Federated States of Micronesia: Staff Report for the 2004 Article IV Consultation

The staff report for the 2004 Article IV Consultation on the Federated States of Micronesia (FSM) focuses on economic developments and policies. Fiscal and structural reforms are needed for the FSM to achieve self-sufficiency. The large government sector will be increasingly unsustainable given coming declines in grants. Fiscal adjustment will need to comprise both expenditure cuts and revenue measures. Structural reform priorities should include improvements to the legal framework for land use, foreign investment, and lending.

Abstract

The staff report for the 2004 Article IV Consultation on the Federated States of Micronesia (FSM) focuses on economic developments and policies. Fiscal and structural reforms are needed for the FSM to achieve self-sufficiency. The large government sector will be increasingly unsustainable given coming declines in grants. Fiscal adjustment will need to comprise both expenditure cuts and revenue measures. Structural reform priorities should include improvements to the legal framework for land use, foreign investment, and lending.

I. Economic Setting

1. The Federated States of Micronesia (FSM) is a small Pacific island country that is highly dependent on external assistance. Since independence in 1986 it has relied heavily on U.S. grants, first under an initial Compact of Free Association covering FY1987–2001 and then under an amended Compact covering FY2004–23 (Box 1).1 Compact grants have been on the decline and are set to fall further and expire in FY2024; currently, they amount to about a third of GDP or about $700 per capita. Starting in 2024, the FSM will be able to draw on a trust fund established with its own contributions as well as those of the United States. The trust fund will invest in U.S. stocks and bonds (see Box 1).

uA01fig01

Compact Grants in Percent of GDP

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

Source: Fund staff estimates.

2. The country comprises four states in a loose federal structure. Each state has its own administration and legislature; there is a national government as well. Presidents are selected by the National Congress from the four at-large Congressmen, and serve four-year terms; the current president took office in May 2003. The states formulate their own budgets, which are a significant share of the consolidated budget, and levy taxes, thus limiting the national government’s influence on the overall direction of fiscal policy.

3. Success in adjusting to past reductions in Compact funds has been mixed. During FY1996–99, the public wage bill was cut substantially in the context of a Public Sector Reform Program supported by the Asian Development Bank (AsDB), but these cuts were partly reversed, and the wage bill remains high. Modest recent surpluses partly reflected a temporary increase in grants and compression of investment, while fiscal discipline has been uneven across states.

4. Reflecting the size of Compact grants, the public sector dominates the economy. Notwithstanding past declines, public expenditure is over 60 percent of GDP while government accounts for half of formal employment. Moreover, high public sector wages—around double those in the private sector—exacerbate structural impediments to private sector development. While the private sector has grown modestly over time, many firms mainly serve the government and its employees. Export-oriented sectors—tourism, commercial agriculture, and fisheries—account for only 6 percent of employment.

Renewed Compact of Free Association with the United States

The economic assistance provisions of the original Compact covered FY1987–2001. It provided annual cash grants of $97.9 million during FY1987–91, $91.1 million during FY1992–96, and $79.2 million during FY1997–2001. The funds were to cover general government and capital expenditures, with the latter to comprise a minimum of 40 percent of grants. During the FY2002–03 interim, while the Compact was being renegotiated, grants were provided at the average level of the initial Compact period—a sizeable increase.

The renewed Compact covers FY2004–23 and features declining grants assistance, a trust fund, and enhanced accountability and monitoring:

  • Total funding: Total funding of $92.7 million per year comprises grants, audit funds ($0.5 million), and trust fund contributions. Grants are $76.2 million during FY2003–05, after which they decline by $0.8 million per year in nominal terms. Grants and trust fund contributions are indexed at the lesser of two-thirds the increase in the U.S. GDP deflator or 5 percent.

  • Trust fund: Trust fund contributions rise from $16 million in FY2004 to $29.6 million in FY2023. In addition, the FSM made a $30.2 million contribution in FY2004 (of which $30 million was required under the Compact). The trust fund cannot be used to finance spending or as collateral for borrowing before 2024. The fund is administered by a five-member committee (three U.S. and two FSM appointees), and can invest in U.S. stocks and bonds and other instruments as approved by the committee.

  • Accountability and monitoring: A US-FSM Joint Economic Management Committee (JEMCO) approves grant allocations and reviews performance outcomes and audits. The committee is comprised of three U.S. and two FSM members.

  • Sectoral allocations: Funds are to be allocated to six priority sectors—health, infrastructure, education, capacity building, environment, and private sector development. There are no explicit formulas for allocation by sector, but JEMCO has resolved that infrastructure spending should rise towards at least 30 percent of annual Compact grants and achieve that level in FY2006.

Other key provisions of Compact II include:

  • Disaster assistance from the U.S. Federal Emergency Management Agency is to be phased out over time and replaced by assistance administered through the U.S. Department of State.

  • Funding under certain U.S. educational programs is to be replaced by the Supplemental Education Grant (about $12 million in FY2005).

  • Immigration provisions were tightened (for instance, visitors now must show a passport).

