Republic of Palau
Recent Economic Developments

This paper examines recent economic developments in the Republic of Palau. Palau has made a modest recovery in 2000 and 2001. Real GDP growth has been about 1 percent in 2000 and 2001, after the recession brought about by the Asian crisis reached its trough of negative 5½ percent growth in 1999. This recovery was mainly owing to grant-financed large infrastructure projects. However, the outlook on tourism, Palau’s major industry, remains weak owing to the events on September 11, and the expected El Nino, which also threaten the development of tourism-related private sector projects.

Abstract

This paper examines recent economic developments in the Republic of Palau. Palau has made a modest recovery in 2000 and 2001. Real GDP growth has been about 1 percent in 2000 and 2001, after the recession brought about by the Asian crisis reached its trough of negative 5½ percent growth in 1999. This recovery was mainly owing to grant-financed large infrastructure projects. However, the outlook on tourism, Palau’s major industry, remains weak owing to the events on September 11, and the expected El Nino, which also threaten the development of tourism-related private sector projects.

I. Introduction and Summary

1. The Republic of Palau (hereafter Palau), located in the Western Pacific, is among the smallest of the Pacific islands and has a relatively high per capita GDP.1 The population is around 19,000, and per capita GDP is estimated at $6,000 in 2000. Palau consists of eight main islands and some 250 smaller islands making up an archipelago that stretches over 650 km. The islands were part of a strategic trust of the United Nations, administered by the U.S. from 1947, and became self-governing in 1981 and independent in 1994, since then Palau has been in free association with the U.S. (Staff Report, Box 1).2 Under the Compact of Free Association (Compact), Palau receives about $600 million over 15 years to 2008/09. Palau faces many development constraints common among Pacific island economies, including a narrow resource base, geographical isolation, a small domestic market, a lack of infrastructure and skilled labor, and vulnerability to external and natural shocks.

2. Palau has made a modest recovery in the last two years. Real GDP growth has been about 1 percent in 2000 and 2001, after the recession brought about by the Asian crisis reached its trough of negative 5½ percent growth in 1999 (Table 1). This recovery was mainly due to grant-financed large infrastructure projects. However, the outlook on tourism, Palau’s major industry, remains weak due to the events on September 11, and the expected El Nino, which also threaten the development of tourism-related private sector projects.

Table 1.

Republic of Palau: Selected Economic and Financial Indicators, 1993/94–2000/01 1/

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Sources: Data provided by the Palauan authorities; and Fund 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, 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.

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

Usable reserves estimated as the government financial balance plus annual drawable amount from CTF less the balance of capital grants.

3. Palau remains heavily dependent on grants from the United States to finance large fiscal deficits. Compact grants have averaged 16 percent of GDP in the last six years, in addition to 8 percent of GDP in non-Compact U.S. grants and 3 percent of GDP in grants from other countries. The large upfront disbursements of Compact grants provided for an accumulated balance of unspent current and capital grants that form government financial assets (or reserve assets) a large part of which is tied to specific projects. With a relatively narrow tax base, low tax rates, and high current expenditure (averaging 55 percent of GDP in the last three years), the overall fiscal deficit after grants has averaged 9 percent of GDP in the last seven years, financed by grants and asset drawdown.3 Recognizing the need to generate domestic funds to replace the imminent loss of Compact grants, the new administration that took office in January 2001 is implementing tax and expenditure reforms.

4. With the decline in tourist receipts, the external current account has recorded large deficits in recent years. Imports increased to accommodate the large infrastructure projects, and the export base remained narrow (tuna fish and garment exports). After benefiting from a period of bullish U.S. stock markets, investment income declined by 17 percent in 2000/01. Reserve assets have been temporarily boosted by $30 million in capital inflows from Taiwan Province of China to finance public infrastructure (Table 2).

Table 2.

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 Fund staff estimates.

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

Includes realized investment gains and losses.

Includes estimates of profit repatriation by foreign fish and garment export companies.

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 for 1999/00 and 2000/01.

