Federated States of Micronesia: Selected Issues and Statistical Appendix

This Selected Issues paper examines the reasons for the poor initial performance of the Compact Trust Fund (CTF) of Micronesia and the issues related to the governance framework. The design and recent implementation of the CTF raise concerns that Micronesia will still face a difficult transition after U.S. aid ends in FY2023. The paper provides forecasts for the fund over the medium term. It also examines the business environment in Micronesia and identifies possible areas for improvement.

Abstract

This Selected Issues paper examines the reasons for the poor initial performance of the Compact Trust Fund (CTF) of Micronesia and the issues related to the governance framework. The design and recent implementation of the CTF raise concerns that Micronesia will still face a difficult transition after U.S. aid ends in FY2023. The paper provides forecasts for the fund over the medium term. It also examines the business environment in Micronesia and identifies possible areas for improvement.

II.Improving the Business Environment in Micronesia12

27. The private sector in the Federated States of Micronesia (FSM) faces significant challenges from its limited resources and geographical remoteness. Situated in the western Pacific, Micronesia consists of 607 islands spread across 1,800 miles. The small size of its economy, poor infrastructure, and high costs of energy and transportation are large impediments to business activity and investment, including from overseas. Compared to its neighbors, Micronesia is located farther away from the large eastern Asian countries, such as China and Japan, and lacks direct international flights to these markets. It relies almost entirely on oil imports for its energy needs and other than fish, exports very little.

28. The difficult business environment in terms of regulations and administration has also held back the growth of private sector. According to the World Bank’s Doing Business in 2007: How to Reform report,13 Micronesia ranks 106th in the world and last among Pacific island countries (PICs) in the ease in doing business. Partly as a result, private sector growth has languished. Using the World Bank data, this chapter examines the business environment in Micronesia and identifies possible areas for improvement.14 Improving the business climate is important as the public sector is expected to shrink with the expiry of the Compact, leaving the private sector as the key driver for growth and sustaining living standards.

A. Overview of the Private Sector

The role of the private sector has been limited to serving mainly the needs of the large public sector. External grants have contributed to a large public sector which at 40 percent of GDP dominate the economy. The private sector is geared mainly to meeting the demands of the government which employs nearly 55 percent of the labor force. The main sectors within the private economy include agriculture, fishing, services (wholesale and retail), transportation, and construction. Tourism, commercial fishing, and other export-related activity remain largely underdeveloped.

GDP and Employment by Sectors, 2001–05

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Source: Micronesian authorities.

Includes agriculture, fishing, mining, manufacturing, and construction.

Includes wholesale, retail, transport, storage and real estate services.

Includes government, health service, education and public financial sector.

30. Since 2001, private sector growth has stagnated. During 2001-05, private sector GDP grew by 0.9 percent on average, compared with 2.2 percent for the public sector. As a result, the private sector’s share in GDP fell to 29 percent in 2005, compared to 40 percent for the public sector. During this period, employment in manufacturing, construction, and tourism fell sharply, while in services, mainly retail, it expanded. Across the states, Yap experienced the fastest growth in private sector employment and output. The size and composition of the private sector also varies across the four states. Yap has the largest the private sector, in terms of the share in total output and employment, while Chuuk the smallest.

uA02fig01

Share of Private Sector in GDP and Employment by State

(In percent; average 2001–05)

Citation: IMF Staff Country Reports 2007, 105; 10.5089/9781451813807.002.A002

Source: Micronesian authorities.

B. Business Environment in the PIC Region

31. The results of the World Bank’s Doing Business in 2007: How to Reform survey of the business and regulatory environment revealed some common features across the PICs. In 2006, the overall ranking of PICs ranged from Fiji in 31st place to Micronesia at 106th. Across the ten business areas covered, the region as a whole scored fairly well in five areas—employing workers, dealing with license, paying taxes, business entry and trading across borders. In these areas, the PICs on average ranked above 50. However, they appeared less efficient in the remaining 5 areas, namely getting credit, enforcing contracts, closing a business, protecting investors, and registering property, where they ranked on average around 100. These low average rankings suggest some common weaknesses shared by this region. For example, rigid land tenure systems have been a long-standing feature of many PICs, while the poor access to financing (except for Fiji) may reflect the underdeveloped state of their financial systems.

Doing Business Economy Rankings for the PICs

(From 1–175 with 1st place being the best)

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Source: Doing Business in 2007: How to Reform (World Bank and IFC).