5. A lack of domestic job opportunities appears to have driven significant emigration, particularly following the late 1990s government restructuring and the subsequent economic slump (the Compact allows FSM citizens to readily emigrate to and work in the United States). According to unofficial estimates, emigrants comprise 10 to 25 percent of the population, most of whom live in the United States or in its territories such as Guam. As a result of increased emigration, since the mid-1990s annual population growth has slowed from about 2 percent to about 0.2 percent. Micronesians living overseas probably send substantial amounts of income home, increasing the resilience of the domestic economy. While official data put net remittance inflows at only 1 percent of GDP, these estimates are based on a household survey from the 1990s, and the subsequent pickup in emigration has likely boosted remittances.

6. The authorities recognize the need for fiscal and structural reforms, but implementation has been slow. The authorities have made some progress in addressing problems highlighted by Directors at the conclusion of the 2003 Article IV consultation: fiscal accountability has been enhanced under the amended Compact, and modest headway has been made in some areas of structural reforms under the AsDB-supported Private Sector Development Program. In addition, the FSM’s third Economic Summit held in early 2004 highlighted the benefits of a sustained-growth development strategy and identified key policy challenges, and disseminated information to the public on the need for reforms. However, much remains to be done: fiscal imbalances remain sizeable; the wage bill is high, including by regional standards; revenues remain low; a VAT is still under discussion; and key structural reforms have not moved forward. The limited progress reflects the difficulty of reaching agreement among the states on national fiscal priorities, as well as a lack of understanding among stakeholders of the challenges facing the FSM and policy options for dealing with them. In addition, weak capacity continues to hamper policy implementation.

II. Recent Economic Developments and Near-Term Outlook2

7. Real output contracted in FY2004 (Table 1). In FY2003, government spending rose, while private sector activity recovered owing to reduced uncertainty as Compact negotiations ended. In FY2004, however, economic activity was adversely affected by a stepdown in Compact grants and a typhoon. Employment growth has been stagnant the past two years, with falling public employment broadly offset by rising private employment, while wage growth has been modest. Inflation has remained low despite higher oil prices.

Table 1.

Federated States of Micronesia: Basic Data, FY1999-2005 1/

article image
Sources: Data provided by the FSM authorities; and Fund staff estimates.

Fiscal year ending September 30.

A price index for the FSM has been only available since FY2000. Data shown are for FSM from FY2000 onward. Prior to this, the U.S. CPI is used.

Estimated stock of domestic arrears in Chuuk and Pohnpei; end of period.

Cash and other liquid investments not reserved for specific uses.

Includes changes in reserves, valuation changes and errors and omissions.

Government and public enterprise debt only.

8. The fiscal position swung sharply to deficit in FY2004 (Table 2). This deterioration after two years of surpluses reflected both a programmed drop in Compact grants and the withholding of Compact infrastructure grants disbursements owing to delays in preparing a required infrastructure development plan. Domestic revenues continued falling relative to GDP. State fiscal performances varied, with Chuuk state accumulating arrears. Reflecting the consolidated deficit and a $30 million trust fund contribution, uncommitted government financial assets fell sharply from 21½ percent to 8¼ percent of GDP.

Table 2.

Federated States of Micronesia: Consolidated General Government Finances, FY1999-2005 1/

(In millions of U.S. dollars)

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

Fiscal year ending September 30. The consolidated government fiscal accounts cover the national and four state governments.

Including investment income.

Cash and other liquid investments not reserved for specific uses.

uA01fig02

Public Sector Balance in Percent of GDP

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

Source: Fund staff estimates.

9. The external position also worsened. The trade deficit widened as the petroleum import bill rose with oil prices and as exports fell, partly due to the typhoon.3 The trade imbalance drove the current account sharply into deficit (Table 3). Gross reserves declined slightly to 5½ months of imports (official capital-account data are incomplete and likely omit significant inflows). With the U.S. dollar the official currency, the real exchange rate has depreciated in recent years, although it remains somewhat appreciated compared with other Pacific island currencies. However, structural difficulties, rather than exchange rate competitiveness, seem to be the main cause of the FSM’s weak export performance. External debt has remained low, including by regional standards (Box 2). Debt service is about 6 percent of exports, and about half of debt is owed to the AsDB, on concessional terms.

Table 3.

Federated States of Micronesia: Balance of Payments, FY1999-2005

(In millions of U.S. dollars)

article image
Sources: Data provided by the FSM authorities; and Fund staff estimates.

Include changes in FSM reserves, valuation changes, errors, and omissions.

uA01fig03

Real Effective Exchange Rate Comparisons 1/

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

Sources: IMF, Information Notice System; and staff calculations.1/ Average of monthly/quarterly REER through 2004Q1 is used for 2004.

10. Domestic credit continues to shrink. The FSM’s two commercial banks are well capitalized and highly liquid, with low nonperforming loans.4 However, owing to limited domestic lending opportunities and shortcomings in the legal framework, the financial sector mainly invests in U.S. securities markets, rather than lending to domestic businesses and households. In the recent period, private sector credit has been contracting owing to weak economic prospects, and the loan/deposit ratio has declined to record lows.