Large error and omission in 1994/95–1998/99 reflect underreporting of imports 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.

Reflects the changes in the financial holdings of the government excluding Compact Trust Fund’s non-Trust Fund Asset (NTFA).

5. Banking operations appear sound as the larger banks are subject to U.S. regulations and nonperforming loans are reported to be very low. However, banking data is sparse and there is no supervisory framework in place. Banks appear to benefit from large interest rate spreads and very cautious lending practices (Table 3). Financial problems of the development bank resulted in a sharp reduction in lending, but this was reversed in 2000 following restructuring measures and a budgetary transfer. In June 2001, congress approved financial sector legislation that limits the scope for money laundering and provides a framework for banking regulation and supervision. A financial institutions commission is being set up to implement the new legislation.

Table 3.

Republic of Palau: Structure of Interest Rates, 1997–2000

(In percent)

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Sources: Data provided by the Palau National Development Bank (PNDB) and individual commercial banks.

Under government-directed loan scheme, loan is provided to Palauans who have never owned a house.

Bank of Hawaii commercial loan rates follow the highest New York Prime plus 4 percent, between 1998 and 2001.

Rates between 1998-2000 are those for Bank Pacific Ltd. (Guam Savings Bank).

II. Output, Prices, and Employment

A. Output

6. Palau experienced a modest recovery of 1 percent real GDP growth in 2000 from a recession of negative 5½ percent growth in 1999.4 The economic slowdown, which began in 1997, reached its trough in 1999 with the impact of the Asian crisis on tourism, the phasing down of U.S. grants under the Compact, and freezing of loan activity by the National Development Bank of Palau (NDBP). The rebound in 2000 was mostly driven by large infrastructure projects including the Compact Road (Babeldaob island’s ring road), Koror-Babeldaob (K-B) Bridge, and National Capitol which began in late 1999, totaling over $160 million to be spent over four years.

uA01fig01

GDP Growth, 1994-2001

(in percent)

Citation: IMF Staff Country Reports 2002, 070; 10.5089/9781451831498.002.A001

7. Construction activity led the recovery, financed by higher foreign grants and the resumption of NDBP lending and guarantees. The construction sector recorded a significant improvement of 8 percent in 2000 from negative 21 percent in 1999 (Table 4). As imports of heavy equipment for the new infrastructure projects rose sharply, the trade sector also rebounded from negative 7 percent to 4 percent growth in 1999. The finance and insurance sector recovered from negative 25 percent to 6 percent growth in 2000 as demand for loans increased. The growth in construction activity, combined with a recovery in the financial sector, had a positive effect on real estate and business services, which grew by 6 percent in 2000 from negative 30 percent in 1999. Transport and communication sectors also contributed to the recovery by sustaining 7 percent growth in 2000 reflecting growth in internet-related and mobile telephone services.

Table 4.

Republic of Palau: Gross Domestic Product, 1995–2001

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Sources: Data provided by Corporate Registrar, Social Security, and Government Audit Reports.

Data for 1995 have been estimated using indicators for tourism, trade, and public administration between 1993 and 1996 benchmarks.

Data for 1996 to 2001 have been estimated by a UNDP statistics specialist.

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

uA01fig02

Sectoral GDP Growth, 1996-2001

(in percent)

Citation: IMF Staff Country Reports 2002, 070; 10.5089/9781451831498.002.A001

8. Meanwhile, activities in the hotel and restaurant sector remained flat as the number of tourist and business arrivals, which had declined significantly since the Asian crisis, recovered only marginally in 2000. Agricultural activity, which accounts for only 1 percent of GDP, remained stagnant (Table 5).

Table 5.

Republic of Palau: Visitor Arrivals by Purpose and by Country of Residency, 1996–2001

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Source: Data provided by the Palau Visitors Authority.

On a calendar year basis up to 1997.

Other includes returning residents, fishermen, crews, students, transits, and dependents.

