Economic Developments and Challenges

The FSM economy remains heavily dependent on financial assistance under the Compact arrangements with the United States (with compact grants currently equivalent to a third of GDP). However, this assistance has been declining, and will continue to fall in the years ahead, and changes in compact assistance levels have been quickly mirrored in short-term fluctuations in the rate of GDP growth (the economy saw the sharpest declines in the two years of compact funding step-down, first in 1997, and again last year reversing the trend of positive economic growth since 2000).

The scale of adjustment already achieved, however, has been impressive. Since 1999, current government expenditure as a share of GDP has fallen by 13 percentage points (from 65 percent to 52 percent). The authorities have shown an impressive, and sustained, degree of fiscal discipline in bringing about this adjustment. Nominal wages in the public sector have been frozen since 1997, and subsidies to public enterprises, once a very large proportion of public spending, have been cut further from 4.3 percent of GDP in 1999 to 1.3 percent now (most of the operational public enterprises are now generating sufficient revenue to cover costs). These are substantial adjustments by any standards and the authorities deserve considerable credit for what has already been achieved. It is also encouraging that, as public sector employment has fallen, employment opportunities in the private sector have steadily increased, and the number of private sector employees now exceeds those in the public sector.

With a typhoon and delays in Compact-funded capital expenditure exacerbating the decline in output, 2004 was a challenging year for the authorities. The fiscal position is set to improve significantly in the 2005 budget as compact infrastructure grants resume and expenditure restraint is maintained. The overall fiscal balance is projected to be only 2.1 percent of GDP this year and, if anything, increasing capital expenditure suggests that there could be an upside risk to staff’s rather cautious growth projections for 2005. As staff note, the government’s usable reserves fell sharply last year from 21½ percent to 8¼ percent of GDP, but it is important to stress that the bulk of this fall represented FSM’s investment in its own future, in the form of the $30 million contribution to the trust fund that is established under the Compact. Moreover, debt remains low, with 50 percent of it on concessional terms.

Policies under the amended compact

The amended Compact agreement with the United States reflects the shared objectives for the FSM economy: macroeconomic stability, sustainable growth, and ultimate self-reliance. To achieve these objectives, the amended compact incorporates the following features:

• declining annual grants;

• sectoral grant allocations with emphasis on health, education, and infrastructure;

• trust fund contributions; and

• enhanced accountability and monitoring¹.

Dealing with the far-reaching fiscal, political, and economic implications of the amended compact has been the biggest issue confronting the government for the last few years, and will remain so in the years ahead.

Looking ahead, the authorities agree that a comprehensive set of fiscal and structural reforms will be needed to promote medium-term fiscal and economic sustainability. Building on the substantial adjustment already achieved since the mid-1990s, these are important medium-term challenges, and meeting them will require strong political leadership, continued efforts to build a consensus for reform, and ongoing support from FSM’s international partners.

The road ahead will be difficult in places and many of the necessary changes are likely to occur only slowly. But progress in meeting the new challenges continues to be made. The 3^rd FSM Economic Summit held last year was instrumental in building public awareness on the alternatives facing the country, illustrated by the three scenarios presented in the selected issues paper. The summit endorsed pursuing the third scenario of comprehensive fiscal consolidation and structural reforms. Reflecting the priorities that came out of the summit, the FSM Strategic Development Plan (SDP) was then drawn up providing an overall framework to guide the use of government resources, including compact grants².

The annual reduction in the operating grant featured in the compact is designed to ensure that a gradual shift away from compact grant to greater reliance on domestic revenue takes place. This will inevitably require on-going fiscal adjustments over the life of the amended compact. The authorities agree that, in the shorter-term, the expenditure side will have to bear the brunt of the fiscal adjustment (although would put less emphasis than staff on the need for “immediate cuts in the wage bill and other current expenditures”). However, given the magnitude of the adjustment over time, and the substantial adjustments already achieved in recent years, expenditure cutting will not be able to meet the medium- to long-term fiscal adjustment needs without severely compromising the government’s ability to provide essential services. Also, as staff note, tax revenue remains low as a share of GDP by regional standards, although it is augmented by significant fishing access revenues which raise total domestic revenue to around 19 percent of GDP at present.