11. For the near term, output should grow slightly in FY2005 as public investment rises and private-sector activity picks up. Inflation is expected to remain low. The fiscal deficit should narrow to 2 percent of GDP if grants withheld in FY2005 are disbursed as anticipated. The external current account would remain in significant deficit owing in part to the pending closure of a garment factory. Steady emigration is likely to continue owing to limited job opportunities, although the attendant increase in remittance inflows would partly offset its effects on income. Downside risks to the outlook include a sustained increase in oil prices and a global slowdown that could dampen exports. Adverse weather conditions are another risk, which could worsen over time with global climate change.5

The FSM Economy: Comparison with Other Compact Countries

The FSM, the Republic of the Marshall Islands (RMI), and the Republic of Palau (all formerly part of the Trust Territory of the Pacific Islands) currently have Compact of Free Association agreements with the United States. These three countries have similar characteristics, with heavy reliance on official grants and dollarization. Nonetheless, cross-country comparisons highlight notable differences among them.

uA01fig04

Nominal GDP per capita1,2

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

Sources: Data provided by the FSM authorities; and IMF staff estimates.1 Although reliable GDP deflators for long periods are not available, inflation in the FSM does not seem to be higher than those in the other countries for these years.2Data for Palau are for calendar year.

Compared with the RMI, the FSM has experienced higher GDP growth and enjoys higher GDP per capita at present. However, both the FSM and the RMI have lagged Palau in terms of economic development, and a large part of their population is still in the subsistence sector. Furthermore, growth in paid private-sector employment has been modest. The differing economic performances might be partly attributed to geography: Palau is the closest to large Asian countries and receives the greatest number of international visitors. All three countries have enjoyed price stability during recent years, thanks to the U.S. dollar’s use as the domestic currency.

uA01fig05

Private sector employment1

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

Sources: Data provided by the FSM authorities; and IMF staff estimates.1 Data for Palau are for calendar year.
uA01fig06

Fiscal Indicators (FY2003)

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

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

Regarding fiscal performance, the three countries are characterized by low domestic revenue, high dependence on grants, and large current expenditures. As a share of GDP, the FSM has the lowest domestic revenue, the highest grants, and the largest wage expenditures. That said, its government debt, along with Palau’s, is at comfortably low levels, thanks to large grants and relatively prudent past fiscal policies.

uA01fig07

External debt

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

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

III. Policy Discussions

A. Medium-Term Framework

12. The discussions revolved around medium-term prospects, and particularly the need for fiscal and structural adjustments to adapt to reduced Compact funding (Annex I). The mission stressed that growth is likely to be sluggish in the medium term—around 1 percent a year—unless fiscal and structural reforms are undertaken. In addition, the large government sector will be increasingly unsustainable given coming declines in grants. Slow or partial reforms would entail mounting fiscal vulnerabilities and a continued drag on private sector activity, while a prolonged lack of private-sector opportunities could spur more rapid emigration that would reduce human capital and economic potential. To be sure, the FSM’s remoteness, small size, and limited resource base continue to pose obstacles to development. However, strong private-sector growth in Yap state and higher per-capita GDP and employment in nearby Palau suggest that such obstacles are not insurmountable. The mission also stressed that fiscal and structural reforms could complement one another: for example, structural reforms would aid the fiscal effort by stoking growth in the tax base.

13. The authorities agreed on the need for policy adjustments, but highlighted the difficulty of mobilizing public support and implementing policies. In particular, the states account for a large proportion of the overall fiscal imbalance, and thus must undertake a significant share of the measures to correct it. Moreover, while the states and Congress are exploring options for adjustment, they are not convinced of the need for a VAT. The authorities continue their outreach and coordination efforts in the context of the Economic Summit and an Economic Policy Implementation Council (comprising the leaders of the five governments, including Congressional representatives). The mission recognized these efforts and encouraged the authorities to build upon them, but stressed the urgency of launching adjustments in earnest to promote medium-term fiscal and economic sustainability.

B. Fiscal Adjustment

14. The authorities noted that the FY2005 budget incorporated expenditure restraint. Wage freezes and hiring ceilings would remain in place, holding down the wage bill. While expressing concerns that states might experience pressure on service delivery given Compact restrictions on how grants can be spent, the authorities nevertheless thought that each state should be able to trim other current expenditure, including on wages and travel. On the revenue side, customs administration has improved with the recent introduction of an automated clearance system. However, the revenue impact has been small, and audits and penalties need strengthening.

15. The mission supported steps to restrain expenditure but stressed the need for immediate fiscal consolidation. Based on the FY2005 budget, the mission estimated that current expenditures would remain broadly unchanged, while capital expenditure would recover with the release of Compact grants held back in FY2004. Tax revenues would remain low, while grants would rise substantially. Overall, the deficit would narrow but would remain large. To reduce this imbalance, immediate cuts in the wage bill and other current expenditures are needed. Efforts are also warranted to stem the decline in tax revenues by further improving administration, although the initial payoff would be modest. Delays in reducing the deficit would worsen fiscal vulnerabilities through further erosion of government financial assets and buildups of arrears—which was particularly a risk in Chuuk state. Alternatively, prompt consolidation would signal commitment to stabilizing the public finances and streamlining expenditure, and thereby bolster public support for tax reforms.

16. The mission stressed that a sizeable fiscal adjustment would be required in the medium term. Medium-term surpluses of around 3 percent of GDP would be needed to accumulate assets sufficient to absorb shocks and supplement trust fund income after 2023, as well as to stabilize assets relative to GDP in the long run. This would entail an adjustment of 5 percentage points of GDP from FY2005. With such an adjustment, complemented by reforms to spur private sector development, income on assets would stabilize relative to GDP in the long run.

uA01fig08

Compact Grant and Assets Returns 1/

(In percent GDP)

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

Source: Staff estimates.1/ Compact grants 2004-23 and Compact Trust Fund and other assets returns from 2024.

