This 2002 Article IV Consultation highlights that the economic activity in the Federated States of Micronesia (FSM) is estimated to have slowed. Despite the use of the bump-up funds by some of the FSM’s four state governments to boost spending during FY2002, GDP is estimated to have grown only by 0.8 percent. The fiscal stimulus appears to have been mostly offset by an emerging fiscal crisis in Chuuk and a “wait and see” attitude of the private sector in the face of uncertainty associated with the new Compact of Free Association.
We thank the staff for their thorough analysis of recent economic and policy developments in the Federated States of Micronesia. The Staff Report and Selected Issues Paper outline some of the unique challenges faced by small and geographically isolated constituent members.
As the staff clearly showed, the Federated States of Micronesia is next only to Palau as the smallest member of the Fund in terms of its voting power, which reflects its small economic size. Through the Compact of Free Association with the United States in 1986, FSM became a Freely Associated State, no longer subject to US administration, in an effort to: (i) secure self-government; (ii) assure certain national security rights; and (iii) advance economic self-sufficiency. While the first two objectives have been achieved, the task of becoming economically self-reliant is extremely challenging. US direct financial payments continue to cover general government and capital expenditures. Additional allocations have been used in specific sectors including energy, communications, maritime surveillance, health and education.
But this 15-year funding provision came to an end in 2001, with amounts decreasing every five years. A new 20-year Compact Agreement was signed in November 2002 providing for declining levels of annual US grants, pre-determined sectoral allocation, strict procedures and audits to ensure accountability and transparency and a Trust Fund to provide revenues after 2023.
Herein lies, and we agree with staff, the key challenge for the FSM. Namely, the need to adjust to significantly reduced grant assistance from the United States and overcome the constraints to expanding private sector activity posed by a small, geographically isolated island economy with a population of only about 110,000. Towards this end, fiscal consolidation, reducing impediments to an expansion of private sector activity, strengthening the financial system and improvement of institutional capacity are the overriding agenda for the authorities. There is no disagreement between the staff and the authorities as to what needs to be done. However, the practical reality is the difficulty in gaining the necessary political support for the required reforms given the forthcoming elections and the autonomy of the states. In this regard, a number of other Fund members, many considerable larger than the FSM, face similar challenges in building the necessary consensus in support of difficult reforms.
Where FSM is Coming From
Since independence in 1986, FSM has shown an average growth rate of 1.8 percent despite higher migration of the population to the United States and, with geographic isolation, limited private sector activity. Institutional capacity remains severely limited. While growth has slowed in 2001–2002 due to the impact of natural calamity in one of the states of the Federation, an expansion of some 2.4 percent is forecast this year due to the expected $8 million in US assistance in the calamity areas and the activation of the new Compact funds which is expected to normalize economic activity. As the staff reported, the inflation rate has remained stable due to favorable price trends in the domestic components of consumer prices.
Public finance has been most challenging in the last two years. While FSM achieved some success in its initial efforts to streamline the bureaucracy, the fiscal performance of the national government and the most populous state, went off track. With a large public sector, and a loose federation, decisions on reducing working hours and other expenditure cuts to achieve fiscal discipline, has become more political. It is easy to appreciate the comments of the US Chair two years ago during the last Article IV consultation with FSM: it is not always the case that small economies with small populations should have simple processes. Achieving agreement between the national government and the states is indeed as difficult as in large economies.
The external payments position of FSM has been quite weak in the past two years due to the persistent trade deficit. This reflected the limited export base consisting of fish and some agricultural commodities. As a small island economy, FSM is heavily dependent on imports. With the temporary bump-up in funds from the US, the current account position is anticipated to show some improvement, although the observed real exchange rate appreciation coming from the strong US dollar could reduce FSM’s external competitiveness. The external debt service ratio fell from 31.4 percent in FY 2001 to 6.7 percent in FY 2002 after FSM fully repaid its commercial borrowing. Gross international reserves increased from $98.3 million in FY 2001 to $104.4 million in FY 2002, representing an increase in import coverage from 7.9 months to 8.2 months.
One could only expect that bank lending will remain limited in the next few years because there are very few business options in FSM. Business infrastructures are limited. There is little incentive to produce domestically because: (i) the market is small; and (ii) most domestic consumption and production items are imported, mainly from the US. However, the experience in the State of Yap does indicate the benefits that can come from good financial management. Yap has the best fiscal performance of the five governments, the lowest differential between public and private sector wages and has had the greatest success in generating private sector growth and employment.
The Economic Agenda for FSM
The FSM authorities fully realize that under the framework of the new Compact, there will be greater expectations for self-reliance and fiscal responsibility. The last 15 years of Compact I were to be a period of building institutional capacity, when there was practically none, and of financing the cost of governance immediately after independence.
Some Political and Institutional Problems. It has been an uphill battle for the FSM authorities to implement the Fund’s policy advice from the 1998 and 2000 Article IV consultations. With limited growth in economic activity in the islands, growth in tax revenue has remained low, even though the VAT was recently introduced following the Revenue Symposium. The process of government in FSM is expensive due to some existing difficulties in public administration. For instance, political elections are not synchronized. Elections are held separately for members of Congress, President/Vice President and local officials. The federation is a loose one with the federal government having very little control over the four autonomous states on public finance. The authorities have indicated they recognize the need for political re-engineering in the Federation if the major source of fiscal excesses were to be plugged and governance were to be rationalized for better and more effective delivery of public service. Another major obstacle is, of course, the lack of adequate institutional capacity for reforms in the FSM.
