Statement by Hi-Su Lee, Executive Director and Teea Tira, Advisor to the Executive Director

The key findings of the Republic of Palau’s 2010 Article IV Consultation shows that the single most important issue in Palau remains fiscal policy, including its effect on medium-term growth, as fiscal consolidation proceeds. The global financial crisis followed on the heels of a massive terms-of-trade shock, leading to a sharp curtailment of foreign direct investment and private credit. Tourism tumbled following an airline bankruptcy, and construction activity fell as major infrastructure projects reached completion.

Abstract

The key findings of the Republic of Palau’s 2010 Article IV Consultation shows that the single most important issue in Palau remains fiscal policy, including its effect on medium-term growth, as fiscal consolidation proceeds. The global financial crisis followed on the heels of a massive terms-of-trade shock, leading to a sharp curtailment of foreign direct investment and private credit. Tourism tumbled following an airline bankruptcy, and construction activity fell as major infrastructure projects reached completion.

Background

Our Palauan authorities thank the staff for their frank assessment of the developments in the economy and the constructive exchange of views during the Article IV consultation. The dialogue was greatly enhanced by the joint presence of the World Bank and ADB.

A decline in domestic activity following on the heels of the global crisis hit Palau’s economy hard, resulting in a cumulative economic contraction of 7 percent since 2008. A drop in foreign direct investment (FDI), completion of major infrastructure projects such as the compact road and a fall in tourism all contributed to the decline in economic growth. Sustainable growth in the medium and long-term will hinge on prudent fiscal policy, liberalization of the FDI regime as well as oil and gas exploration.

Compact Fund Agreement

The authorities appreciate the continued support from the international community, in particular from the U.S. Since the last Article IV consultation, negotiation of the compact grant funding has been the authorities’ topmost priority and they look forward to the finalization of the negotiation in the upcoming weeks. Conclusion of a favorable compact fund agreement will give them breathing space to concentrate further on the necessary fiscal adjustments.

Fiscal Policy

The current administration came into power in January 2009 facing a very weak economy, uncertainty surrounding compact grant funding, and major losses in the compact trust fund (CTF). It was a significant turning point for the authorities, strengthening their determination to avoid repetition of the situation they faced in FY 2008/2009 of contemplating too large an adjustment within a very short-time period. The authorities maintain the long standing desire, shared by most Palauans, to lessen their dependency on external assistance notably the compact grant fund and to pursue their underlying objective of self-sufficiency.

The authorities see merit in staff recommendation of a gradual fiscal adjustment, though they feel that the key issue in this context is the timing and implementation of the adjustment. As such, the authorities believe that a clear and credible medium-term strategy would be beneficial and are open to further technical assistance in this area.

Short-term measures

In the short-term, the authorities do not agree that an immediate reduction of 1 percent of GDP in expenditure is warranted, given the current weak economic environment. However, the authorities do see scope for a more measured mix of revenue and expenditure adjustments measures, weighted towards increasing tax revenues. As such, the authorities have submitted for Congressional approval measures to eliminate food import duty exemptions and a hike of the wage and salary tax for top earners. These measures are politically difficult, especially at a time when most Palauans are feeling the effects of higher commodity prices. Though inflation has been contained compared with previous years, the price of essential goods remains high compared to prior the global economic crisis. As a step towards reducing expenditure, the authorities have started with reducing the number of schools seeing the rationale to streamline government provided education services.

Medium to Long-term measures

In recognition that an adjustment will need to occur to close the gap between projected expenditure and revenue, the authorities will continue to explore ways and means of increasing revenue and containing expenditure. On the revenue side, they are working towards further expanding the tax base through refinement of the existing FDI regime and increasing tax measures on visitors/foreigners. Part of the tax measures have already been implemented through increasing departure tax on visitors and further consideration of environment-related taxes. In respect of the oil and gas exploration, the authorities concur with staff that, while it is too early to rely on potential oil revenues when deriving medium-term adjustment needs, these will need to be taken into consideration as the project progresses.

On the expenditure side, the authorities consider proper reallocation of resources across the public sector as a means of exercising greater restraint on current expenditure as well as addressing the issue of under-staffing in key areas. The authorities see value in expenditure rationalization as a means of reducing and enhancing further the quality of government expenditure. However, their limited capacity in respect of the required skills needed to carry out such an exercise without necessarily disrupting government key services is a constraining factor. They are open to assistance in this area.

