Abstract
The economy has recovered following the stabilization of commodity and food prices. The Article IV discussions focused on policies to secure a sustained recovery and achieve long-term economic and fiscal sustainability. The recovery will likely remain weak, and the consolidated fiscal surplus is expected to decline in the near term. Long-term sustainability could be achieved through increasing the fiscal surplus. The reliability, coverage, and timeliness of economic statistics need to be improved to guide policies. The global crisis has increased the urgency of major fiscal and structural reforms.
Background
Our Micronesian authorities appreciate staff’s frank assessment of the developments in the economy and the constructive exchange of views that characterized these consultations. The consultations provided a timely stock take, prior to the March 2011 elections, of the progress made in recent years, and the remaining challenges to preserve macroeconomic stability and ensure long-term growth.
Micronesia is a small Pacific island country that has a total population of 110, 218 (2006) living on a land area of 700 square kilometers, and scattered across 2.9 million square kilometers of Exclusive Economic Zone (EEZ). The federation consists of four autonomous states guaranteed by its constitution. This autonomy presents complex and diverse challenges for the Federated States of Micronesia.
As noted by staff, Micronesia’s recent recovery has been underpinned by the gradual implementation of delayed infrastructure projects. Sustainable growth in the medium to long-term will hinge on improving the implementation of Compact grants, adjusting fiscal policy over the medium-term to the reduction in these grants, and fostering a larger role for the private sector in the economy.
Compact Fund
The authorities appreciate the continued support from the international community, in particular from the United States through the Compact Fund. However, the mismatch in the capacities that exist in a small island country, like Micronesia, and the administrative requirements of development partners, is a major challenge. To overcome this challenge, our authorities are determined to work with development partners to improve the timely utilization of the Compact Fund and further private sector investments.
Macroeconomic Stability
Fiscal Policy
The authorities had made significant progress in restoring medium term fiscal balance, following an average deficit of 5.9 percent of GDP over FY2004-FY2008. This was achieved through the implementation of stringent measures across states, despite social and political risks.
Appendix 1 clearly sets out the size of the fiscal challenge involved to ensure that the current level of public service can be maintained in 2024. With the inability of the Compact Trust Fund (CTF) to supplement expiring Compact-related grants, the authorities acknowledge the necessity of early containment of current expenditures and fiscal reforms in order to attain the required level of fiscal surplus. The authorities also agree with the medium-term target, but the implications of the forthcoming election, and the challenge of coordination across states, mean that the path of adjustment will likely be slower.
Nevertheless, my authorities recognize that early containment of current expenditures, in particular public wages, is essential to attaining the required fiscal surplus. For example, notwithstanding the social and political costs, the Chuuk jurisdiction has pursued significant workforce downsizing and reduced working hours for non-Compact related employees, aimed at reducing current expenditures and restoring fiscal balance. But our authorities consider a more targeted approach, rather than across-the-board reductions, to be desirable, given the wide diversity of the fiscal situation confronting the individual states, and the spending pressures associated with the Presidential elections. Such an approach will help ensure priority spending on healthcare, education, and infrastructures are safeguarded. Legislation passed in 2010 has reduced the unfunded liabilities on the social security system and the authorities’ continuous monitoring will ensure affordability. The authorities also consider the collection of the consolidated fiscal data a pre-requisite for the development of the multi-year fiscal plan.
Tax Reforms
The staff report correctly highlights the central importance comprehensive tax reform legislation to create a Unified Revenue Authority (URA) and introduce a net profits tax and value added tax (VAT). Passage of these bills will necessarily have to await the election and the formation of a new government. In the meantime, the authorities will pursue the enhancement of the current operations of the state and national tax offices and broaden personnel training, in anticipation of the broader tax reform. This will be supported by sustained utilization of technical assistance from PFTAC and other development partners, incorporating wherever possible the lessons from the experiences of comparable Pacific island countries that have already undertaken such reforms. Complimenting these efforts, and critical to the success of the reforms, will be a more targeted public awareness program regarding the reforms. In many ways, the Article IV consultation was a watershed moment for officials at all levels of government to understand the value and thinking behind the tax reforms bills. Equally, with the authorities conducting state summits, followed by a national economic summit, economic opportunities and challenges will be fully aired, providing a broader context for issues of tax reform and fiscal sustainability. Technical assistances from the Pacific Forum Secretariat (PFS) and other development partners such as the Secretariat of the Pacific Community (SPC) may be requested, to ensure focused discussions.