Areas for Reform
1. Getting Fiscal Policy Right These institutional limitations in FSM should also help put into perspective staff’s major recommendations for fiscal consolidation. Our authorities realize the importance of increasing revenues and curtailing expenditures. But it is important for private sector activity to be expanded by providing much-needed infrastructures and other components of a robust investment climate. This will require time as well as high levels of public spending. Tightening expenditures is essential to achieve fiscal sustainability, but this should be limited to those that do not translate into higher levels of productive capacity. We agree with staff that, under Compact II, the axe should fall on public sector wages and/or the number of work weeks, travel outlays, discretionary spending for constituency-based projects and public subsidies. Capital expenditures and spending on social safety nets should be maintained to keep the productive potential of FSM at least at present levels. This Chair is therefore interested to know how the dynamics of the staff proposal for FSM to undertake fiscal consolidation “which will curtail economic activity” in the short-run, translates into acceleration in private sector activity. It will also be useful to have some hard numbers on the amount of private sector growth necessary to absorb the large number of people joining the labor force in the next 5–10 years.
The authorities have agreed to Compact II with the full understanding that it needs to prepare to cut the fat and keep itself lean and cost-effective. One way the authorities have approached this issue is to intensify public information on the new order in FSM and to broaden public support for fiscal consolidation. In fact, the authorities circulated to the members of Congress, local governments and the press, the closing statement of the IMF Article IV mission. This essentially contains the message of fiscal discipline contained in the Staff Report to help ensure public awareness and support for the impending fiscal adjustments starting this year, the beginning of the Compact II agreement. In this connection, we are pleased to inform the Board that the authorities have consented to the publication of the Staff Report for the 2002 Article IV consultation.
We reiterate that the authorities have taken the necessary initial steps by putting in place the VAT in lieu of import duties and gross revenue tax (GRT) and advancing this in an expeditious way. While the VAT will be revenue neutral in the initial phase, the authorities consider this as a prerequisite for eventual gains in tax effort. We also agree with staff, and the authorities will work to this end, that no stone should be left unturned to minimize divergence in rates, coverage and exemptions of VATs in the four states. VAT administration will also be made uniform. The authorities also agree with staff in respect to bolstering non-tax receipts from fishing license fees by, among other things, strengthening the monitoring of illegal fishing and enhancing the fishing grounds of the Federation.
Greater focus would be given to the Chuuk State. Decisive action will be undertaken in terms of repayment of state arrears and reduction of the state wage bill to levels suggested by the staff. To complement the work of the new Chuuk Financial Control Commission, the national government would do its share of monitoring of the finances of the Chuuk State.
Finally, public enterprise reform shall be undertaken consistent with the calls of the Asian Development Bank. The size of the public sector remains large but the authorities will look at the possibility of rationalizing public wage rates relative to the private sector. The authorities are convinced that in view of Compact II, it is important for government to eliminate its losses from state-owned enterprises and to be able to pay gross receipts tax. We should realize, however, that in larger and more developed economies, this problem was not solved overnight.
2. Revitalizing the Private Sector With the reduction in US grants, the growth plank is now to be increasingly covered by higher contributions from the private sector. The authorities realize that this is the only way of sustaining growth for the Federation. As the staff stressed, FSM’s resource base is narrow, while viable investment opportunities are limited. The authorities agree that structural reforms are necessary to develop tourism and key agricultural exports. These will include a better legal and regulatory framework, transparent and less distortionary approvals of foreign investments and greater flexibility in the use of land for commercial purposes. However, cultural considerations should be taken into account in moving forward with the structural reform agenda. For instance, land is an important cultural issue in FSM and land reform might not be the best way to immediately revive business and commerce in the Federation.
3. Strengthening the Financial Sector A strong banking system will buttress any effort to expand private sector activity. In this regard, the FSM authorities are to be commended for the recent amendment of the Banking Act to move it closer to the Basle Core Principles. The authorities have advised that the Chuuk Government will be repaying its outstanding arrears to both wage earners and vendors.
4. Statistical Issues The FSM authorities recognize that there is further room for improvement in public sector statistics. They have continued improving the statistical system, particularly on matters involving quality, coverage and timeliness. Late last year, the authorities signified their interest in seeking more sustainable forms of technical assistance in statistical compilation, including those on public sector account, national income data, and monetary sector and balance of payments. We are pleased to acknowledge the interest of PFTAC to assist, however, their resources are severely limited.
FSM is small and geographically isolated group of small islands in the Pacific. Its resource based is narrow and its growth potential is quite limited. For many years, the Federation has relied on US grants to run the government and to deliver public services like education and medical health. There is a need for the international community to extend key assistance in re-engineering the government to reduce costs. The delay in the implementation of many staff recommendations from earlier Article IV consultations derived not entirely from the authorities’ lack of political will and concern for public welfare. Rather, we also need to consider the impact of the serious lack of institutional capacity in the FSM bureaucracy. The FSM, like the other small island economies, is in urgent need of sustainable technical assistance and capacity building. More frequent staff visits than the current 24-month cycle may be appropriate. Fund staff recommendations are all well taken, but wisdom dictates that the Fund itself may have to give more time and resources, this time in favor of FSM and other small island economies. For instance, we need to see more research on cross-country comparisons among small economies with respect to their growth experiences. This is one important way of making Fund surveillance more fruitful and more convincing.