Republic of the Marshall Islands; Staff Report for the 2011 Article IV Consultation

The economy of the Republic of the Marshall Islands has experienced a strong recovery with a 5.2 percent growth in 2010 following strong improvement in the fisheries sector and a moderate recovery in exports. The financial sector remained focused on consumer lending and contributed little to overall economic growth. Although the financial sector remained profitable, much of the rapid growth in credit has been in consumer loans. The authorities are monitoring high levels of household debt and intend to begin work on strengthening the regulatory framework.

Abstract

The economy of the Republic of the Marshall Islands has experienced a strong recovery with a 5.2 percent growth in 2010 following strong improvement in the fisheries sector and a moderate recovery in exports. The financial sector remained focused on consumer lending and contributed little to overall economic growth. Although the financial sector remained profitable, much of the rapid growth in credit has been in consumer loans. The authorities are monitoring high levels of household debt and intend to begin work on strengthening the regulatory framework.

INTRODUCTION

1. The Republic of the Marshall Islands (RMI) is a small island country in the north Pacific highly dependent on external aid, mainly from the United States. The renewal of the Compact of Free Association Agreement in 2004 has provided a stream of stable, but declining grants aimed primarily at education, health, and infrastructure sectors. After Compact grants expire in 2023, the RMI is expected to complement its domestic revenues with returns from its Compact Trust Fund (CTF), which receives annual savings from fiscal surpluses along with donor contributions.

2. Achieving fiscal and economic self-sufficiency remains a huge challenge and is exacerbated by the difficult political situation. Like other small Pacific Island countries, the RMI is vulnerable to external shocks given its geographical remoteness and structural impediments. Given the pressures on public finances from scheduled declines in Compact grants, growth prospects remain weak over the medium term, requiring decisive policy measures to put the economy on a sound footing. The outlook for key reforms, however, is clouded by the political uncertainties surrounding the general elections scheduled in late November.

3. Against this background, the Article IV discussions focused on policies to achieve long-term economic and fiscal sustainability. The key issue was how to strengthen fiscal management building on government efforts to implement tax reforms, cut current expenditures, and reform ailing SOEs. Staff also discussed policies to promote the private sector and strengthen the financial system.

RECENT ECONOMIC DEVELOPMENTS AND OUTLOOK

A. Recent Economic Development

4. Since the last Article IV consultation, the economy has recovered strongly. Following a severe recession in FY2008–09, the economy grew by 5.2 percent in FY2010, driven by an expansion of fishery output and exports, and moderating fuel prices. With growth concentrated in only a few sectors, rising unemployment and financial hardship, especially in outer islands (see chart), have driven migration to the urban atolls and the United States. Inflation stabilized in FY2010 following the temporary surge of food and fuel prices in FY2008–09.

5. Along with the economic recovery, the overall fiscal balance improved in FY2010, but mostly as a result of unspent earmarked appropriations. Only a modest surplus ($0.4 million) was recorded in the general fund for discretionary uses in FY2010. The overall surplus in FY2011 is estimated to be modest, with a 5.5 percent across-the-board cut of current expenditures and additional revenues from fishing fees partly offset by temporary tax exemptions on food and other basic consumables and increased subsidies and transfers to public enterprises to cover operating losses. Despite a potential upside of higher fisheries revenue, the fiscal outlook will continue to be hindered by weak financial positions in the SOEs and limited budget planning, unless reforms in these areas are accelerated. Over the medium term, fiscal balance is expected to be modest at about 1 percent of GDP.

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Population Migration

(In thousands of people)

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Source: Data provided by RMI authorities.

Selected Economic Indicators

article image
Sources: RMI Authorities and Fund staff estimates.

Including official current transfers.

6. The deterioration in the current account is expected to continue until FY2013 due to temporary factors. The widening of the current account deficit since FY2009 reflects increased imports under the Kwajalein land use agreements (LUA), 1 new investments in the fisheries sector and the airport extension project, which have been financed mainly through foreign direct investment and capital grants. Tourism receipts declined after the discontinuation of charter flight services, but this has had a limited impact on the external balance given its small share in services receipts. Once these temporary factors expire, the current account deficit beyond FY2013 is expected to decline to around 5 percent of GDP. Though external debt is relatively high at about $117 million (about two-thirds of GDP) as of end-FY2011, it is mainly on concessional terms and is expected to decline.

7. The recovery is likely to continue in the near term, but medium-term prospects are overshadowed by the scheduled declines in Compact grants. Growth in FY2011 is estimated at about 5 percent, driven by higher fish catches from the newly commissioned purse seiners (fishing boats), large inflows from the Kwajalein LUA, and the FAA-funded airport extension project. Over the medium term, staff expects growth to stay low at around 1½ percent with the growth in fisheries sector partly offset by the decline in Compact grants (about $½ million per annum before adjusting for inflation).

8. Pressures on domestic prices from rising commodity prices in early 2011 are likely to subside. Inflation increased following the significant rise in commodity prices in early 2011, but is projected to moderate gradually (Box 1). Domestic price movements over the medium term are projected to be broadly in line with those in the United States reflecting the close trading ties and the use of the U.S. dollar as the legal tender. However, prices are likely to remain highly volatile with fuel and food prices constituting nearly half of the CPI basket.

9. Risks to the outlook are on the downside. The economy could face stiff headwinds if the global slowdown proves severe and prolonged (Box 2). Overseas investments are also likely to suffer losses. The weak financial position of the SOEs (operating losses before government contributions among key SOEs were $7 million in FY2010) could erode public finances (Figure 2). Growth could further weaken under a protracted global slowdown if the planned foreign investments in fisheries were withheld due to higher uncertainty. On the upside, further investment in commercial fisheries could generate positive spillovers to the rest of the economy. The pending U.S. funded satellite project in Kwajalein might also create new jobs that offset lay-offs from the downsizing of the Kwajalein military base. Longer-term risks include continued outward migration and shore erosion on local atolls from climate change.