9. Economic activity in 2001 is estimated to have grown by only 1 percent in real terms. Although Palau seems to have stepped out of negative growth, the near-term prospects remain a concern. Most industries are anticipating growth levels similar to those of 2000, particularly following the events of September 11, 2001. Moreover, the expected El Nino in the spring of 2002 could also affect tourism and slow down the development of private tourism-related projects.

10. Tourism remains the main source of future growth and its prospects depend on infrastructure development and foreign investment. Tourist activity is currently limited to scuba diving and snorkeling, but there is a potential to also provide facilities for golfing, hiking, and sports fishing, especially with the development of Babeldaob, the largest island. Completion of the Compact ring road has been delayed due to rainy weather and unexpected soil conditions. On current plans, the K-B Bridge is expected to open in early 2002, and the Compact road by the summer of 2004. Their completion should greatly improve opportunities to expand tourist facilities and related commercial activities. In addition, private sector projects estimated at $100 million have received permits and are planned for completion by mid-2003, including hotels, golf courses, and ancillary services.

B. Prices, Employment, and Wages

11. Palau began compiling quarterly CPI data for Koror from June 2000. The 12-month inflation rate to June 2001 was estimated at 2¼ percent, lower than for the U.S. The items registering the largest increase during this period were housing (7 percent), followed by clothing and footwear (4 percent), and food (3 percent). Prices of alcohol, tobacco, and betel nut declined slightly by less than ½ percent over the 12-month period.

12. Employment increased by 12 percent in 2000 mainly due to foreign workers in the construction and service sectors. Palauans constitute about 52 percent of the workforce, and more than half of those are government employees. Employment of Palauan nationals remained unchanged in 1999 and increased by 5 percent in 2000, following the resumption of NDBP lending and pick up in construction. Although the number for non-Palauan workers also remained constant in 1999, it increased by 21 percent in 2000. Workers from Philippines constitute the largest single country of origin, amounting to over one-half of total foreign workers.

uA01fig03

Employment and Average Wages of Workers in Palau

(number of workers, wage in US dollars)

Citation: IMF Staff Country Reports 2002, 070; 10.5089/9781451831498.002.A001

13. As the share of foreign workers in the labor force increased, average wages declined by about 3 percent in 2000. The average wage of Palauans remained stable, but the average wage for non-Palauans declined by about 5 percent. Wages in the construction and service sectors are lower than average. The financial sector had the highest reported average gross wage in 2000 ($16,700), followed by professional and related services ($13,300), and public administration ($11,400) (Table 6). The minimum wage scheme of $2.50 per hour for Palauan workers, which was introduced by legislation in early 2001, may induce a further inflow of foreign workers who are willing to accept much lower hourly wages.

Table 6.

Republic of Palau: Employed Persons by Industry, 1990, 1995, 1999, and 2000

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Sources: Office of Planning and Statistics, 1994 and 1999 Statistical Yearbook; 1995 and 2000 Census of Population and Housing, and Social Security Office (SSO) for 1999.

Includes business, repair, personal, community, entertainment, recreation, health, education, and other social services.

C. Foreign Direct Investment

14. A number of procedural obstacles limit foreign investment flows. The main obstacles include cumbersome foreign investment regulations, constraint on land use, labor shortages and regulations on foreign labor, and restrictions on the size of investment income in some sectors. As a result, only 23 Foreign Investment Approval Certificates (FIAC) were issued in 2000, 12 percent lower compared to 1999. Of those, three were for banking businesses; three for construction, engineering, and design; and two were for auditing and accounting services. The rest were for miscellaneous activities including architecture, restaurant, sports facilities, consulting services, health care services, Internet game sites, water supply, and wireless communication. In the first nine months of 2001, a total of 14 additional FIACs were issued out of 16 applications.

15. Foreign investments are regulated by the Foreign Investment Board (FIB), which was established in 1981. The FIB is comprised of seven members, many of who are members of the local business community. The application procedures are reported to entail a number of different documents and agencies, which can span several months, and the cumbersome regulations have been criticized as discouraging for the interested investor.