Budget and Liquidity Issue

The authorities acknowledge that the liquidity issue is of critical importance in light of the fact that stocks of arrears brought forward from previous years are competing for the same pool of financing resources as government operations. Such arrears are due to domestic suppliers and are currently being settled from domestic revenue collected within the current period. The authorities have made efforts to ensure that the level of arrears remains stable, and agree with staff that it highlights the importance of further enhancing budget management processes. The authorities would like to clear the arrears through either:

  • possibly frontloading of the compact grant or,

  • restructuring the arrears - though this is relatively difficult given the arrears are from domestic suppliers who require immediate repayment in order to maintain their business activities or,

  • securing external assistance in the form of a loan to clear the arrears and allow for a more long-term and structured repayment schedule. The authorities are contemplating ADB assistance in this respect.

In all three options, the authorities will require a credible plan of action that supports domestic economic activity whilst at the same time preventing further accumulation of arrears. In this context the authorities view further enhancement of the budget management processes as critical with the potential assistance from the ADB to include revenue and spending plans that ensure sufficient room to make repayments on the restructured debt.

Structural Policy and Growth

Efforts have been made by the authorities in addressing the long standing issue of land tenure, an impediment to private sector growth common across most of the Pacific islands. A 2008 referendum approved the extension of land lease agreements for foreign investors to 99 years from the previous 49 along with the introduction of resident visa aimed at increasing certainty to foreign investment.

There is still a lot of work to be done in improving the business environment not just for foreign investors but also for the local investors. In respect of FDI, the legislature is expected to review several bills, all of which intend to streamline the existing regime replacing it with a rules based approach that is much less arbitrary and cumbersome. The authorities agree that further refinement of the FDI regime will be necessary and will take into consideration staff recommendation. Clarification of land issues such as ownership, zoning laws and land use will also need to progress along with labor and immigration issues.

In working on improving the business environment, the authorities see value in strengthening select productive sectors such as agriculture, tourism and fishing.

The tourism industry remains a lynchpin of economic growth but was impacted to a certain extent by the global economic crisis with various developments funded by foreign investors put on hold and tourism numbers declining. The authorities feel that, as the global economy picks up, such projects would resume as well as expansion of flight services and market sources will assist in boosting this sector. Nevertheless, the authorities will continue to market Palau towards a specific niche market particularly high-end tourism as a means of maintaining the balance between increasing growth in this sector and preserving their pristine environment.

Development of the fishing and agricultural sector form part of the authorities’ long-term objectives. In respect of the fishing sector, they aim to build on the outcomes of the regional collaboration, Parties to the Nauru Agreement (PNA), on managing the regional fish-stock as a means to capture a higher share of fishing profits. In respect of the agriculture sector, the authorities see value in cultivating and putting to good use idle land. They have noted what is happening in neighboring countries where local produce are substituting imported items and would like to explore further such options.

Exploration of Oil and Gas

The authorities concur with staff that a fiscal and legal framework is key to ensuring maximum returns to the nation as a whole from the potential oil and gas revenues. As such the authorities have a taskforce in place overseeing the oil and gas project. Membership is drawn from relevant stakeholders including the government (chair), the legislature and private sector. With relatively broad representation, the authorities feel that the proposed fiscal and legal framework will gain wide support and express appreciation for the technical assistance (TA) by the World Bank in this area.

Data and Staffing

The authorities acknowledge the need to strengthen the statistics, budget and planning office and advised that they are currently consulting with an overseas firm that will provide long-term TA for the statistics office. They see merit for a locally based consultant set up at key offices such as Statistics to not only build up the quality of the existing data but to also build up staff capacity so that in future years there is a readily available domestic pool of the required skills. They also request that they be given more time to review the GDP numbers before formally adopting them.

Anti-money Laundering

The AML/CFT legal framework was upgraded with the help of the Pacific Anti-Money Laundering Program. In addition, further resources have been put into the Financial Intelligence Unit with a strategic move to the Attorney General’s office as a means of maximizing use of limited resources. The authorities note staff concern but do not agree that setting up a ship and corporate registry would undermine the efforts underway on strengthening the anti-money laundering framework. They are currently reviewing what other countries within the region have accomplished in this respect and will build on their experiences in setting up a proper framework for a ship and corporate registry. They consider that revenue earned from such a venture can be utilized to build the required capacity and add to their efforts to strengthen oversight in all sectors.

Conclusion

Our Palauan authorities appreciate the recent Article IV consultation and interim staff visits. Bearing in mind the challenges that they face, they remain committed to undertaking the required policy and reform efforts necessary for long-term sustainable growth. They also intend to work closely with the Fund through its technical assistance programs.

Republic of Palau: 2010 Article IV Consultation: Staff Report; a Public Information Notice; and a Statement by the Executive Director of the Republic of Palau on the Executive Board Discussion.
Author: International Monetary Fund