32. Notwithstanding the similar economic conditions, top performers in the region led the bottom performers by a large margin. The two top performers among the PICs were Fiji and Samoa ranking 31st and 41st in the world respectively. In contrast, the two economies at the bottom, the Marshall Islands and Micronesia, ranked 87th and 106th. A closer examination shows that Micronesia sharpened the contrast between the region and the rest of the world. For example, Micronesia ranked higher the PIC’s average in the five areas where the region was relatively more efficient, but ranked lower, by a large margin, in the areas where the region as a whole was weak. This also suggests that Micronesia has considerable room for improving its business environment in those areas where it lags behind its regional peers.

uA02fig02

PIC and Micronesia’s Ranking in Ten Business Areas

(From 1–175 with 1st place being the best)

Citation: IMF Staff Country Reports 2007, 105; 10.5089/9781451813807.002.A002

Source: Doing Business in 2007: How to Reform (World Bank and IFC).
uA02fig03

Pacific Islands: Growth vs. Business Climate

Average annual growth (2000-06) vs. World Bank Doing Business 2007 ranking

Citation: IMF Staff Country Reports 2007, 105; 10.5089/9781451813807.002.A002

33. There is evidence within the region suggesting a link between the business climate and private sector growth. A simple plot of average growth rates during 2000-06 and the World Bank’s Doing Business in 2007: How to Reform rankings show that PICs with lower costs of doing business featured faster average growth rates. With Micronesia ranking near the bottom among PICs in both the business environment and growth performance, improving the regulatory regime could yield significant economic benefits.

C. Difficult Business Conditions in Micronesia

34. Overall, Micronesia ranked 106th among the 175 participating countries and at the bottom among PICs in the ease of doing business. While Micronesia ranked high (in the 1st quartile) in the areas of employing workers, dealing with licenses, paying taxes, starting a business and trading across borders, it fared poorly in the areas of registering property, getting credit, protecting investors, enforcing contracts and closing a business. In these 5 areas, Micronesia ranked below 100 and in 4 of them, near the very bottom, which helped to drag down its overall ranking.

35. Micronesia’s weakest area was in registering property. In this category, the survey looked at the costs involved for a medium-sized business to register a fixed area of property (557.4 square meters) in a semi-urban location. Since this is not possible in Micronesia due to the restrictions on land transactions, it ranked near the bottom of the world in this category (172nd), in stark contrast to the average for the PICs and Palau, which was the top performer in this category. While land tenure represents a shared weakness with most other PICs, Palau was able to register such property in a relatively short period of time and at minimal cost, giving it a ranking of 13th in this category.

Registering Property

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Source: Doing Business in 2007: How to Reform (World Bank and IFC).

Top performer among the PICs.

36. The process for enforcing contracts is also much less efficient compared to the PICs average. Micronesia ranked 139th in enforcing contracts with the time and cost of enforcement significantly higher than the region. In particular, the period of judgment (365 days) and enforcement (400 days) were extremely long. Samoa, on the other hand, topped the PICs in this area (ranked 54th) with significantly shorter time and lower costs.

Enforcing Contracts

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Source: Doing Business in 2007: How to Reform (World Bank and IFC).

Top performer among the PICs.

37. Similarly, Micronesia took much longer and recovered much less in closing a business. It takes as long as 5¼ years, nearly twice the average for the region, to go through bankruptcy proceedings for a failed medium-sized business. At the end, the recovery rate is estimated to be only 3 cents on the dollar, compared to 21 cents for the region, giving Micronesia a ranking of 148th. Among the PICs, Vanuatu ranks the highest at 45th where closing a business takes half the time and recovers 13 times more than in Micronesia.

Closing a Business

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Source: Doing Business in 2007: How to Reform (World Bank and IFC).

Top performer among the PICs.

38. Like other PICs, the private sector in Micronesia suffers from poor access to credit. Except for Fiji which ranked at 21st, other PICs ranked low between 100th and 140th in terms of access to credit. Fiji’s strong performance appears be due to its legal framework and private credit registry system.15 In Micronesia and other PICs, the lack of credit information has hindered access to financing, particularly for unsecured loans, and may reflect the early development stage of their financial systems.

Getting Credit

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Source: Doing Business in 2007: How to Reform (World Bank and IFC).

Top performer among the PICs.