16. The inability to use land as collateral also acts as a significant barrier to foreign investment. Foreigners are prohibited from owning land in Palau; instead, they are able to lease land for up to 50 years. However, even leasing can be a problem as land-ownership rights are poorly defined due to the historically communal form of ownership. The authorities expanded the Land Courts to expedite resolving existing court claims. However, it has been difficult for the Land Courts to resolve cases expeditiously. Out of a total of 8,540 cases recorded in 1989, only about 50 percent of all cases have been settled to date.

17. Labor laws can also act to deter foreign investment. The current foreign investment regulations stipulate the share of local employment for a number of activities, and those nationals must be paid the minimum wage of $2.50 per hour. When hiring non-Palauan workers, foreign investors must pay an annual fee of $500 per head, but this does not apply if the foreign workers are hired by Palauan investors. Foreign workers must contribute to social security, regardless of the length of their contract and their eligibility to receive benefits from the system at a later stage.

18. Some sectors are restricted from foreign participation. These include wholesale and retail trade, all tour-related businesses, ocean transportation, land transportation, and car rentals. For hotels, foreign investment is only allowed if the number of rooms exceeds 50.

19. Foreign investors have resorted to ways to circumvent these restrictions. In what has been commonly referred to as a so-called ‘front,’ the foreign investor provides capital and operates the business as a hired manager by the Palauan. The Palauan front is responsible for signing legal documents, and he/she receives a certain percentage of profits. This practice reduces transparency of business operations and complicates taxation. Moreover, it has been problematic for both the foreign investor and Palauan partners. Some foreign investors have difficulties in finding someone they can trust to act as local front, and this can discourage larger investments. For the Palauan, they can find themselves liable to large outstanding debts and liabilities once the foreign investor flees the country.

20. Recognizing the need to remove impediments to foreign investment, a new foreign investment law is currently under committee review in congress. The proposed law aims to provide a legal system that is simple, transparent, and non-discriminatory. It is also intended that the FIB be abolished and a one-stop foreign investment licensing unit be placed in the Ministry of Commerce.

D. Environmental Issues

21. Palau shares similar concerns to those of other Pacific island countries on global climate changes and storm damage. Climate changes may result in damage to infrastructure and the ecosystem of coastal areas, causing soil erosion, changes in biodiversity, coastal inundation, and extensive coral bleaching. Scientists expect another El Nino and a severe drought in the spring of 2002 in the region. Among other things, this could be expected to reduce the potential flow of income from tourism, although the severity of the impact is difficult to predict.

22. Recognizing Palau’s vulnerability to environmental damage, the authorities have accorded this issue the utmost priority. A number of governmental organizations have recently been established including the Office of Environmental Response and Coordination (OERC), the Palau Conservation Society (PCS), and the Palau Environmental Quality Protection Board (PEQPB). Palau recently acceded to the 1995 Vienna Convention on Protection of the Ozone Layer and the 1987 Montreal Protocol on Substances That Deplete the Ozone Layer. The Ministry of Resources and Development, in coordination with the OERC, hosted a national workshop to review and assess vulnerability to climate and possible adaptation options for Palau. Meanwhile, the Drought Mitigation Committee in Palau has been educating the locals on El Nino and drought, water resources, sanitation and health, drought crops, fire prevention, and public safety. In early 2001, the United Nations recognized Palau’s efforts in this area and selected it as one of the countries to be highlighted in the global synergies review process.

III. Public Finances

23. The public sector in Palau consists of the national government, 16 state governments, and a number of nonfinancial public enterprises.5 The national government is funded through tax revenue, nontax revenue, and foreign grants.6 Most public enterprises receive budgetary subsidies, while the noncommercial public enterprises rely on government transfers or direct federal contributions. The state governments receive some government transfers and have their own funding sources.