17. A more decisive fiscal strategy is needed to achieve this adjustment. As significant revenue measures would take several years to implement, continued reductions in current expenditures would be needed. Indeed, the structure of expenditures could benefit from a broad review. However, as core expenditures on health, education, and infrastructure should be preserved, given their crucial importance to growth and to meet Compact requirements, revenue efforts should contribute significantly to fiscal adjustment over time. This would include further strengthening administration to boost tax revenue, which remained low by regional standards, as well as aid with implementation of future tax policy measures. Beyond this, however, more fundamental tax reforms are needed to reduce distortions and improve compliance while bolstering revenue. In this connection, the mission expressed concern that piecemeal measures introduced by Congress, such as increasing duties, would divert attention from fundamental tax reforms and could even undercut revenue gains by worsening compliance. The authorities noted that a high-level Task Force that includes representatives of the five governments and the National Congress is reviewing options for comprehensive tax reform.

uA01fig09

Tax Revenue/GDP

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

Source: Staff estimates.

18. The staff argued that the best option for tax reform remains introduction of a VAT, similar to those introduced in a number of other Pacific island countries. Properly planned and implemented, this could yield 2 to 3 percentage points of GDP in revenue. Moreover, it would reduce distortionary tax cascades—taxes levied upon taxes—as well as conform with plans for trade liberalization and improve compliance. The administrative burden could be managed by setting an appropriately high sales threshold for selecting the firms that would be required to comply with the VAT (other firms would be covered by a presumptive tax similar to the existing gross revenue tax). The authorities noted that the Task Force saw the VAT as an important option. However, implementation would require the cooperation of the states, which have constitutional jurisdiction over consumption taxes (a proposed constitutional amendment to allow a national VAT failed in 2002). A VAT could be implemented through the introduction of four state VATs, although coordinating the tax schemes would be challenging. The mission recognized these difficulties but noted that other options, such as expanding the income tax base, were unlikely to yield as much revenue. Thus, absent a VAT, larger expenditure cuts would be needed.

19. The mission and the authorities concurred that reforms of public enterprises are needed to reduce their budgetary burden and avoid crowding out private firms. Heavy government involvement in commercial activities, notably in agriculture and fishing, has failed: some public enterprises are defunct, while others depend on subsidies. The public enterprise sector remains significant in size, accounting for 5 percent of employment—roughly the same size as all the main export-oriented sectors combined. The authorities’ strategy going forward is to facilitate private sector development by creating a fertile business environment, rather than undertaking commercial activities. The mission welcomed this aim, but noted the need to expeditiously close inessential enterprises and strengthen essential but weak ones.

20. The financial situation of the Social Security Administration warrants attention. While the Administration currently runs a small surplus and is unlikely to be a drain on the budget soon, its unfunded future liability remains very high at $203 million (90 percent of GDP). This situation mainly reflects an unsustainably high rate of return on contributions: for most participants, the present value of benefits is 300 to 400 percent higher than the present value of contributions. Accordingly, it was agreed that measures will be needed to address the unfunded liability—perhaps by increasing the retirement age or reducing benefits.

21. Budgetary management needs to be strengthened. Progress has been made toward compliance with the Fiscal Procedures Agreement (FPA) under the renewed Compact, but capacity limitations risked further delays in meeting FPA requirements that could hold up disbursements. Thus, the mission considered that efforts to meet the Compact’s accountability and oversight requirements needed to be intensified. The authorities noted that the planned implementation of a unified financial management information system should improve financial control and reporting, as well as timeliness in completing audits (final accounts for FY2002 are still unavailable).

22. Draft legislation would allow foreign corporations to pay corporate income tax in the FSM, thus exempting them from paying tax at home and creating a tax haven. The authorities stressed that they opposed the legislation, which was pushed by members of Congress. The mission and PFTAC advisors strongly advised against the measure, which would likely bring few if any economic benefits to the FSM but would be viewed unfavorably by the international community. The President vetoed the legislation but the veto could be overridden by Congress. (The FSM is not now on the OECD list of tax havens.)

C. Structural Reforms

23. It was agreed that structural reforms are needed to encourage private sector development and employment. Structural problems include periodic power outages in some parts of the country, obstacles to foreign ownership of land and to the use of land as collateral for loans, and an intransparent and lengthy review process for foreign investments. The authorities’ priorities to resolve these problems, as reflected in the Private Sector Development Program (PSDP; Box 3) and the third Economic Summit, include:

  • infrastructure enhancements to reduce the cost of doing business;

  • measures to ease the use of land for production and for investment and collateral; and

  • steps to make the foreign investment regime more efficient and transparent by reducing bureaucratic discretion and shortening the review process.

24. The mission concurred with these priorities but noted that progress in reforms has been slow. Approval of PSDP loans was delayed for over two years, reflecting limited capacity and a lack of a sense of urgency about reforms. As a result, considerable reform momentum has been lost, with little or no legislative action in most areas. The mission stressed the need for prompt and concrete progress, noting the risks and costs of further delays, and encouraged the authorities to intensify their dialog with stakeholders on the importance of timely reforms.

Private Sector Development Program

Since 2003, the FSM has been implementing the Private Sector Development Program (PSDP) with $13 million in financial support from the Asian Development Bank (AsDB). The PSDP complements the late 1990s Public Sector Reform Program, which helped to cut government payroll costs (though the progress was partly undone later).