Figure 1.
Figure 1.

Marshall Islands: Regional Comparison of Recent Developments

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Sources: RMI authorities and Fund staff calculations.Note: RMI and FSM stand for the Republic of Marshall Islands and the Federated States of Micronesia, respectively. The top four charts are sorted by 2010 data.
Figure 2.
Figure 2.

Marshall Islands: Economic Developments and Outlook

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Sources: RMI authorities and Fund staff calculations.

Marshall Islands: The Impact of High Fuel and Food Prices

The RMI relies heavily on fuel and food imports and was not shielded from the surge in food and commodity prices. Similar to other Pacific Island countries, which rely heavily on fuel and food imports, the RMI’s share of fuel and food imports in merchandise imports are 27.4 percent and 30.5 percent, respectively, as of FY2010.

The RMI has almost full pass-through of food and fuel prices with a lag of about two months for fuel and 3-6 months for food. When commodity prices rose sharply in 2008, inflation soared to 14.7 percent. The price of rice, which is a main imported staple in the RMI and accounts for 13.5 percent of the CPI food basket, also rose significantly.

Domestic prices returned to trend in FY2009–10 as commodity prices subsided, but is estimated to rise in FY2011. In the first four months of 2011, oil prices increased by about 30 percent from the same period in 2010 before moderating in recent months, pushing up the projected year-on-year CPI increase in FY2011 to around 9.5 percent. The recent episode of high global fuel prices did not lead to a drastic increase in RMI’s domestic fuel prices as in 2008-09, likely due to tax exemptions on fuel in effect since 2008. Domestic fuel prices are, however, rigid downward due to the limited competition in the supply of fuels.

The high and immediate pass-through of commodity prices could worsen both fiscal and external positions. Higher commodity prices would likely raise the import bill and government spending on goods and services. A case in point was the transfer of $8 million from the government to the Marshalls Energy Company (MEC) in 2008 to ensure continued oil procurement in the midst of high world oil prices. This transfer alone constituted 5 percent of GDP. An increase in the oil prices by 30 percent from 2011 level would lower the growth in FY2012 by 1.4 percent (from 5.4 percent in baseline) and the current account balance would worsen.

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Index of World Oil Price and Marshall Islands Petrol Price US$/liter

(Jan 2004=100)

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Sources: RMI authorities and Fund staff estimates.
uA01fig04

Pass-Through of International Food Prices to Domestic Food Inflation

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Sources: WEO, RMI authorities, and Fund staff estimates.

Marshall Islands: Implications of the Global Slowdown and Financial Turmoil

Although the RMI has so far been weathered well the global financial turmoil, the economy is vulnerable to a protracted global slowdown and deepening financial crisis. In addition to the direct impact of declining asset prices on its sizeable investment overseas, the RMI is likely to be affected through the following channels:

  • Weaker exports and fiscal revenues. RMI’s exports represent around 23 percent of GDP, with the United States and East Asia—mainly China, Taiwan, Province of China, and Japan—as the largest export destinations. A sharp slowdown in advanced economies with spillovers to Asia would reduce demand for fish and copra exports. Lower fish prices would further erode export values and fiscal revenues from fishing fees. Export competitiveness could weaken if the global slowdown led to U.S. dollar appreciation as investors seek safer assets.

  • Uncertainty of foreign direct investment and official aid flows. Global slowdown could put existing foreign investment plans—particularly in fisheries—on hold as investors face higher uncertainty and tighter financing conditions. Although annual Compact grants are unlikely to change, other aid flows and concessional lending could come under pressure as donors face tighter budget constraints.

  • Insufficient trade finance. A global slowdown could curtail trade financing, raising the risk of a sharp fall in international trade as happened during 2008-09. Although importers do not rely heavily on trade credits, their overseas suppliers could be adversely affected by tighter credit conditions, forcing them to raise shipping cost or to reduce trade volumes.

  • Lower disposable income. Many migrant workers in lower-skills jobs in the United States may be at risk in a softening U.S. labor market, requiring more support from their families in the RMI. Returning workers could also put downward pressure on local wages.

  • Declining value of overseas investment. In addition to the Compact Trust Fund, the banking system and social security fund also have large overseas exposure through their foreign asset holdings, which make up nearly two-thirds of their assets. Much of this comprises of U.S. Treasuries, and U.S. and global equities. Banks’ concerns over potential losses could cut back their lending. Lower U.S. interest rates would generate capital gains on their bond holdings, but over the longer term could depress net interest margins.

Near-term growth prospects would worsen if the global slowdown and financial turmoil proves to be more severe and protracted. During FY2008–09, the economy underwent severe recession where growth fell to 3 percent below its potential and the CTF faced a cumulative investment loss of over 20 percent. A protracted global slowdown this time could also pose significant costs to the RMI. Overseas investments are estimated to have fallen by about 10 percent (based on the CTF’s asset allocation) since June. Growth could slow by a half to a range of 2–3 percent in FY2012, and could further weaken if the planned foreign investment in fisheries was held back due to uncertainty of global outlook.

The Authorities’ Views

10. Compared to staff’s projection, the authorities expected a higher growth due to the strong expansion of fisheries. On this basis, officials forecast near-term growth of 9.0 and 8.8 percent in FY2011 and FY2012, respectively, compared to staff’s projection of 5.2 percent on average. While sharing the authorities’ views that fishery expansion and construction activities have been key drivers of near-term growth, staff sees that the new investment will take time before reaching full operation while the inflows with the LUA has so far had smaller-than-expected positive spillover to the overall economy. The authorities agreed the growth prospects would be hindered by the scheduled declines in Compact grants over the medium term.