A. General Government Overview

24. Budget deficits have averaged 9 percent of GDP (after grants) in the last six years, financed by Compact grant disbursements, about half of which were associated with capital projects, while the remainder was intended to finance current operations. Large up-front grants helped to generate an overall budget surplus of 105 percent of GDP in 1994/95, which became the stock of government assets used to finance deficits in the following years (Table 7).7 The deficit in 2000/01 is estimated to have reached 15 percent of GDP, with an increase in tax revenue and sharp reduction in expenditure being more than off-set by a dramatic fall in investment income and much smaller level of grants realized than was expected in the budget. The 2001/02 budget approved by congress would yield an overall deficit of 7½ percent of GDP, but tax measures are under consideration to bring it to below 5 percent of GDP.

Table 7.

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 $l.2 million.

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

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

This is the change in government assets (NTFA).

Calculated using simple quarterly interpolation.

The road is estimated to cost around $12.5 million, the budge $24.7 million, and the airport $14 million: estimates of the expenditures by year are reported.

25. Under current practice, the budget presented to congress excludes the majority of grant-financed capital projects, which are included when reporting fiscal operations to the Fund. The authorities’ rationale is that these specific projects would not exist unless they secure new capital grants or can utilize unspent balances of capital grants for these capital projects. Thus, the 2001/02 budget, presented to congress targeted a zero balance, whereby expenditures were limited to the total of domestic revenue and Compact grant receipts. The deficit as shown in Table 2 represents staff adjustments to budget assumptions, as well as the excess of capital spending over capital grants, which are to be financed by new non-Compact capital grants and drawdown of assets (unspent balances of capital grants received in previous years).

Revenue and grants

26. Tax revenue, mainly from the gross receipts tax (GRT), salaries and wages tax, and the general import tax,8 increased significantly in 2000/01, reaching 21 percent of GDP. GRT is paid by businesses at 4 percent on gross revenues (with the exception of financial institutions which pay 4 percent on receipts net of certain deductible expenses). GRT accounts for one-quarter to one-third of total tax revenue, equivalent to 5–6 percent of GDP. Wages and salaries tax is paid by all workers in Palau and accounts for about a quarter of total tax revenue. Revenue from this tax has clearly trended upward: there has been no change in the rate, and the increased yield in recent years reflects improvements in tax administration and collection (see below). Revenue from import tax has increased steadily since the mid-1990s as tax rates were raised on cigarettes and alcohol in 1996 and 1998, and a new Customs recording system was introduced in 1999.

uA01fig04

Domestic Revenues

(in percent of GDP)

Citation: IMF Staff Country Reports 2002, 070; 10.5089/9781451831498.002.A001

uA01fig05

Grants and fiscal balance, 1994/95-2001

(million US dollars)

Citation: IMF Staff Country Reports 2002, 070; 10.5089/9781451831498.002.A001

27. Nontax revenue has fluctuated, depending on investment income earned on government assets consisting of unspent grant balances (Table 8).9 The unspent balances of current and capital grants are invested largely in the U.S. and returns constitute investment income.10 Investment income peaked in 1999/00 at about $14 million (reflecting the strong U.S. stock market performance). The remaining nontax revenue mainly comprises license and permit fees, interest income on domestically held assets, local trust funds, and court fines. These miscellaneous nontax revenues have increased significantly since the mid-nineties.11 There has been an upward trend in fees and charges since the mid-1990s—a large part of which is permits for foreign workers—and the peak in 1998/99 reflects the increase in fees for foreign workers’ permits.

Table 8.

Republic of Palau: U.S. Grants, 1994/95–2008/09

(In thousands of U.S. dollars; end of the period)

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Sources: Independent Auditor’s Report on financial statements; and data provided by the Bureau of Program, Budget, and Management, Ministry of Administration.

Other U.S. assistance is based on the proposals submitted to each grantor agency. Based on the Compact agreement, various programs were to be phased out beginning fiscal year 1996. Scheduled phasing out is 25 percent reduction of grant authorization for each fiscal year. However, there are old and new programs for which the Republic of Palau is eligible-accordingly, other U.S. assistance is forecast to continue, but at a reduced level from 2002/03.