The goal of the PSDP, which is to be completed in 2006, is to promote economic growth by expanding the private sector, thereby raising domestic employment and incomes and reducing dependence on external assistance. To attain this goal, the PSDP’s objectives are to: (i) improve the policy and legal environment for private sector development, and (ii) strengthen capacity to manage land, labor, and capital resources. Its key performance targets and required actions are the following:

  • Public sector reforms:

    • Maintaining balanced budgets (in terms of current revenues and expenditures);

    • Setting aside the FY2002–03 increase in Compact grants for the trust fund;

    • Maintaining government payroll levels; and

    • Reforms of at least one public sector enterprise by each national and state government.

  • Economic and legal reforms to enact or revise laws in the areas of long-term land leases, mortgages, foreign investment, and bankruptcy.

Progress in implementation has been generally limited. The FSM satisfied prior conditions for the first tranche of the program loan, which was disbursed in 2003. To receive the second tranche disbursement ($2.5 million) slated for 2005, however, AsDB staff consider that much needs to be done, particularly on economic and legal reforms. Progress in economic and legal reforms has been as follows:

  • Public sector enterprises. Reforms have been delayed. These reforms are seen as the biggest hurdle to disbursement of the second tranche.

  • Long-term land lease laws and new foreign investment laws. Local and national governments have prepared relevant model legislation.

  • Mortgage laws. Only Chuuk passed the law, while other states submitted legislation.

  • Bankruptcy law. A draft law has been prepared.

25. The authorities described their policy goals in the sectors of tourism, fisheries, and agriculture. Tourism is seen as having potential to develop. While neighboring islands were more competitive and advanced, especially in mass tourism, with vigorous promotion the FSM could develop niche tourism in areas such as diving. In fisheries and agriculture, commercial production is at a nascent stage. The government’s priorities are to privatize public fishing enterprises and encourage FSM-based fishing fleets, with due attention to marine resource sustainability; and to increase agricultural production and reduce reliance on imports for food security purposes.

uA01fig10

Visitor Arrivals

(2002, 1000 persons)

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

Source: World Tourism Organization.

D. Other Issues

26. The banking system remains well supervised and regulated but lends little domestically. The 2002 Banking Act amendment brought supervision and prudential standards closer in line with the Basle Core Principles. However, the mission and the authorities agreed that reforms to improve the lending environment are still needed to better support the domestic economy. The authorities noted that drafts of a bankruptcy code and secured transaction legislation have been prepared, but were not yet taken up by Congress. The mission saw these elements of the legal framework as key priorities.

27. The banking system also includes a development bank, which accounts for half of domestic credit. It has a slightly larger nonperforming loan rate than the commercial banks and received total capital contributions of around $2 million from the National Government over the past three years. The authorities saw the bank’s competition with private banks as limited, as it deals mainly with loans that commercial banks considered too risky to underwrite, and viewed the associated fiscal risks as modest. The mission nevertheless noted that the development bank should avoid competing with the commercial banks and should contain possible budgetary implications of its operations.

28. Efforts have been under way to strengthen the AML/CFT framework. Money laundering legislation was put in place in 2001 and bank staff have received AML/CFT training. A 2003 Legal Department mission provided assistance in upgrading AML legislation to conform with international standards and advice on establishing a financial intelligence unit (FIU), which has recently been created. (The FSM is not on the FATF’s list of countries that are noncooperative in AML/CFT.)

29. The authorities intend to pursue trade liberalization. The mission saw the strategy of engaging in regional trade agreements as a prelude to broader liberalization as appropriate; ratification of the Pacific Island Countries Trade Agreement (PICTA) would be a step forward in this regard.6 The FSM is a member of the Pacific Agreement on Closer Economic Relations, which is a framework for negotiation of regional trade agreements, and participates in Economic Partnership Agreement negotiations with the EU (which are at an early stage). The FSM has a relatively open trade regime, rated “4” on the Fund’s index of trade restrictiveness. A few items are subject to import duties of 25 percent but rates for food and general merchandise are 3 percent and 4 percent, respectively. There are no quantitative restrictions on imports and no significant nontariff barriers to trade. While the government maintains a monopoly on copra exports, such exports are at negligible levels.

30. Domestic capacity to produce economic statistics remains weak, hampering economic monitoring and policy evaluation. The mission welcomed ongoing efforts, based on a 2003 PFTAC plan, to strengthen the capacity of local staff and reduce reliance on external experts. It also encouraged the authorities to participate in the General Data Dissemination System (GDDS) to complement enhancements in capacity and define a framework for further improvements to statistics.

IV. Staff Appraisal

31. The medium term outlook is worrisome. Given anticipated declines in external assistance the large government sector will be increasingly unsustainable. In addition, minimal progress has been made towards rectifying fiscal imbalances or undertaking structural reforms needed to promote private sector development. Without steps to remedy these problems, the medium-term outlook is for weak growth and mounting fiscal vulnerabilities, with a significant risk of more rapid outward migration.

32. The main policy challenge is thus to foster fiscal and economic self sufficiency. Reforms will be difficult, particularly given the states’ policy autonomy, and the country’s remote location and small size will continue to pose obstacles to development. Nevertheless, starting comprehensive reforms in earnest is the only option to ensure medium-term sustainability. Further dialog with public and private stakeholders will be essential to raise awareness of the choices facing the country and to build the needed consensus for reform.