11. The authorities also emphasized upside risks to the staff projections. The downsizing of Kwajalein military base was smaller than initially expected (15 layoffs versus 100–120 anticipated), and learning from the previous experience in FY2008–09, the authorities considered themselves better prepared for a surge in food and fuel prices. For instance, electricity tariffs now have a built-in mechanism to reflect global oil price movements. While the authorities recognized the economy’s vulnerability to external shocks via trade and foreign investment channels in addition to direct overseas investment losses, they believed that the economy was more resilient this time given the ongoing fishery expansion and construction activities. They also have the policy option to extend some tax exemptions to mitigate the impact of a shock.

12. Officials also expected better fiscal performances for FY2011–12. A strong economic recovery would bring in more tax revenues through personal income tax and import duties, while the regional efforts to manage fish stock through the Parties to the Nauru Agreement (PNA) would bring in more fishing fees. Earlier efforts on expenditure control should also improve the fiscal outrun.

B. External Stability and Exchange Rate

Background and Staff’s Views

13. The risks to external stability appear to be limited. The current account deficits are expected to remain wide until FY2013, mainly related to investment in fisheries and airport extension project mainly financed through foreign direct investments and capital grants. Compact financial flows dominate external balances and will continue to provide a stable source of funding over the next decade. External debt is expected to decline, as debt repayments rise in the coming years. The use of the U.S. dollar as the domestic currency remains appropriate given the small size of the economy and its close financial linkages with the United States.

14. The RMI’s real exchange rate appears to be in line with the medium-term fundamentals of the economy. The real appreciation in FY2008–09 was largely reversed in the second half of 2009 as domestic prices stabilized. More fundamentally, exports have continued to expand, in contrast to some other Pacific Island countries. In the long run, the expiration of the Compact grants could, however, lead to an erosion of foreign assets undermining external stability unless the authorities undertake needed fiscal adjustments and structural reforms.

Authorities’ Views

15. The authorities agreed that the near-term risks to external stability were contained. They also indicated the use of the U.S. dollar remained appropriate and the Compact grants would continue to provide stable funding over the next decade. They noted that the fishery expansion seem to suggest the RMI’s competitiveness on key sectors had improved.

16. External debt is not a key concern at the moment. The authorities noted that, while external debt has slightly risen owing to the new program with the Asian Development Bank (AsDB), a large portion of debt was on concessionary terms with a relatively long grace period. Interest payments would rise in the coming years, but are likely to remain manageable.

POLICIES TO ACHIEVE SUSTAINABLE GROWTH

A. Fiscal Policy and Public Sector Modernization

Background

17. Under current policies, the build up in government assets in the Trust Fund is projected to fall short of replacing Compact grants expiring in FY2023. In particular, the global financial crisis, by reducing investment returns, has made it more difficult to achieve long-term budgetary self-reliance. The market value of the CTF stood at $142 million (82 percent of GDP) as of end-June 2011, but is likely to have declined since then following the deterioration in global equities markets (see chart). Under the assumption that all Compact grants would expire in FY2023, the projected income from the CTF would fall short of replacing these grants by as much as $15.4 million (about 8½ percent of GDP) in FY2023 (see Box 3). Even under a more optimistic assumption that non-Compact sector grants would be extended beyond FY2023, the shortfall—about $4.1 million—is still sizeable and warrants prompt action to ensure sustainability.2

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Compact Trust Fund: Cumulative Contributions and Investment Returns

(in millions of USD)

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Sources: RMI authorities and Fund staff estimates.1/ Numbers refer to fiscal year ending September 30. CTF balance for 2011 as of June 30, 2011.

Policy Issues and Staff’s Views

18. Steadily increasing fiscal surpluses to about 5 percent of GDP by FY2016 would help achieve long-term sustainability. This would involve gradually raising the fiscal surplus by about 1 percent per year for the next four years to 5 percent of GDP in FY2016, and then maintaining the surplus at that level until FY2023. The required fiscal adjustment could increase by 2.3 percentage points if both medium-term growth prospects and investment returns of the CTF worsened from the baseline by 1 percent. Staff reiterated the importance of starting implementing reforms early to create fiscal space and address possible setbacks. Staff supported the recent transfer of $1.1 million to the CTF during FY2011 and the plan to continue such transfers in the FY2012 budget. In view of the substantial adjustment required, higher-than-expected revenues from the fisheries sector should be saved and transferred to the CTF.3

19. Achieving the required fiscal adjustment will require targeted cuts in expenditures. The government has initiated cumulative across-the-board cuts of over 10 percent in current expenditures over the past two years. To avoid compromising quality public services, such as spending for the poor, a more targeted approach is needed.

Marshall Islands: Long-term Fiscal Sustainability

This box assesses the RMI’s long-term fiscal sustainability under the amended Compact agreement, updating the estimates in the 2009 Article IV Consultation Staff Report. The analysis considers implications for sustainability after the financial provisions under the amended Compact expire in FY2023. Fiscal sustainability is measured by the usable government’s asset position as of FY2023 that would generate an investment income large enough to supplement expiring Compact-related grants without significantly disrupting public services and eroding the Compact Trust Fund value. The analysis is based on a broader perspective than what the CTF was designed to specifically support.1

The assessment of the long-term fiscal outlook considers three scenarios. The baseline scenario features limited fiscal adjustment and structural reforms, while a policy action scenario takes into account comprehensive fiscal reforms, including swift implementation of tax reforms by FY2012, targeted expenditure cuts, and structural reforms to strengthen private sector development. Finally, under the downside risks scenario, we gauge the impact of possible adverse shocks on the required fiscal adjustment.

1) Baseline scenario

This scenario assumes that the government maintains a modest fiscal surplus of about 1 percent of GDP over the medium term, and GDP growth gradually declines to about 1½ percent over the medium term as foreign grants decline while private sector growth remains sluggish, and stays at that level after the financial provisions under the amended Compact expire.