D. Recent Initiatives and Priorities for Further Reform

39. Although some recent initiatives will likely help the private sector, much more needs to be done to improve the business environment, particularly in the areas highlighted by the Doing Business in 2007: How to Reform report. The introduction of a new bankruptcy and secured transaction law are positive steps and will promote effective restructuring and new lending. Effective implementation and enforcement will be key for stimulating private business and building support for further reforms. At the same time, more work is needed to strengthen those weak areas highlighted by the Doing Business in 2007: How to Reform report. To summarize, the main priorities should be to: reduce the time and cost in closing a business, improve access to credit, strengthen the enforcement of contracts, and expand property registration. The fact that Micronesia significantly lags behind the rest of the region in these areas suggests that progress can be made with positive results.

40. For starting a business, states have taken steps to lower the regulatory requirements. In 2006, states eliminated the minimum capital requirement for starting a business (previously equivalent to ½ of per capita income) which resulted in an significant improvement in their Doing Business in 2007: How to Reform ranking from 82nd to 39th. In October 2006, the Pohnpei Registrar of Corporation announced plans to drop an article in the Corporation Law that linked the license fee to the number of shares in a business startup. This is estimated to reduce the cost of starting a business further from 136 percent of per capita income to 9 percent and would remove an important hurdle to starting a new business in Pohnpei.

Policy Intentions to Promote Private Sector Development

In the Third Economic Summit held in March 2004, Micronesia formulated a Strategic Development Plan outlining their reform agenda for the private sector. As part of the amended Compact, the plan envisaged a strong commitment to fiscal discipline and regulatory reform as a way of improving the business climate. The goal was to raise private investment from 7 percent of GDP in 2003 to 17 percent of GDP by 2023. Specifically, the strategy called for:

  • Limits on the size of government;

  • Making tax regime consistent with outward-oriented economic strategy;

  • Encouraging investment in priority and potentially competitive export growth industry;

  • Ensuring labor is wage competitive by reducing public/private sector wage differentials;

  • Increasing labor productivity and competitiveness;

  • Making land more readily available for sound development and as collateral for financing;

  • Developing a business-enabling regulatory environment; focusing support on competitive tradable goods and services

So far, implementation has been held back by the difficulties in coordinating policies across the states and national governments. The Economic Policy Implementation Council (EPIC), composed of national and state executive and legislative leaders, was established to push the reform policies and monitor their implementation. However, the EPIC lacks the legal authority to push states to enact the reforms. As a result, progress in the areas of tax, public sector, labor and land reform remains slow. Some progress, however, has been made at the micro level, such as in upgrading the secured transaction and bankruptcy legislations and easing some regulations for business.

Source: Federated States of Micronesia: Towards a Self-Sustainable Economy, Asian Development Bank.

41. It is too early to assess the impact of the new bankruptcy law on the efficiency of closing a business. The law, passed in 2006, represents a positive step towards establishing a process for orderly and equitable resolution of creditor claims against a debtor. Its impact on reducing the time and cost of bankruptcy and raising recovery rates for failed businesses has yet to be determined since as of October 2006, only one bankruptcy case had been filed under the new law.16 Further bankruptcy reforms should focus on increasing the recovery rate which is very low, even by regional standards (3.1 percent vs. the average of 27 percent for poor countries). Based on international experience (see below), further streamlining of court procedures and finding the appropriate balance between the rights of creditors and debtors would help improve the efficiency of bankruptcy and boost recovery rates.

Recent Reforms in Closing a Business in Selected Countries

Recent reforms in closing a business in other countries focused on reducing delays in bankruptcy, improving the regulation of administrators, and giving more power to the creditors. For example, Serbia in 2005–06 set strict time limits and strengthened accountability standard for bankruptcy administrators. As a result, the average time for bankruptcy fell from seven years to less than three, while the recovery rate for creditors increased by 45 percent. Greater supervision of administrators also helped to cut down on misconduct in the proceedings. Serbia also created a new agency to supervise administrators, established ethical standards for the profession, and required administrators to pass an examination.

Finding the right balance between the rights of creditors and debtors could boost recovery rates. In Slovakia, the old law gave creditors only a limited role in the bankruptcy process. Businesses often did not enter bankruptcy until it was too late, and when they did so, the process could take as long as five years. The new reforms allowed creditors to form a committee representing their interests and shortened the time limits which helped to speed up bankruptcy by at least 9 months. Recovery rates also increased by 5 percentage points, to 48 cents on the dollar.

Another recent trend is to limit appeals. In many countries unnecessary multiple appeals are a major source of delay. For example, in India an appeal on the initiation of enforcement proceedings could delay the process for up to a year, leading to a fall in recovery rates by as much as 15 cents on the dollar. Many countries are now exploring limiting appeals as a way of unblocking delays.