28. With the step down in Compact grants in 1998/99, tax revenue surpassed grant receipts for the first time in 2000/01. As scheduled, Compact grants were steady at over $20 million from 1995/96–1997/98 and then declined to about $13½ million in 1998/99—the level at which they will remain (with inflation adjustments) through to the end of the Compact period in 2009. Other non-Compact grants have fluctuated—ranging from $7½ million to $18½ million, reflecting the lumpy nature of project related grants. The largest single non-U.S. grant has been the $10 million grants from Taiwan Province of China in 1999/00. Direct grants for the three large infrastructure projects are not included in budgetary grants because the authorities do not have reliable disbursement information.

Expenditure

29. Current expenditure has fluctuated between 47 percent of GDP and 61 percent of GDP in recent years. The increase in 1999/00 reflects a tripling of subsidies and transfers over two years to the pension fund in 1999 and 2000 ($4¼ million and $3½ million, respectively) to cover increased benefits and the earlier mentioned one-off transfer to the NDBP (of $3 million) in 2000. Purchases of goods and services also increased sharply in these years, representing supportive expenditure by the government during the economic slowdown in 1998/99 and pre-election spending in 1999/00 (Table 9).

Table 9.

Republic of Palau: National Government Expenditure by Budget Category, 1994/95–1999/00

(In thousands of U.S. dollars)

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Sources: Reports on the Audit of Financial Statements for fiscal years 1992/93–1997/98 (1997/98 data are preliminary); and data provided by the Bureau of Program, Budget, and Management, MOA.

Other expenditures include other programs from General Fund expenditures, Special Revenue Fund expenditures, CIP management fees, and prior year appropriations.

Includes subsidies and other transfers for current operations.

Other major public entities receiving transfers are: Palau Community College PCC Board of Trustees, COM Board of Regents, Civil Service Pension Plan, and National Development Bank.

30. Fiscal consolidation efforts by the new administrations are geared toward reducing current expenditure relative to GDP. Current expenditures declined to an estimated 52 percent of GDP in 2000/01, and a further reduction to 46 percent of GDP is planned for 2001/02. The decline in 2000/01 is largely explained by cuts in expenditure on goods and services and in subsidies and transfers, particularly to the Civil Service Pension Fund and the Public Utilities Corporation.

31. Capital expenditure has picked up to 11½ percent of GDP in 2000/01 from a low of 7 percent of GDP two years earlier. The increase reflects efforts to secure additional capital grants to supplement the $2 million received annually under the Compact, since a large part of the initial $63 million Compact capital allocation has been spent. Rehabilitation spending following Storm Utor, financed by Taiwan Province of China and U.S. assistance, also contributed to boosting capital spending. Budget-reported capital expenditure excludes directly financed projects, namely the Compact Road, K-B Bridge, and the new airport terminal building.

uA01fig06

Expenditures

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 070; 10.5089/9781451831498.002.A001

B. State Governments

32. State government accounts are sketchy. Only two state governments have reported their activities to the national authorities since 1998/99 (Table 10). In addition to-small transfers from the general government, state governments are mainly funded by 85 percent of the fishing rights fees, and some local fees and charges (such as motor vehicle registration fees). Expenditures typically cover local wages and salaries, municipal and civic services, and small-scale capital expenditures. The authorities indicated that only two local governments have the authority to borrow, namely Koror (the current capital) and Melekeok (the site of what will be the new capital). Otherwise, states are required to keep spending within available resources, i.e., local revenues plus grants from the national government.

Table 10.

Republic of Palau: Operating Accounts of the State Governments, 1992/93–1998/99

(In thousands of U.S. dollars; end of period)

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Source: Data provided by the Office of the Public Auditor.

A total of 2 States’ Operations are not yet included in FY 1997.

A total of 11 States’ Operations are not yet included in FY 1998.

A total of 12 States’ Operations and the Fund balances are not yet included in FY 1999.