Under the baseline scenario, the CTF’s income flows would not be sufficient to cover Compact grants in FY2024. The nominal rate of return in FY2010 was about 8 percent, slightly lower than the projected return of about 10 percent assumed in the 2009 Article IV report. This return is then set to decline to an historical average of 6 percent in the medium term. Compact related grants (net of fiscal surplus) are projected to reach $39.1 million in FY2023. Under the terms of the Compact Agreement and without additional grants, the CTF’s investment earnings are projected to be $35.5 million. However, in order to preserve the real value of the fund, the government would only be able to withdraw $23.7 million, leaving a gap of $15.4 million to fully replace expired grants after FY2024 (see text table). Therefore, in the baseline scenario, the government would either need to erode the real value of the CTF or face a large budgetary shortfall.

While higher returns could support the value of the fund, maintaining such high returns over a long period is not realistic. For example, the shortfall would be eliminated if the average rate of return reached 8.2 percent. However, higher returns would be possible with a more aggressive investment strategy, albeit at the cost of higher risks. In that regard, the baseline assumes a relatively conservative investment strategy with an average nominal rate of return of 6 percent.

2) Policy action scenario

This scenario continues to assume a nominal rate of return of 6 percent. With these assumptions, fiscal sustainability would be achieved with a fiscal surplus of around 5 percent in FY2016. The surplus stays at this level until FY2023 then declines to about 1.5 percent.

Long-term sustainability can be achieved through significant fiscal consolidation and structural reforms to boost private sector growth. In the policy action scenario, the government would gradually increase fiscal surplus (by about one percent of GDP each year) and channel the savings into the CTF. Over the medium term, the majority of the fiscal adjustment is financed by reductions in targeted current expenditures (about 3½ percent of GDP), while the comprehensive tax reform could bring in additional revenue of 1 percent of GDP through improved tax administration and tax-base broadening (see chart). In parallel, structural reforms would boost real growth to 2 percent in the long term. Together with the additional earnings resulting from higher balances, the fiscal surplus would eliminate the shortfall of $15.4 million in the baseline scenario (see text table). The required level of fiscal surplus (5 percent of GDP) is similar to that in the 2009 Article IV Consultation estimates.

With fiscal consolidation, the government will be able to rely on a constant revenue stream to finance its expenditures. In particular, under the policy action scenario, the government keeps the level of capital spending roughly constant throughout the projection period. Current expenditures are adjusted such that total revenues can both finance total expenditures and generate enough savings to build up the CTF. After FY2024, there is no need to save additional amounts to top up the CTF, with total revenues including interest income obtained from the CTF used only to finance current level of expenditures.

uA01fig06

Contributions of Required Fiscal Adjustments under Policy Action Scenario

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Sources: RMI authorities and Fund staff estimates

Required Fiscal Adjustments for Sustainability

article image
Source: Fund staff estimates.

3) Downside risks scenario

The required fiscal adjustment is sensitive to assumptions on medium-term growth and investment returns. If medium-term growth rate is 1 percentage point lower than the baseline projection and at the same time the assumed rate of return is lower by 1 percentage point until FY2023, the required fiscal surplus would be 7.3 percent of GDP instead of 5 percent of GDP under the baseline, higher by 2.3 percent of GDP.

Marshall Islands Compact Trust Fund (CTF) Scenarios

article image
Source: Fund staff calculations.

In the policy action scenario, the government would gradually increase fiscal surplus (by about one percent of GDP each year) over the medium term through tax reforms and targeted expenditure cuts. In parallel, structural reforms would be implemented to boost real growth.

Earnings withdrawn such that the real value of the Trust Fund remains the same.

Calculated as earnings available for withdrawal minus Compact grants in 2023 net of fiscal surplus.

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Marshall Islands: Long-Term Fiscal Adjustment Scenarios: FY2008-30 1/

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Source: Fund staff estimates1/ From FY2024 onward, interest income from the Trust Fund is considered as part of domestic revenue.
1 The analysis considers that the CTF needs to generate investment income to cover the Compact-sector grants, and the Supplemental Education Grant (SEG) without eroding the present value of the Trust Fund after FY2023.

Targeted cuts in areas proposed by the Comprehensive Adjustment Program (CAP) group could achieve a saving of $7–8 million over the medium term (see chart). These could include:

uA01fig08

Possible Savings from Expenditure Reforms

(in millions of USD)

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Sources: Comprehensive Adjustment Program (CAP) and staff estimates.
  • Containing public sector payroll. Although the annual average rise in public wages during FY2005–11 was modest at 1.4 percent, average public wages remain around 2½ times higher than comparable wages in the private sector, and a similar gap exists between wages in public enterprises and those in the private sector (see chart). Building on the efforts to identify over-staffing and excess pay, staff recommends limiting public sector payroll further by eliminating redundant vacant positions beginning in FY2012, which could save as much as $1 million. An AsDB consultant will undertake personnel audits beginning FY2012 and provide further assistances in containing the public payroll.

uA01fig09

Average Public and Private Sector Wage Gap

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Sources: RMI authorities and Fund staff estimates.1/ Public sector refers to RMI government and local government only.
  • Limiting subsidies to SOEs. Several SOEs continue to be a large and recurring drain on the budget, with transfers amounting to about $14.2 million per year (nearly 15 percent of the overall budget) on average over FY2007–10. These transfers take the form of pricing subsidies, capital contributions, and payments in kind. The largest recipients are the Marshalls Energy Company (MEC) and Air Marshall Islands (AMI). Staff advises against the proposal to extend a government subsidized loan of $1.5-$2 million to AMI for operating expenses and recommends limiting subsidies to the SOEs and accelerating the reform. The Cabinet has approved a set of good practice principles on SOEs to address governance framework (see Section B). A comprehensive recovery plan for the MEC was separately approved, and early resolution of payment arrears (nearly $9 million) is imperative to address recurring cash flow problems and widening operating losses, which pose significant fiscal risks.

  • Reducing allowances. As part of the expenditure cuts, the government should adopt the recommendations by the CAP committee to reduce allowances to public officials, in areas such as housing and electricity, thereby saving about $2 million.