It is therefore widely accepted that in the medium-term revenue increases will be relied upon to meet some of the adjustment needs. Indeed, the action by congress in December 2004 to increase the rates on certain “sin taxes”, reflect a growing awareness in FSM that revenue increases must be part of the adjustment effort. For the longer-term, the government has for some time been considering a comprehensive tax reform program, two main features of which, are the value-added-tax and improvements in tax and customs administration. Good progress has been made recently in improving the customs and tax administration, including the introduction of the an automated customs clearance system to modernize customs procedures, self-assessment has been introduced, and international codes and classifications have been put in place. The authorities have opted for a cautious approach to the VAT, and are somewhat constrained by the constitutional (and resulting practical) constraints outlined in the staff report. To reinvigorate the momentum on tax reform, a high-level task force on tax reform was officially established last month by a Presidential Order. To ensure consensus, the task force decided that it will now take a step back and consider all possible alternatives for reforming the tax system with the view to selecting one that is most suited for FSM’s unique circumstances. It has invited PFTAC to give a presentation on the VAT in the next task force meeting scheduled for the coming month.

The first round of fiscal consolidation, in preparation for the second compact funding step-down in 1997, had noticeable adverse economic impacts. The country saw a sharp rise in migration to the US in the period immediately following the government’s implementation of its PRSP, which focused on retrenchment of government workers. That experience underscores to the authorities that any further fiscal consolidation in preparation for reduced compact assistance must be complemented by a more aggressive private sector development program. Against this background, the authorities are attaching more importance to pursuing private sector development.

To support private sector development, discussions on the allocation of annual compact sectoral grants has resulted in agreement to protect the infrastructure sector grant to a minimum of 30 percent of annual compact grants. To build on earlier progress to improve the investment environment, the authorities are now implementing an ADB-funded Private Sector Development (PSD) project/program loan. Under the on-going PSD project, progress has been made in improving the capacity and management of land administration offices in the state governments. Consistent with one of the policy conditions, the nation’s first bankruptcy law was passed by the FSM congress last month. Further work in strengthening the legal and regulatory framework is expected under the program. My authorities are committed to taking the measures needed to ensure the success of this programme. More generally, they welcome sustained engagement with development partners and agencies, such as the Fund where the real pressure points might be that hold back the development of a truly self-sustaining private sector in a small isolated multi-island economy.

Improving the pace of reform implementation

Staff described in some detail the loose federation of government in the FSM, which has been one of the key factors in slowing down the pace of reform implementation. Indeed, while some countries are struggling to enhance the participatory nature of their decision making process, in the FSM the highly participatory nature of decision making is complicating the authorities’ task of adjusting to the amended compact. Unfortunately, in the FSM there is no way around a time-consuming and resource-demanding process.

The reform process is now at a critical stage where agreement has been reached on the overall objectives. What is needed now is endorsement and implementation of specific measures (such as the VAT, further expenditure streamlining, and structural reforms) to effect the agreed objectives. To help political leaders sell the case for change, it is important that the authorities have available high level technical support, in their administration and from outside advisers. Consistently articulating the links between specific reform measures, such as the VAT and the longer-term objectives that the government has already agreed to, is vital to help move the reform and adjustment process forward. The government currently relies on technical assistance from the outside, including ADB and PFTAC advisors, to provide this critical support; and while extremely useful, occasional visits are not enough to meet demanding requirements of securing support for these important measures and seeing them through to implementation.

Against this background, interest has been expressed in staff’s offer of an interim visit, in the off-year of the biennial surveillance cycle. This is an important initiative by APD, and in FSM’s case, such a visit, focused on tax reform issues, could help to strengthen the President and his administration in building consensus for change.

Conclusion

As we noted at the outset, our authorities appreciated the contribution this Article IV round has made. Nonetheless, as we have pointed out previously, the effectiveness of Article IV missions can benefit greatly from more continuity in the composition of missions, especially when full staff reports are done only every two years. We would also encourage future Article IV missions to FSM dedicate more time to outreach. Outreach is especially needed in the context of the decentralized decision making-process that exists in FSM.

In a decentralized system, with limited technical capacity, and a history of generous aid support, the progress of reform and adjustment is always likely to be slower than suggested by some abstract ideal. But material progress has been made in adjusting to the changing environment, and moving towards greater self-reliance, and my authorities are committed to confronting the challenges ahead. They continue to appreciate the support of all of their international partners, bilateral and multilateral alike. They continue to value the bi-ennial Article IV consultations and reiterate their interest in an interim staff visit. They have also indicated their consent to the publication of the staff report.