Source: Doing Business in 2007: How to Reform (World Bank and IFC).

42. The new Secured Transaction Act represents an important step in improving access to credit. The law, which took effect in October 2006, defines the legal rights and obligations of parties involved in borrowing against movable assets, such as equipment. It also created a web-based national registry for secured claims. These measures will help banks to expand their lending to groups who were previously denied credit because of the lack of fixed collateral. Further reforms could focus on expanding the national registry to include other credit information, such as on businesses and individuals, to help develop a credit reporting system like in other countries.

43. In improving contract enforcement, the priority should be to enhance the capacity of the courts. The efficiency of the courts in processing cases is limited by the lack of specialized judges and outdated case log management systems. For example, Chuuk, Pohnpei and the national government have only two judges each with a long backlog of cases that range from the criminal to the corporate. With the recently introduced bankruptcy and secured transaction law, there will be an even greater need to enhance the capacity of the courts to handle the additional case work. Reforms, such as the introduction of bailiffs with limited legal authority, the creation of specialized commercial courts, simplified rules for small cases, and firm time limits on enforcement, have helped in other countries to improve the efficiency in enforcing contracts and could be considered in Micronesia.

Recent Reforms in Enforcing Contracts in Selected Countries

The introduction of private bailiffs has help reduce delays in contract enforcement. For example, to speed up enforcement, Slovakia required that commercial cases be enforced by private bailiffs who were granted some legal authority. Bulgaria and Macedonia also introduced private bailiffs but have restricted their operations to certain locations.

Specialized commercial courts and commercial divisions in high courts have improved efficiency. Countries that have specialized courts or specialized commercial sections in general courts are estimated to resolve commercial disputes 40 percent faster than countries that do not. For example, Georgia established specialized commercial sections in the courts that helped to reduce caseload times by 45 percent in 2004.

Source: Doing Business in 2007: How to Reform (World Bank and IFC).

44. Land reform remains a difficult but important issue in Micronesia. Although some progress has been made to free up land for business investment, deeply rooted customs and traditions continue to hold back comprehensive reform of the land tenure system. Land tenure in Micronesia is based on communal ownership, and land sales are prohibited by the constitutions of the four states. As part of the ADB Private Sector Development Program, land reform has focused on legislating land lease arrangements. Under the ADB program, the four states have changed their laws to allow leases of over 50 years. In addition, land surveys, valuation and titling continue to expand, despite limited resources. In many cases, however, the registration process is delayed by frequent disputes on land ownership and boundaries. The ADB project in Chuuk, for example, aims to complete its first registration within 10–12 years (BGSI, 2006, Consultant Report). Liberalizing land sales is likely to remain a politically and culturally sensitive issue.

45. In the meantime, land reform efforts could focus on the efficient enforcement of land lease mortgage laws. These new laws will significantly improve the access to land for business development. The lease term of 50 years is broadly considered an acceptable length of time for implementing a business plan. At the same time, clear land titling valuation would help reduce uncertainty in securing land lease mortgage contracts. Based on experience elsewhere, digitizing titling certificate and allowing for online registration and streamlined procedures would also facilitate property registration.

E. Attracting More Foreign Investment

46. Compared to other PICs, Micronesia is more closed to external trade. The measured trade share of Micronesia (exports plus imports over GDP) is significantly below other PICs except for Samoa, Tonga, and Vanuatu. Although FDI data is not available, it is likely that foreign investment is also low. Despite the small presence, evidence does exists suggesting that foreign-owned businesses operating in Micronesia do contribute significantly to the economy. For example, according to the Foreign Investment Board of Pohnpei State, there are about 200 licensed foreign business entities operating in sectors such as service, merchandise trade, tourism, construction and fishery, with a combined gross turnover exceeding $10 million in 2003. These foreign businesses accounted for 6 percent of jobs in the state and contributed around 44 percent of the state tax revenue (2004 Investment Status Report).

uA02fig04

Trade Openness of PIC Economies

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 105; 10.5089/9781451813807.002.A002

Sources: World Development Indicators Database, World Bank.

Contribution of Foreign Business to Job Creation and Tax Revenue in Pohnpei

(as of end 2003)

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Source: 2004 Investment Status Report, Foreign Investment Board, Pohnpei.

47. Foreign investment is held back by the restrictive regime at the state level. Some problems include:

  • With foreign investment regulated at state level, licensing procedures lack uniformity. This makes the regime prohibitively cumbersome for potential foreign investors looking to start a business across all four states. This has in turn restricted the size and type of foreign investment that would come to Micronesia.