20. Along with these expenditure cuts, swift legislative approval of revenue reforms is imperative to put public finances on a sustainable path. The government’s tax reform plan intends to rectify the drawbacks of existing tax regime (for example, discourage capital investment, regressive nature on personal income tax, and enforcement difficulties) by replacing the gross revenue tax and import duties with a net income tax and a consumption tax.4 While designed to be revenue-neutral, the tax reform could generate additional revenue and support a more pro-growth business environment by broadening the tax base and improving tax administration. The authorities should look to overcome remaining public concerns regarding the new tax rates, and to bring forward the legislative process as a full package, so as to start implementing the tax reform within FY2012. Systematic consultation and public outreach, including community-based forums, would help mobilize public support. Further efforts to strengthen the tax administration, particularly on identifying unaccounted import duties, would lead to a fairer tax system and bring in additional revenue. As domestic prices stabilize and the economy recovers, temporary tax exemptions effective since the recession in FY2008-09 would need to be wound down.

21. A sound public financial management would improve the efficiency of spending. In the face of scheduled declines in Compact grants, the authorities have begun to formulate a five-year rolling medium-term budgeting framework to better allocate public resources based on previous performance audit. To enhance the efficiency of spending, staff would recommend:

  • Accelerating efforts to enhance public financial management through completing a Public Expenditure and Financial Accountability (PEFA) 5 assessment and modernization of the Financial Management Act to streamline procurement procedures.

  • Integrating the medium-term budgeting framework into the annual budget and national development plans.

22. The capacity for performance audits needs to be strengthened. The government would benefit from enhancing the capacity of the Office of Auditor General in areas related to investigation and performance audits. In that regard, staff recommends granting the Auditor General the authority to prosecute public sector fraud through delegation by the Attorney General. Staff sees room for further increasing resources to the Office, possibly by utilizing the capacity-building grants under the amended Compact.

23. The social security system still faces a sizeable unfunded liability. The Marshall Islands Social Security Administration (MISSA) has partially recovered long-time arrears from local governments, but still faces rising benefit payouts in excess of contributions (about $1 million in FY2009 and $1.5 million in FY2010, see chart).6 The MISSA has liquidated trust fund assets to finance the shortfall since FY2010. To restore health to the pension system over the medium term, the authorities are considering a transition to a defined contribution scheme. As the transition would take time to be put in place, staff recommends taking interim measures to safeguard the value of the Social Security Fund, including through raising contribution rates, and reviewing the benefit structure. If contribution rate rose by 1 percentage point and benefit was reduced by 10 percent, it could save about $3½ million per year. Increasing the retirement age from 60 to 65 could further reduce benefit payouts by $3.0 million a year.

uA01fig10

Social Security--Shortfall between Benefits and Contributions

(in millions of U.S. dollars)

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Source: MISSA.

The Authorities’ Views

24. The government recognizes the need for fiscal adjustment and is aiming to achieve a fiscal surplus in FY2012. They note that progress has been made in building up the fiscal surpluses. For instance, they transferred $1.1 million during FY2011 to the CTF. The authorities are also targeting a further modest contribution to the CTF in FY2012 by implementing tax reform and intend to reduce allowances, which are part of the recommendations by the CAP and the Tax and Revenue Reform and Modernization Commission (TRRM). The market value of the CTF is likely to have declined in recent months, but the authorities have no plans to switch the investment strategies based on short-term market fluctuations.

25. While agreeing in principle to the need for expenditure cuts, the authorities expressed concerns over the broader social and economic impact of the reductions.

  • Public sector payroll. On public wages, the authorities noted that the large private-public wage gap was primarily driven by higher expatriate wages at the SOEs. The authorities also had frozen or reduced public wages over the past two years, leaving limited room for further cuts. Further payroll reductions could reduce household incomes without a social safety net, as the private sector is unlikely to absorb layoffs. Instead, the authorities preferred starting with eliminating vacant positions, enforcing mandatory retirement rules, and reducing gradually excessive allowances. Staff recognized these risks and supported a targeted gradual approach, but noted that those steps came at a cost by maintaining the large public-private wage gap and hindering private sector employment.

  • Subsidies to SOEs. The authorities indicated that pressures to support weak SOEs were mounting. The large spending cuts had weakened various public services, making it difficult to reduce further subsidies to SOEs. The government has been addressing the financial problems of SOEs through AsDB assistance. On the proposed support to AMI, the Cabinet preferred granting a low interest government loan to AMI for regular equipment maintenance, instead of leaving it to seek a more costly private loan requiring guarantees.

  • Reducing allowances. The government planned to propose a bill to reduce allowances to public officials, in areas such as housing and electricity, thereby gradually limiting the expenses by about $2 million.

26. On the revenue side, the authorities plan to gradually implement tax reform starting in late FY2012 after resolving issues over tax rates. While the authorities and the public in general favored tax reform, no agreement has been reached over the new tax rates that would be revenue neutral. Against this background, they intend to:

  • Put forward tax reform legislation in January 2012—the first Nitijela (Parliament) session after the general elections.

  • Recruit an external consultant with donor support to determine appropriate tax rates and ensure a smooth transition.

  • Implement tax reforms in stages starting in FY2012 and continue to strengthen tax administration.

27. The authorities were keen to improve public financial management. They have undertaken a self assessment of their public financial management system and have sought technical assistance in modernizing the Public Finance Management Act to further streamline the procurement procedures. The authorities noted that they had scaled up performance budgeting efforts, but have not yet fully integrated so far the five-year medium-term budget framework into the annual budget process.

28. The authorities welcomed staff recommendation on expanding the audit capacity. An additional $0.15 million was appropriated to the Office of the General Auditor in the FY2012 budget. This will enhance the capacity for conducting investigation and performance audits, as called for in the latest report by the Public Accounts Committee.