33. Given declining assistance, fiscal adjustment is unavoidable and should start right away. In the context of the FY2005 budget, efforts to restrain the wage bill through a continued wage freeze and hiring ceilings are welcome. The authorities should build on these efforts by making immediate cuts in the wage bill as well as reductions in other current expenditure. Prompt consolidation would both reduce fiscal vulnerabilities and usefully signal the commitment to stabilizing the public finances and rationalizing expenditure.

34. In the medium term, a sizeable adjustment will be needed. Because necessary comprehensive tax reforms will take time to implement, expenditure cuts will need to continue beyond FY2005. However, fiscal adjustment should preserve core expenditures on health, education, and infrastructure, given their importance to growth and Compact requirements to target them. In addition, revenue administration and budgetary management should be strengthened.

35. To safeguard core expenditures, revenue measures should contribute significantly to the medium-term adjustment. The best option remains comprehensive tax reforms centered around introduction of a VAT, which would eliminate tax cascades, conform with plans for trade liberalization, and improve compliance. Implementation will be challenging given the decentralized fiscal system. However, viable alternatives are lacking: absent a VAT, significantly larger expenditure cuts that would imperil core social spending would be needed.

36. As the public sector shrinks with falling assistance, structural reforms can encourage private sector growth and employment. In this connection, the authorities’ strategy to facilitate business by creating a fertile business environment and avoiding commercial activities is welcome. Priorities should include improvements to infrastructure and to the legal frameworks for land use, foreign investment, and lending. Also, public enterprise reforms could reduce crowding out of private firms, as well as yielding fiscal savings. With regard to trade policy, the strategy of using PICTA as a stepping stone to broader liberalization is appropriate.

37. Economic monitoring and policy evaluation remain hampered by the limited domestic capacity to produce economic statistics. Efforts to move compilation from outside experts to local staff are welcome and should continue. Participation in the GDDS would complement capacity enhancements and guide further improvements to statistics.

38. It is recommended that the next Article IV consultation take place on the 24 month cycle. The authorities expressed interest in a staff visit during 2005, possibly focusing on tax reform.

Table 4.

Federated States of Micronesia: External Vulnerability Indicators, FY1999-2004

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

Calendar year basis.

Data for FY2004 are for end of June 2004.

Preliminary figures. Defined as loans with arrears in excess of 30 days.

Data for Bank of FSM (accounting for around 50 percent of domestic commercial bank credit).

Table 5.

Federated States of Micronesia: Social Indicators 1/

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Sources: World Development Indicators 2004, World Bank; Key Indicators 2004, Asian Development Bank.

FY2002 or latest available year prior to FY2002.

ANNEX I Federated States of Micronesia—Long - Term Fiscal Adjustment

Coming declines in external Compact assistance will necessitate both fiscal adjustment and structural reforms if the FSM is to attain economic self-sufficiency. Illustrative calculations describe the possible outturn under baseline, fiscal reform, and comprehensive fiscal and structural reform scenarios. The results suggest that comprehensive reforms could foster both strong private-sector-led growth and a robust fiscal position over the long run.

Basic assumptions

  • Compact grants and trust fund contributions will be disbursed as scheduled during FY2004–23 (see the table), with adjustments for inflation as described in Box 1 (U.S. and FSM inflation are assumed to be 3 percent and 2 percent, respectively). No other new assistance is made available. Neither the trust fund nor the income from it are available to finance spending before FY2024.

  • Except in the baseline scenario, capital expenditure is raised over the near term in line with Compact requirements to raise spending on infrastructure.

  • No additional borrowing takes place (borrowing has been for development purposes rather than to finance deficits; no new loans are currently scheduled).

Baseline Scenario

Assumptions: Tax revenues are assumed to remain around the current level as a percentage of GDP, and capital spending bears the brunt of fiscal adjustment to accommodate declining external assistance. With capital spending insufficient to shore up the infrastructure, economic growth is about 1 percent.

Outcome: With the budget in balance, usable government assets remain low, leaving only a slim buffer to absorb fiscal shocks such as the end of Compact grants in 2023. Returns on the trust fund plus other assets would initially suffice to replace expiring Compact grants, but only for a few years, and the stock of assets would decline relative to GDP over time. As in the other scenarios, usable government assets rise relative to GDP in the long run because returns on assets exceed the growth rate of nominal GDP.

Fiscal Reform Scenario

Assumptions: On the revenue side, a VAT is introduced in FY2006, increasing revenues by 3 percent of GDP. From 2007 onwards (including beyond 2023), further improvements to tax administration foster a modest rise in taxes relative to GDP. On the expenditure side, wages are frozen up to FY2010, while travel and other current expenditures are cut by 10 percent over FY2006–08 and then indexed to inflation. Capital expenditure increases in line with Compact requirements through 2007 and grows by 4 percent thereafter. Higher capital expenditure facilitates private-sector activity, raising GDP growth to around 1¾ percent.

Outcome: The fiscal balance initially rises steeply after the introduction of the VAT, then declines to about 1 percent of GDP reflecting the fall in Compact funds. In the long run, returns on assets are too small to replace expiring grants, as assets fall relative to GDP. Assets are lower relative to GDP than under the baseline because GDP is higher.