  • The conditions for approving foreign investment are strict. State regulations prohibit foreign investment in certain sectors and set minimum local or maximum foreign equity requirements, conditions for local employment, export requirements and other criteria. For example, Pohnpei prohibits foreign investment in the retail sector and allows up to 40 percent of foreign equity in mining, logging, and services (except professional and tourism). It also sets criteria regarding the extent to which a prospective foreign business will increase exports or decrease imports and gives preference to local workers. These measures in part reflect protectionist sentiment by local businesses who argue that only those business lines requiring capital and technology that are not available locally be open to foreign investors.

  • The wide discretion of the foreign investment boards in granting a foreign investment permit clouds the transparency of the approval system. The criteria for approving state foreign investment permits are not spelled out in clear terms. Whether a foreign applicant meets the criteria or not depends very much on the discretion of the foreign investment boards, whose members are selected mainly among the local business community (The Richard Caldwell Consultant Report).17

48. With donors’ assistance, some progress has been made in upgrading the foreign investment laws and regulations. In the late 1990s, the Foreign Investment Advisory Service, sponsored by the International Finance Corporation and the World Bank, conducted two reviews of the foreign investment regime and proposed a “spotlight” system with red, amber and green lists for foreign investments.18 In 2000, the ADB made reform of foreign investment laws and regulations by the five governments of Micronesia a condition for the second tranche of the private sector development loan. The objective was to streamline the application process and improve the consistency, transparency and fairness of the regulatory environment. By November 2005, the national, Kosrae and Yap governments had amended legislations to meet the condition, while Chuuk and Pohnpei had not.

49. Liberalizing further the foreign investment regime would help attract much needed capital and technology. Reforms such as moving to a “negative-list” system or “spotlight” for foreign investment would help to streamline the process and limit the risks of FIBs from being captured by narrow interests. Over the longer-term, centralizing the permit system across the four states so that foreign investors could do business in all of Micronesia with a single permit would help attract larger scale foreign investment.

F. Conclusion

50. Reforms to improve the business environment would help support private sector growth and development. Notwithstanding its difficult business environment, Micronesia faces a number of natural hurdles to developing further its private sector. However as demonstrated elsewhere and in the region, targeted reforms can significantly ease the cost of doing business and stimulate growth. Based on the Doing Business in 2007: How to Reform results, the priorities should be to strengthen the enforcement of contracts, expand land registration, reduce the time for closing a business, and improve access to credit. Expanding the capacity of the courts and streamlining procedures would strengthen contract enforcement and expedite bankruptcies. Building up a credit reporting system would improve access to financing for small businesses and households, while expanding land registration would facilitate the use of lease arrangements. At the same time, relaxing the restrictions on foreign investment would help attract much needed capital and technology. While challenging, evidence elsewhere, including in the region, shows that such reforms can help create a more vibrant and dynamic private sector and improve overall growth prospects.

References

  • BGSI, 2006, Consultant Report, Land Administration and Management Project in Micronesia, Asian Development Bank Technical Assistance Program.

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Table 1.

Federated States of Micronesia: Basic Data, FY2002–06 1/

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

Fiscal year ending September 30.

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.

Table 2.

Federated State of Micronesia: Gross Domestic Product, FY2001–06 1/

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

Fiscal year ending September 30.

Table 3.

Federated States of Micronesia: GDP by States, FY 1995–2006 1/

(In millions of U.S. dollars)

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

Fiscal year ending September 30. Real GDP estimates are at FY1998 prices.

Includes national government.

U.S. CPI is used through FY1999 and Micronesian CPI for FY2000 and onwards.

Table 4.

Federated States of Micronesia: Public and Private Sector Employment and Wages, FY 2001–06 1/

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

Fiscal year ending September 30.

Table 5.

Federated States of Micronesia: Consumer Price Index, 2000–06

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Source: Data provided by the Micronesian authorities.
Table 6.

Federated States of Micronesia: Pohnpei Consumer Price Index, 2000–06

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Source: Data provided by the Micronesian authorities.
Table 7.

Federated States of Micronesia: Chuuk Consumer Price Index, 2000–06

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Source: Data provided by the Micronesian authorities.
Table 8.

Federated States of Micronesia: Kosrae Consumer Price Index, 2000–06

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Source: Data provided by the Micronesian authorities.
Table 9.

Federated States of Micronesia: Yap Consumer Price Index, 2000–06

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Source: Data provided by the Micronesian authorities.