29. The authorities were considering converting the social security system to a defined contribution scheme. The Social Security Reform Commission expected the funding gap (about $1.5 million in FY2010) to widen without a change in policy. The Commission hired an actuarial advisor to consider options to safeguard the value of the social security fund. Among the options, the Commission favored a shift of the existing defined benefit scheme to a defined contribution scheme and capping certain benefits.

B. Private Sector Development and Structural Reforms

Policy Issues and Staff’s Views

30. A vibrant private sector is a prerequisite for sustainable economic growth and fiscal adjustments. Many private sector activities depend largely on government contracts and services provided by inefficient SOEs. To offset the declines in Compact grants, the government should look to provide an enabling environment for private sector growth. Key obstacles include limited access to commercial lending, difficulties in securing land uses, aging infrastructure, and the large gap between public and private sector wages.

31. Comprehensive reforms of SOEs are needed to raise their efficiency. The SOEs are economically significant with total assets of $116 million as of end-FY2008 (about 76 percent of GDP), but their financial performance has been lackluster. Many SOEs have social service obligations, which are often not clearly defined, further complicating resource planning and leading to weak management and underinvestment. In areas where SOEs provide purely commercial services, their operations should be divested or contracted out (for example, government ownership in Majuro Resorts, Inc. and AMI). The authorities are preparing a new SOE policy, which will form the basis for the forthcoming SOE Reform Act, but progress is slow (Box 4). Staff urges the authorities to take full ownership of the reform and swiftly approve the new policy.

32. Recent expansion of commercial fishery activities through foreign investment and regional agencies could help spur private sector development. Commercial fisheries, a key source of employment and growth in recent years, have increasingly diversified operations in harvesting, processing, transshipment, and exports. Taking advantage of this momentum, the government should strengthen the investment environment, including vessel support services, and retail and wholesale areas. In this context, the PNA, in which RMI participates, will contribute to long-term growth by fostering the sustainability of fishery activities through enforcing and exchanging fishing rights.

Marshall Islands: State-Owned Enterprises Reform under the AsDB Program

The RMI government entered into a Public Sector Program loan with the AsDB in September 2010. While the primary concern was to resolve the immediate financial difficulty in the Marshalls Energy Company, the program has been designed to support the government in its broader reform initiatives, including fiscal adjustment and SOE performance.1

The weak financial position among the SOEs call for immediate reform. The size of the SOEs in the economy is significant, with total assets of $116 million as of FY2008 (about 76 percent of GDP). Long-term financial performance has been poor with recurring operating losses every year during FY2002–08.2 The cumulative operating losses were $42 million (net of government subsidies and debt forgiveness) and public capital contributions totaled $39 million, adding to a substantial sum of $81 million (about 53 percent of GDP), about 1.7 times the average equity. The losses were so severe that the SOEs sector consumes its own equity every 4.3 years.

uA01fig11

Operating Losses among the SOEs

(Return on Assets; in percent)

Citation: IMF Staff Country Reports 2011, 339; 10.5089/9781463929244.002.A001

Source: RMI authorities.1/ Based on FY2010 audited financial statements. Operating losses shown here are before government and other contributions, and capital injection.

Recognizing the need to reform the SOEs, the government adopted a comprehensive recovery plan (CRP) for the energy company and six good practice principles. The CRP is tailored for the energy company to improve its operational and financial performance, placing it on a more sound commercial footing. The principles aim to strengthen the governance and monitoring framework for SOEs and address corporate planning and pricing issues. Specifically,

1. Concrete Business Plans. The government and the SOEs will jointly establish and publicly release the Statements of Corporate Business Plan and performance targets.

2. Essential Services. The SOEs will identify essential activities and all non-essential activities would be sold or wound down.

3. Boards of Directors. The government ensures qualified and experienced members would serve the Board of Directors in the SOEs and the directors have independence in operation.

4. Management. The government would ensure senior management have suitable qualifications and experience.

5. Cost and Pricing. The prices and charges would need to be aligned with the total cost of service, except where funded by subsidy from government.

6. Sound Financial Management. The SOEs would need to maintain sound and prudent financial management.

Based on these principles, an SOE policy has been drafted, which will serve as a basis for the new SOE Act. The implementation of these good practice principles is slow across the SOEs. The Cabinet has not approved the SOE policy yet, noting the new eligibility of Board directors is too restrictive.

The AsDB also provides technical assistance to selected SOEs as part of the reform. After consultations with stakeholders, three SOEs were selected for reform support in addition to the MEC.3 The AsDB provides technical assistance in developing medium-term reform plans to improve the viability and sustainability in terms of financial and operational performance. The implementation of the reforms plans over 2012 will be critical to improving the SOEs’ performance.

1 See AsDB report on ‘Proposed Program Cluster, Loan for Subprogram 1, and Technical Assistance Grant—Republic of the Marshall Islands: Public Sector Program’.2 AsDB research shows two largest SOEs—MEC and Marshall Islands Ports Authority—accounted for about 60 percent of total SOEs losses. Only the National Telecommunications Authority achieved a net positive income during the period.3 The SOEs under AsDB technical assistance include the Marshall Islands Shipping Corporation, the Tobolar Copra Processing Plant, and the Majuro Water and Sewer Company.

Authorities’ Views

33. The authorities, while noting the business environment remained challenging, planned to take advantage of ongoing recovery to foster growth. They agreed that many private activities had been dependent on public spending and unemployment remained high. Structural impediments on land uses were deep-rooted, which would take more than political will to rectify, though measures were in place to support long-term land lease. To take advantage of the ongoing recovery, the authorities welcomed recent private investment in niche tourism and were exploring possibilities in expanding the existing joint venture and intended to foster vessel support services. The RMI’s participation in the PNA would further strengthen commercial fishing activities.