Comprehensive Reform Scenario (Fiscal-Private Sector Development)

Assumptions: In addition to the above fiscal reforms, current expenditures other than wages are cut by a further 5 percent over FY2006–08. Also, structural reforms are undertaken that raise private-sector growth to 6 percent—in line with the growth rate of Yap state during the first Compact period. Overall GDP growth rises to 2¾ percent.

Outcome: Better fiscal performance permits both modestly increased capital expenditure and higher long-run surpluses. In the long run, assets stabilize relative to GDP and returns on the trust fund plus other assets suffice to replace expiring grants. Assets are lower relative to GDP than under the baseline or fiscal reform scenarios because GDP is higher.

Selected Indicators in FY2023

(In millions of U.S. dollars)

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Source: IMF staff estimates and projections.

Compact II Funding for the FSM

(In millions of U.S. dollars)

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Source: “Compact of Free Association, as Amended, Between the Government of the United States of America and the Government of the Federated States of Micronesia,” 2003.
uA01fig11

Micronesia: Long-Term Fiscal Adjustment Scenarios, 2004-32

(In percent of GDP)

Citation: IMF Staff Country Reports 2005, 104; 10.5089/9781451813791.002.A001

Source: IMF staff estimates.1/ Excludes trust fund.

ANNEX II Federated States of Micronesia—Fund Relations

(As of October 31, 2004)

I. Membership Status: Joined June 24, 1993; accepted Article VIII

II. General Resources Account:

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III. SDR Department:

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IV. Outstanding Purchases and Loans: None

V. Financial Arrangements: None

VI. Projected Obligations to Fund: None

VII. Exchange Rate Arrangement:

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

VIII. Article IV Consultation:

The FSM is on the 24-month consultation cycle. The 2002 Article IV consultation discussions were held during October 22–31, 2002. The Executive Board discussed the staff report and concluded the consultation on January 24, 2003.

IX. Technical Assistance, 1999–2004:

STA, MFD, LEG, and PFTAC have provided technical assistance on statistics, banking supervision, tax policy, and combating of financial crime and financial system abuse.

X. Resident Representative: None

ANNEX III Federated States of Micronesia—Technical Assistance from Headquarters

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ANNEX IV Federated States of Micronesia—Relations with the Pacific Financial Technical Assistance Center (PFTAC)7

Since 1998, the Center’s assistance to the FSM has included 34 advisory missions, mostly in the area of banking supervision and tax policy and administration. The FSM has also sent 13 officials to various regional seminars and workshops organized by PFTAC.

Public Financial Management

A July 2001 mission assessed fiscal transparency against the Code of Good Practices on Fiscal Transparency. A performance-oriented budget system has been introduced (partly to comply with Compact reporting obligations), but some building blocks are missing. A mission is planned for CY2004 to review progress and discuss further budget reforms.

Tax Administration and Policy

A Tax Reform Task Force has been established to review tax options, including recommendations of a PFTAC report. Depending on the outcome of the Tax Force’s work, a mission will provide further TA, including designing an action plan to assist implementation.

PFTAC also designed a Customs Modernization project in 2002, which resulted in a sharp drop in the average time to clear goods, and also introduced electronic customs declarations (now more than 40 percent of the total); self-assessments; internationally accepted coding systems; a single identification number for income tax and customs duties; the metric system and the CIF value for customs forms; and standardized procedures for all four states. More training is proposed on risk management, post-clearance audit and valuation.

Financial Sector Regulation and Supervision

Since January 2001, a Fund peripatetic advisor has visited the FSM five times to provide technical assistance, focusing mainly on on-site examination. Further missions over the next twelve months will focus on off-site surveillance and prudential reporting. The Banking Commissioner has benefited from Fund and PFTAC seminars and workshops.

Economic and Financial Statistics

A March 2003 mission reviewed an earlier development plan for economic statistics. It recommended strengthening the statistics function and reducing reliance on external consultants by recruiting four economic trainee statisticians, extending the resident external adviser position for two years, and conducting a new Household Income and Expenditure Survey. Participation in the GDDS was also encouraged. The number of qualified staff increased in 2004, but other initiatives have yet to be implemented.

ANNEX V Federated States of Micronesia—Relations with the World Bank Group8

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The Federated States of Micronesia (FSM) joined the World Bank Group on June 24, 1993. To date, no loans have been extended to the FSM. The main focus of the World Bank’s work in the FSM has been regionally focused economic and sector work and country specific work in the fisheries sector.

The Bank approved a grant of about $140,000 in 1995 through the Institutional Development Fund to help improve the institutional capacity for coordinating fisheries development policies across the four states and to improve the performance of fisheries parastatals, including through privatization.

More recently, the World Bank has been collaborating with the AsDB, the Forum Fisheries Agency, and the Secretariat of the Pacific Community in estimating the economic importance of fisheries to key Pacific Island countries, including the FSM. It presents new estimates of the economic importance of fisheries in these countries that takes into account employment values, volume and value of fish harvested (including commercial and subsistence fisheries), export and import data, access fees, and levels of fish consumption. The study was published by ADB as a joint publication with the World Bank in 2002.

ANNEX VI Federated States of Micronesia—Relations with the Asian Development Bank9

Since becoming a member in 1990, the FSM has received substantial assistance from the AsDB. As of August 2004, cumulative AsDB assistance to the FSM consisted of six loans and a number of TA prospects.10 During the period 1997–99, the AsDB launched the Public Sector Reform Program (PSRP), achieving important reductions in public sector payroll costs and employment through the Early Retirement Program with significant budgetary savings.

