regulations as presented in the FIA. They will also begin to collect banking data that can form the basis for a banking survey.

ANNEX I: Republic of Palau: Fund Relations

(As of November 30, 2001)

I. Membership Status: Joined: 12/16/1997; Article XIV

II. General Resources Account:

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III. SDR Department: None

IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Obligations to Fund: None

VII. Exchange Arrangement:

The U.S. dollar is legal tender and the official currency. Palau maintains an exchange system that is free of restrictions on international payments and transfers for current and capital transactions.

VIII. Article IV Consultation:

The first Article IV consultation discussions took place during June 24—July 6, 1999 and the Article IV consultation procedure was completed on November 10, 1999. Palau is on a 24-month consultation cycle.

IX. Current Financial Arrangement: None

X. Technical Assistance:

Technical assistance for the period June 1996–September 2001 is reported in the following table.

XI. Resident Representative: None

Republic of Palau: IMF Technical Assistance, June 1996-September 20011

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Palau has also been receiving technical assistance from the PFTAC for developing economic and financial statistics (see Annex II).

The Legal Department is providing ongoing assistance during the implementation stage (which is expected to begin shortly).

ANNEX II: Republic of Palau: Support from the Pacific Financial Technical Assistance Centre1

The Centre’s assistance since Palau joined the Fund has included 16 advisory missions, with the main focus on the design of a comprehensive tax reform package and the establishment of a financial institutions act that would meet international standards.

Public Financial Management

Advice from the Centre has concentrated on the strengthening of budget processes through improved monitoring of government expenditure and its financial position during the year, implementation of performance budgeting, and the preparation of medium-term budget projections as a basis for fiscal management.

Tax Administration and Policy

Beginning in 1998, the Centre assisted the authorities with the design and advancement of a comprehensive tax reform package through the stages of planning, public debate, and congressional hearings. In parallel, plans were prepared for a strengthening of the Revenue and Customs Bureau. Following an inactive period around the Presidential election in 2000, the reform effort has resumed. Legal assistance from the Fund is being organized, and the Centre will help with implementation and administration.

Financial Sector Regulation and Supervision

The absence of a regulatory system and supervisory capacity despite a sizable number of licensed onshore and offshore banks and deposit-taking institutions presented a systemic and reputational risk for Palau. In response, assistance from the Centre focused on the establishment of a comprehensive Financial Institutions Act and the definition of principle features needed to meet international standards. Subsequently, an IMF legal expert assisted in drafting the required legislation. PFTAC’s Banking Advisor is currently assisting with the establishment of a supervisory framework.

Economic and Financial Statistics

In 2000, the Centre conducted an assessment of data needs, institutional structures, and operational procedures for an effective production and dissemination of a core set of economic and financial statistics. Following the mission’s advice, the authorities are using the GDDS as an organizing framework. Areas that will require priority assistance include: the establishment of a Statistics Act to legitimize and organize data collection and dissemination, as well as the compilation of banking survey data, quarterly GDP indicators and a GDP deflator, and improved external sector data collection.

ANNEX III: Republic of Palau: Relations with the World Bank Group

Total commitments: None

IFC investments: None

The Republic of Palau joined the World Bank Group on December 16, 1997.

In recent years, the Bank Group has provided nonlending services to Palau in a number of areas.

  • In the health sector, the Bank has provided technical assistance involving the review of a draft health care plan and legislation.

  • In March 1999, the Bank Group’s Foreign Investment Advisory Service (FIAS) carried out a diagnostic review of the investment environment and, since then, has undertaken two separate reviews of new draft foreign investment legislation.

  • The Bank also provided assistance on the Y2K problem, and on the management of coastal areas.

  • In the latter part of 1998 and early-1999, South Pacific Project Facility (SPPF), a small- and medium-enterprise (SME) development initiative of the International Finance Corporation provided advisory services to the National Development Bank of Palau. More recently, work has commenced on a number of SME projects in the tourism sector.

  • Formal input is being provided for a Sustainable Tourism policy.

The Bank’s fourth biennial Regional Economic Report for its Pacific Island member countries, including Palau, was issued in November 2000. This report, ‘Cities, Seas and Storms: Managing Change in Pacific Island Economies,’ aims to help the people and governments of the pacific islands deal proactively with some of the major challenges and opportunities confronting them at the beginning of the twenty-first century. It focuses particularly on the three areas: the growth of towns, the management of ocean resources, and the impact of, and adaptation to, climate change.

ANNEX IV: Republic of Palau: Statistical Issues

The Office of Planning and Statistics is responsible for the compilation of national statistics. There are presently no official statistical publications at the aggregate level and data on national accounts, monetary developments, and the balance of payments are very limited. Since the first Article IV consultation mission in July 1999, the authorities, however, have been providing available core economic data to the Fund.