34. The authorities indicated SOE reforms are underway with the assistance of AsDB. With respect to the new SOE policy, the Cabinet found the conditions regarding new eligibility of the Board directors to be too restrictive and required further review before endorsing the policy to be put into the SOE Reform Act. Divesting plans were initiated for Air Marshall Islands and the Majuro Resorts, Inc. but poor maintenance and lingering land issues have deterred investors.

C. Financial Sector

Background

35. The banking system in general remains liquid and profitable. The banking sector is primarily financed by deposits, with about two-thirds of deposits allocated for lending. Growth in commercial lending has been constrained by the lack of collateral, high interest rates, and limited investment opportunities. Financing conditions have somewhat tightened in FY2010 as interest rate margin widened, especially on commercial credits. Although banks profitability is reasonable with return on assets at about 5 percent and current nonperforming loans (NPLs) are low at less than 2 percent of outstanding loans, profits could decline if credit risks and NPLs were to rise in the event of a slowdown as many households are heavily indebted with short-term consumer loans. The publicly-owned Marshall Islands Development Bank (MIDB) is increasingly engaged in short-term consumer lending, moving away from its primary mandate of providing credit access for viable businesses. The MIDB also provides banks commercial credit guarantees at low fees.

Policy Issues and Staff’s Views

36. Strengthening the regulatory framework would contribute to stability in the financial sector. The Banking Commission currently has limited authority and autonomy to undertake appropriate bank supervision under the Banking Act as its actions could be appealed to and reverted by the Cabinet. Staff supports the Banking Commission’s efforts to revise the Banking Act to strengthen bank supervision in line with PFTAC assistance and to enhance the AML/CFT regime, particularly regarding the offshore company registration sector. Staff also supports broadening the Banking Commission’s oversight to include the MIDB and other nonbank financial institutions that engage in private lending activities.

37. Financial policies should aim to facilitate credit intermediation and support long-term growth. The lack of commercial credit has held back new start-ups and viable business opportunities. The act on secured transactions for moveable property has improved access to commercial credit at reduced cost. Refocusing the MIDB towards commercial and mortgage lending, rather than consumer loans, and further streamlining the land registration process would expand businesses’ access to much needed capital.

Authorities’ Views

38. The authorities recognize the heavy household indebtedness and intend to take measures to mitigate risks. Consumer lending represents about 77 percent of private sector credit and average household debt to income ratio is high at more than 80 percent. However, banks considered risk exposures to be manageable as they granted only short-term loans and required collaterals, personal guarantors, and allotment pledges. The authorities had earlier attempted to limit risk exposures through administrative directives, but these actions were later repealed on the grounds that the Banking Commission was not following the Banking Act.

39. The authorities agreed on the need to strengthen the regulatory framework. The Banking Commission had worked with PFTAC in revising the Banking Act to strengthen bank supervision and AML/CFT capacity. The revised Act would broaden Banking Commission’s oversight on institutions engaging in private lending activities. The authorities also noted the process would need closer consultations with banks and lending institutions in view of possible impacts on credit supply, particularly on housing loans.

40. Besides supporting growth, financial policies should also meet broader social objectives. The Development Bank saw itself as having a broader mandate of assisting individuals who otherwise would be turned away by commercial banks. The authorities viewed high interest rates and lack of commercial credit as partly reflecting high credit risks and limited investment opportunities. The potential fiscal risk arising from the credit guarantees on bank loans through the Development Bank was noted, but the authorities did not see a need to reduce the exposures or revise the pricing of such operations.

D. Other Issues

Staff and Authorities’ Views

41. The authorities and staff agreed that improving the coverage and timeliness of economic statistics would better guide policies. The Economic Policy, Planning and Statistics Office (EPPSO) has taken a number of steps to improve data collection. The authorities are going to publish the 2011 Census results in the coming months to guide policy planning in demographic and socio-economic developments.

STAFF APPRAISAL

42. Medium-term growth prospects in the RMI remain weak given the sluggish private sector and the scheduled decline in Compact grants. The recovery is likely to continue in the near term driven by expanding fisheries sector and ongoing construction activities, but risks are on the downside. Medium-term prospects are constrained by declines in Compact grants in the absence of substantial fiscal and structural reforms.

43. Risks to external stability appear to be contained. The RMI’s exchange rate appears to be in line with the medium-term fundamentals after the significant real appreciation in FY2008–09 was largely reversed following the stabilization of domestic prices. The use of the U.S. dollar as the domestic currency remains appropriate, given the small economy size and close ties with the United States in trade and finance.

44. Without significant adjustment, the fiscal situation is likely to worsen. The RMI has relied heavily on Compact grants to advance its economic development. While the fiscal situation has improved in recent years, the projected value of the CTF is unlikely to generate sufficient income to supplement the expiry of Compact grants in FY2023 without additional contributions. Meanwhile, measures to address the funding gap of the social security system should be taken urgently to ensure inter-generational fairness and to avoid further erosion of the Social Security Fund value. It would be important to start implementing reforms early to create fiscal space and address possible setbacks. Further delays in needed reforms would lead to more costly adjustments in the future.

45. Securing fiscal sustainability requires tangible progress in fiscal and structural reforms. Fiscal reforms should aim to swiftly implement the tax reform by bringing forward the legislature and resolving the pending uncertainties on new tax rates, and implement targeted expenditure cuts on public sector payroll, subsidies to SOEs, and excessive allowances. Structural reforms to develop an enabling environment for private sector and facilitate foreign direct investment would enhance long-term growth and generate higher revenue. In that regard, expediting the SOE reform with the assistance of AsDB is a key priority.

46. Strengthening the regulatory framework would contribute to stability in the financial sector. High household indebtedness and the absence of proper regulatory oversight on the Development Bank and other private lending institutions are major risks to the financial system. Efforts to further strengthen banking supervision by broadening the Banking Commission’s supervisory authority would be welcome steps. Financial policies should aim to facilitate credit intermediation and support long-term growth. The secured lending act would facilitate commercial lending, but further efforts on land registration are needed to facilitate the use of land for collateral.