External Stability
Despite the low level of debt to GDP and its concessional nature, the authorities are aware of the fiscal and exchange rate risks posed by foreign denominated loans. Given this, the authorities are committed to closely monitoring the pressures from foreign loans and the scheduled decrements of Compact grants, on external stability.
Financial Sector
The banking system is highly liquid, with limited lending to the private sector. Nevertheless, the authorities will ensure that the Banking Board is adequately resourced and it’s regulatory and supervision capacity is strengthened. The ambit of the Banking Board’s powers will be expanded to include the development bank and non-deposit taking financial institutions under its regulatory and supervision functions, consistent with international best practice. Continuous use of PFTAC technical assistance will be critical in training new staff and strengthening the Board’s capacity for on-sight monitoring of liquidity policies, compliance with AML laws and loan-loss provisions. The newly created Insurance Board will also benefit from technical assistance from the Fund and other agencies, to enhance its supervisory capacity and strengthen foreign corporation auditing.
Private Sector Development
Although the private sector has been stagnant and has contributed little to growth, it is hoped that the recent completion of key infrastructure projects such as the extension of the Pohnpei airport, the expanded fiber-optic network, and the relocation of a US Marine base to Guam, will support private sector development.
The authorities also see merit in reviewing restrictions imposed by Foreign Investment Acts, at both levels of Government, regarding the ownership and renting of land to harmonize and provide greater clarity on land tenure practices across the states, while respecting local investors’ legitimate interests. As always in the Pacific, this is a delicate issue. The lessons learnt from the Pohnpei FDI legislation will assist greatly in refining FDI legislation across FSM. The authorities also recognize the importance of a sustained public consultation strategy on these matters, to ensure broad awareness and acceptance of the need to reform.
The authorities concur with staff that limited availability of skilled labor holds back FDI. They agree that strengthening education and vocational training is critical and note that this is a long term issue that requires more targeted efforts. In this vein, our authorities are working closely with the Asian Development Bank to redesign vocational and education training to ensure effectiveness. Moreover, the authorities believe that the creation of better working conditions, and greater consistency across states, will assist in retaining skilled labor, especially with the forthcoming job opportunities in Guam. These developments will be discussed further at the national summit. In the short run, the authorities believe that relaxing legal restrictions on hiring expatriates may assist, but only if the expatriates’ roles are well-defined and targeted, appropriate counterparts are identified and follow-up mechanisms are put in place for knowledge transfer. The authorities will solicit technical assistance to assist in these development efforts.
Adequate Infrastructure
The strengthening of project management and the capacity to meet procurement requirements for access to external resources remains a medium to long term goal. The authorities will utilize technical assistance from development partners to accelerate the implementation of projects, especially in the context of planned Compact decrements. While utilizing technical assistance, the authorities will ensure that knowledge and skills are transferred to local counterparts, to ensure its sustainability. These efforts will assist greatly with the needed improvements in the power, transportation and communications sectors
Economic Statistics
The improvement of the reliability, coverage, and timeliness of economic statistics is critical for policy discussion. The authorities will collect consolidated fiscal data across national and state governments on a timely manner, with technical assistances from PFTAC and SPC. Also, with remittances playing an important role in the Micronesia, the authorities will request the Fund, PFTAC and other development partners for technical assistance.
The authorities continue to value the Fund’s assessment of its policies and will welcome a staff visit later this year.