A. Real Sector

Since 1984, GDP estimates by economic activity at current prices have been compiled by different organizations, including the UNDP, the United Nations Economic and Social Commissions for Asia and the Pacific, and under a joint project by the University of Oregon and the U.S. Department of Interior. With assistance from a UNDP consultant, the Office of Planning and Statistics has produced revised GDP estimates for 1996–99 by compiling sectoral data using wage data from social security and profit data from the corporate tax returns. GDP data for 2000 are based on a preliminary compilation and the 2001 estimate is based on interviews with local businesses and on tourist arrival information. There are plans to develop quarterly GDP estimates. Quarterly price statistics have been collected since June 2000 that will be used in the future to produce a CPI series and develop a GDP deflator.

B. Government Finance

Extensive government data are compiled at the national level as part of annual budgetary process, and the authorities have been providing these fiscal data to the Fund on a regular basis. Weaknesses in this data involve mainly the transformation of the data into GFS format and some areas of misclassification. Problems arise from the proliferation of special earmarked funds. Moreover, although external auditors and investment managers provide detailed accounts, these reports are not effectively used to provide public information or regular reports for policy-makers. State Governments have not provided budgetary accounts for the past three years. The reporting of annual, quarterly, and monthly data for the GFS and IFS, respectively, is highly recommended.

C. Monetary Accounts

Balance sheet data are not currently provided by banks to the authorities, hence there is no official banking or monetary survey reported. At present, the banks only file corporate tax forms to the Ministry of Administration. The authorities had agreed to take steps to have banks report their balance sheet by end-1999, but this has not been done. The mission assisted in initiating a summary of operations of the major banks using the corporate tax forms. Improved reporting is expected with the formation of the Financial Institutions Commission.

D. Balance of Payments

Balance of payments data are very weak. Only import data are reported in a systematic way through the new customs system. All other items are rough estimates based on incomplete information. The estimates are based on fiscal data (for official transactions), tourism data (for service receipts), and social security data (for worker remittances). No information is collected on foreign investment activities and the lack of commercial banking data hampers estimation of other capital flows.

Republic of Palau: Core Statistical Indicators

(As of October 15, 2001)

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A - annually; M- monthly, Q - quarterly, D - daily.

D - daily; V - staff visits.

P - publicly released information; A - direct reporting by the authorities; O - staff estimates.

E - electronic data transfer; V - staff visits.

U - unrestricted use; A - for staff use only; B - embargoed for a specified period and thereafter for unrestricted use.

A - annually; D - daily; V - staff visits.

ANNEX V: Republic of Palau: Illustrative Medium-Term Scenarios, 2001/02–2009/10

The authorities’ medium-term strategy aims to establish institutions and policies in Palau that will promote economic sustainability. The strategy as described in the Management Action Plan (MAP) issued in March 2001, focuses on developing the private sector, minimizing government intervention, providing physical infrastructure, and developing human capital. Reforms of the public sector and the financial sector, together with efforts to improve the environment for foreign investors, will—if implemented fully and in a timely manner—move Palau towards sustainability in the post-Compact period. Reform implementation has picked up since the November 2000 election, but most initiatives require Congress approval. Delays would endanger the effectiveness of the reforms in boosting growth and achieving a sustainable fiscal and external position by 2009.

Two alternative medium-term scenarios were discussed with the authorities. The Reform Scenario assumes that the government adheres to the priorities identified in its MAP, pursuing the fiscal and structural reforms necessary to achieve long-term sustainability. Under this scenario, deficits through 2004/05 would be limited to capital spending financed by unspent balances of capital grants and budgetary surpluses would be achieved in the second half of the decade. Structural reforms foster growth in the private sector, tourism, and investment. The No Reform Scenario assumes that the reforms necessary to attain sustainability are delayed and only partially adopted. In both scenarios, growth and imports are expected to reflect the large infrastructure projects scheduled for the next two or three years. The slowdown in growth in the region and globally following the events of September 11 are expected to affect tourism in 2001/02. Both scenarios do not take into account climatic or other external shocks. Both scenarios assume that the government refrains from using the Compact Trust Funds before 2008/09. The main differences between the two scenarios are highlighted in Figure V.1

Figure V.1.
Figure V.1.

Republic of Palau: Medium-Term Macroeconomic Scenarios, 1994/95-2009/10

Citation: IMF Staff Country Reports 2002, 069; 10.5089/9781451831474.002.A001

Source: Palauan Authorities; and staff estimates.

A. The Reform Scenario (Table V.1)

Table V.1.

Republic of Palau: Government’s Reform Scenario1

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Sources: Palau Statistical Yearbook; Palauan authorities; and staff estimates.

Fiscal year beginning October 1.

In calendar years to 1996/97 for visitor arrivals.

Excludes the Compact Trust Fund and Contingency Reserve Fund.

The Contingency Reserve Fund is 5 percent of unrestricted local revenues; unrestricted local revenue is taken as 75 percent of domestic revenue.

The CTF balance is assumed to grow by 8 percent annually, with no withdrawals until FY2010. Withdrawal from FY2010 onwards are assumed to be such that net balance of the CTF grows by 2 percent each year.

The CTF Agreement allows for withdrawals of $5 million a year from 1998/99, with an inflation adjustment of 5 percent each year.

Usable reserves are defined as government assets (NTFA) plus the Contingency Reserve Fund less the balance relating to capital grants.

This incorporates adoption of the full tax package presented to Congress on October 30.