47. The quality of official statistics, while adequate for surveillance, has room for improvement. Data availability has improved through efforts by the EPPSO, but the coverage and timeliness of statistics tend to constrain policy planning and evaluation. Continued staff training and capacity building would contribute to improving data quality.

48. It is recommended that the next Article IV consultation take place on a 24-month cycle.

Table 1.

Marshall Islands: Basic Data, FY2007–12 1/

article image
Sources: RMI authorities and Fund staff estimates.

Fiscal year ending September 30 unless otherwise stated.

The central government finance numbers do not not include the first tranche disbursement of $9.5 million in early FY2011 and a projected second tranche disbursement of the new ADB loan to the Marshalls Energy Company.

The payments by the government to MEC will be recorded as subsidy to public enterprises of $8.5 million and increase of gross borrowing of $9.5 million in FY2011. The second tranche of $5 million is expected to be in FY2013.

Official transfers include current transfers but exclude capital transfers and Trust Fund contributions.

Includes government and government-guaranteed debts.

Table 2.

Marshall Islands: Statement of Government Operations, FY2007–12 1/

article image
Sources: RMI authorities and Fund staff estimates.

The fiscal year ends on September 30.

Does not include Compact funds earmarked for Kwajalein rental payments and trust fund contributions.

For FY11-13, capital expenditure includes additional capital projects financed by U.S. grants for the airport road construction with a total of US$14 million.

Excluding Compact Trust Fund.

Central government debt to AsDB.

Table 3.

Marshall Islands: Balance of Payments, FY2007–16 1/

(In millions of U.S. dollars)

article image
Sources: RMI authorities and Fund staff estimates.

Fiscal year ending September 30.

The significant rise of imports between FY2010 and FY2013 reflects the purchase of new purse seiners mainly financed by foreign direct investment (FDI).

A Land Use Agreement was reached between the RMI government and Kwajalein landowners in May 2011, authorizing $32 million held in escrow to be disbursed from the U.S. government to the landowners. Most amount will eventually be transferred out from RMI as many landowners reside abroad.

Compact funding pertaining to the Kwajalein Atoll Trust Fund and Kwajalein resident and landowner compensation payments are classified as income rather than official transfers. Trust Fund contributions by the U.S. and Taiwan, Province of China, are regarded as capital transfers.

Official transfers include current transfers but excludes capital transfers and Trust Fund contributions.

Table 4.

Marshall Islands: External Vulnerability Indicators, FY2007–12

article image
Sources: RMI authorities and Fund staff estimates.

The large increase in deposits in 2007 reflects a government guaranteed loan to the Marshalls Energy Company (MEC). Data for 2011 are for the first 6 months only.

Data for 2011 are for the first 6 months only.

Defined as loans with arrears in excess of 90 days.

Table 5.

Marshall Islands: Medium-term Scenario, FY2007–16 1/

article image
Sources: RMI authorities and Fund staff estimates.

Fiscal year ending September 30.

The central government finance numbers do not not include the first tranche disbursement of $9.5 million in early FY2011 and a projected second tranche disbursement of the new AsDB loan to the Marshalls Energy Company.

Budget grants are official current transfers which exclude capital transfers and Trust Fund contributions.

Government and government-guaranteed debt only.

1

The LUA was reached between the RMI government and Kwajalein landowners in May 2011, under which the landowners would allow U.S. military operations in Kwajalein until 2066. The agreement also authorized the disbursement of about $32 million from the U.S. government to the landowners. Part of the inflow contributes to the economy through consumption and investment, while a majority is expected to flow out overseas in the form of deposits.

2

The non-Compact sector grants exclude the Supplemental Education Grant (SEG), which is about $6.2 million (before inflation adjustment) per year.

3

The contributions to the Compact Trust Fund (Accounts A and C) are not available for withdrawal prior to FY2023. A separate account (Account D) where the RMI and other donors could contribute to is available for withdrawal if it exceeds $10 million (currently stands at about $7 million), which could be used to mitigate adverse impact of potential shocks.

4

See Staff Report 2008 Article IV consultation—Selected Issues ‘Strengthening the Tax Regime in the Marshall Islands’, No. 08/186.

5

The Public Expenditure and Financial Accountability (PEFA) allows an objective assessment of a country’s public financial management in a standardized manner based on multiple indicators such as budget credibility, comprehensiveness, and transparency.

6

According to the latest actuarial report in 2009, the MISSA faced $163 million of unfunded liabilities (more than 100 percent of GDP) over the long term. Unfunded liabilities represent the projected difference between the net present value of accrued benefits and the available asset level for meeting them, including the net present value of the projected contributions. The amount varies with the assumptions on investment returns, and expected contributions and benefit payouts.

Republic of the Marshall Islands: Staff Report for the 2011 Article IV Consultation: Republic of the Marshall Islands: Staff Report for the 2011 Article IV Consultation
Author: International Monetary Fund
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    Population Migration

    (In thousands of people)

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    Marshall Islands: Regional Comparison of Recent Developments

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    Marshall Islands: Economic Developments and Outlook

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    Index of World Oil Price and Marshall Islands Petrol Price US$/liter

    (Jan 2004=100)

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    Pass-Through of International Food Prices to Domestic Food Inflation

    (In percent, year-on-year)

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    Compact Trust Fund: Cumulative Contributions and Investment Returns

    (in millions of USD)

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    Contributions of Required Fiscal Adjustments under Policy Action Scenario

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    Marshall Islands: Long-Term Fiscal Adjustment Scenarios: FY2008-30 1/

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    Possible Savings from Expenditure Reforms

    (in millions of USD)

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    Average Public and Private Sector Wage Gap

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    Social Security--Shortfall between Benefits and Contributions

    (in millions of U.S. dollars)

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    Operating Losses among the SOEs

    (Return on Assets; in percent)