The AsDB continues to support the FSM with three pillars of the country strategy: (i) good governance, (ii) inclusive social development, and (iii) pro-poor economic growth. In addition, the AsDB’s country strategy for 2005–06 will emphasize further the underlying themes; (i) promoting wider participation of civil society to development processes of the country, (ii) addressing hardship (poverty) issues more explicitly, and (iii) providing assistance with a long-term perspective, with a view to increase the effectiveness of its assistance.

Currently, three loans are active: one focused on basic social services, and two on the development of the private sector. The AsDB approved a Private Sector Development Program (PSDP) at the end of 2001, with two loans totaling $13.0 million. The PSDP aims at promoting small and medium sized businesses, enhancing the regulatory and policy framework, and improving factor markets. Measures are also planned to mitigate any adverse social impact of these adjustment polices. A new loan project for infrastructure development in power, water supply and waste water sectors is being processed with anticipation of AsDB approval in 2004.

The AsDB has been assisting the FSM to improve public sector efficiency and effectiveness since 1995 through TA in economic management and capacity building. The AsDB continues to support the government in increasing its institutional capacity in public sector management, administration and auditing through TA activities.

Table 1.

Loans to the Federated States of Micronesia by Sector

(In millions of dollars; as of end-August 2004)

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Table 2.

Loan Approvals and Disbursements to the Federated States of Micronesia, 1993–2003

(In millions of dollars)

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Includes 1990–92.

ANNEX VII Federated States of Micronesia—Statistical Issues

The Office of Planning and Statistics is responsible for the compilation of national statistics, and the first Statistical Yearbook was published in July 1999. There have been a number of improvements in data compilation, reflecting substantial assistance provided by the AsDB-financed Economic Management Policy Advisory Team (EMPAT) and PFTAC. However, major weaknesses remain, particularly in the area of national accounts.

Real Sector

The last official GDP estimate is for FY1996. No unemployment or aggregate production indicators are available. Recent GDP estimates are calculated by EMPAT from tax and social security data. The authorities have published a quarterly consumer price index for the nation as a whole and each state.

Government Finance

The national and the state governments and public sector enterprises publish annual audit reports detailing their fiscal operations, and are now available in GFS format. However, long publication lags exist. Further improvements in the quality of the fiscal data are dependent on greater cooperation between the national and state governments through timely and accurate reporting of data to the Division of Statistics in the FSM Department of Economic Affairs.

Monetary Accounts

An IFS country page was established in 2000. The Banking Commissioner sends updated data to STA on a monthly basis, with some need for improvement in timeliness. The reported data comprise interest rates, the accounts of the monetary authorities, commercial banks and the FSM Development Bank.

Balance of Payments

The authorities provide annual estimates of the balance of payments and external debt statistics.

Federated States of Micronesia: Core Statistical Indicators

(As of December 1, 2004)

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Approximated by government holdings of financial assets.

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

D-daily; M-monthly; V-staff visits.

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

P-postal delivery; E-electronic data transfer; V-staff visits.

Statistics Department (STA) of the IMF receives interest rates data from Banking Commission (the commission) of the Federal States of Micronesia (FSM) via postal delivery. STA also receives the interest rates data separately from the commission of FSM in an electronic file attached to e-mail that also contains the monetary and financial statistics for the monetary authorities, commercial banks, and FSM Development Bank. The interest rate data submitted via postal delivery often contains more current data.

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

1

The fiscal year runs from October to September (e.g., FY2004 ended in September 2004).

2

The Selected Issues paper accompanying this report covers recent economic developments in greater detail, and also analyzes medium-term prospects and options for tax reform.

3

Key exports are primarily tuna fish and agricultural produce.

4

One bank is a branch of a foreign-headquartered bank; the other is mostly owned by the FSM government and has a small share of foreign ownership.

5

Under the Compact, the FSM is eligible for U.S. disaster relief, which mitigates weather-related risks.

6

PICTA entails phased elimination of tariffs vis-à-vis other Pacific island countries by 2012. Given the limited trade between these states, little or no trade diversion would result. The process may provide an introduction to the mechanics of trade liberalization, which could prove useful for liberalization at the multilateral level.

7

The Pacific Financial Technical Assistance Centre (PFTAC) in Suva, Fiji is a multi-donor technical assistance institution, financed by IMF, AsDB, AusAID and NZAID, with the IMF as Executing Agency. The Centre’s aim is to build skills and institutional capacity for effective economic and financial management that can be sustained at the national level. Member countries are: Cook Islands, Federated States of Micronesia, Fiji, Kiribati, Marshall Islands, Nauru, Niue, Palau, Papua New Guinea, Samoa, Solomon Islands, Tokelau, Tonga, Tuvalu, and Vanuatu. This annex is prepared on the basis of the input from the PFTAC staff.

8

Prepared on the basis of the input from the World Bank staff.

9

Prepared on the basis of information from AsDB staff.

10

The six loans are in the areas of: (i) fisheries development; (ii) public sector reform; (iii) water supply and sanitation; (iv) basic social services; and (v) private sector development.

Federated States of Micronesia: Staff Report for the 2004 Article IV Consultation
Author: International Monetary Fund