C. Trust Funds

33. There are three trust funds administered by the government: the Compact Trust Fund (CTF), the Social Security Fund (SSF), and the Civil Service Pension Fund (CSPF). Under the Compact Agreement, the CTF received an initial allocation of $66 million and an additional $4 million in 1996/97, and returns were to be largely re-invested until 2009 so as to create a sizable trust fund that would thereafter provide a flow of income to help offset the scheduled loss of Compact grants (Table 8). While there was a provision in the Compact agreement allowing for use of some part of the CTF investment income ($5 million a year from 1998/99 onward, adjusted for inflation at 5 percent), none has so far been used.

34. The CTF grew by an average rate of 13 percent from its inception to June 2001, when its market value was $147 million. However, its value dropped to $135 million in September 2001, following the substantial correction in the U.S. stock market. The CTF is managed by a number of U.S. fund managers and must be invested only in U.S. equity and fixed income instruments12 (Table 11).

Table 11.

Republic of Palau: Financial Position of the Compact Section 211(f) Trust Fund, 1994/95–2000/01

(In thousands of U.S. dollars; end of period)

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Sources: Independent Auditors Report on Financial Statement; and data provided by the Office of President and Ministry of Administration.

Investment income for FY 1996 excluding unrealized losses $731,594.

For FYI997, investment income includes restatement of investments at fair value is $11,019,473.

For FY1998, investment income includes restatement of investments at fair value is $8,779,741.

Covers operations of the Compact Section 211(f) Trust Fund, starting in 1994/95.

35. The SSF, set up under a law enacted in 1991, is self-financing by law and is funded by employee and employer contributions (each of 6 percent on all remuneration paid up to a maximum of $3,000 a quarter).13 The fund covers employees of public and private employers in Palau, and benefits include old-age insurance benefit (available after the age of 60), disability insurance benefit, and survivor insurance benefit.

36. The SSF grew by an average annual rate of over 20 percent between 1993/94–1999/00 (Table 12). The funds were invested in U.S. assets, under U.S. fund managers, in the approximate ratio of 35 percent fixed income and 65 percent equity. Annualized returns on equity and fixed income averaged 17 percent and 5 percent, respectively. However, these turned negative in the past year.

Table 12.

Republic of Palau: Financial Position of the Social Security Fund, 1993/94–2000/01

(In thousands of U.S. dollars)

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Sources: Annual audit reports; and data provided by the Palauan Social Security Office.

Total benefit payout includes retirements, survivors, disability, and lump sum payments.

Including administrative and investment management expenses and fees.

37. Although SSF can continue meeting its current obligations from these surpluses, recent changes to benefits have increased its unfunded liability from $15 million to over $20 million. An actuarial study in 2000 (based on 1999 data) indicated that the Social Security System’s funding deficiency had decreased from approximately $19.3 million as of October 1, 1995, to approximately $15.3 million as of October 1, 1999, primarily due to increased contributions. However, based on the changes to benefits in 1999, the unfunded liability is estimated to have increased to $20.2 million. These benefit changes include: (i) allowing individuals to receive double benefits (e.g., a retiree could also receive surviving spouse benefits); (ii) removing the incremental reduction in benefits related to income earned; and (iii) tax-exempting the contributions of government to those with titles. There is proposed legislation pending that may successfully reverse parts of the changes, such as the earnings test and the tax-exemption.

38. The Pension Fund has received large government transfers over the past few years (totaling around $13 million since 1998) to offset the impact of higher benefits on the unfunded liabilities. The civil service pension plan, set up in October 1987, provides retirement, death, and disability benefits to civil servants and their families. The CSPF is financed by contributions from government and employees at 6 percent each. The size of the CSPF also grew rapidly over the 1990s, with revenues much higher than expenditures (Table 13).

Table 13.

Republic of Palau: Financial Position of the Civil Service Pension Fund, 1992/93–2000/01

(In thousands of U.S. dollars; end of period)

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Sources: Independent Auditor’s Report on financial statements; and data provided by the Palau Civil Service Pension Plan Authority.

Including lump sum benefits, refunds, and disability benefits.

Including investment management expenses and fees.