Republic of Palau
Staff Report for the 2012 Article IV Consultation
Author: International Monetary Fund
Publication Date:
14 Mar 2012
eISBN:
9781475502404
Language:
English
Keywords:
ISCR; CR; authority; authorities in the Republic of Palau; staff; fund staff; visitor arrival; pristine environment; gross revenue; economy of Palau; GDP relative; Currencies; Arrears
Download PDF (513 KB)

This 2012 Article IV Consultation reports that Palau’s growth is expected to be favorable at 3 percent in FY2012 and to average 2 percent over the medium term. The outlook is clouded by an unsettled global environment, and downside risks dominate. Highly dependent on tourism, imports of food and fuel, and foreign aid, Palau remains vulnerable to external headwinds and has limited policy space to counter these risks. The authorities have made commendable efforts to reduce the current fiscal deficit markedly during FY2010–11, but the deficit remains sizable.

Abstract

This 2012 Article IV Consultation reports that Palau’s growth is expected to be favorable at 3 percent in FY2012 and to average 2 percent over the medium term. The outlook is clouded by an unsettled global environment, and downside risks dominate. Highly dependent on tourism, imports of food and fuel, and foreign aid, Palau remains vulnerable to external headwinds and has limited policy space to counter these risks. The authorities have made commendable efforts to reduce the current fiscal deficit markedly during FY2010–11, but the deficit remains sizable.

INTRODUCTION

1. One of the smallest Pacific island countries, Palau depends on tourism and foreign aid for its livelihood (Figure 1). Annual tourism receipts amount to about 50 percent of GDP. Grants, in particular under the Compact Agreement with the United States, averaged 25 percent of GDP during the last decade. However, renewed Compact grant assistance is set to end in FY2024.1 Palau is on track to meet Millennium Development Goals (MDGs) by 2015. General elections are due in November 2012.

2. An overarching challenge for Palau is to achieve self-sufficiency when the renewed Compact grants wind down. Against this background, the 2012 Article IV discussions focused on policies to achieve fiscal sustainability, improve public financial management, strengthen the financial sector, and promote private sector development.

3. The authorities have been responsive to the Fund’s advice. During the past two fiscal years, they have tightened government spending and achieved fiscal adjustment in line with the Fund’s recommendation. They have also made efforts to strengthen the budget process and improve the business climate. The Financial Institutions Commission (FIC) has continued to build up its supervisory capacity and strengthen bank oversight.

RECENT ECONOMIC DEVELOPMENTS AND OUTLOOK

A. Recent Developments

4. The economy has recovered strongly from the 2008-09 downturn. Real GDP growth is estimated to have reached about 6 percent in FY2011 (Table 1). This was driven by a 25 percent increase in tourist arrivals, surpassing pre-crisis levels (Box 1). Annual inflation increased from 1½ percent during 2009-10 to 3½ percent in 2011, due to a sharp rise in food and fuel prices during the first half of the year.

5. The fiscal position has improved markedly, but the deficit remains sizable at 14 percent of GDP. Thanks to spending restraint and economic recovery, the current fiscal deficit (excluding grants) declined cumulatively by 3½ percent of GDP during the past two fiscal years (Table 2 and Figure 2.). Nevertheless, government cash reserves stood at only US$7 million (about one and a half months of government spending), while arrears amounted to about US$15 million (7 percent of GDP) at end-FY2011.

6. The rebound in tourist arrivals led to an improvement in the external position. The current account deficit (excluding grants) declined to 11 percent of GDP in FY2011, despite a rise in imports from higher commodity prices (Table 3 and Figure 3). FDI flows have remained subdued. The Compact Trust Fund balance has stabilized at around US$150 million, albeit still 15 percent below its pre-crisis peak.

B. Outlook and Risks

7. The recovery will likely continue in the near term, supported by new scheduled flights and hotel construction. The economy is projected to grow by 3 percent in FY2012 and average 2 percent over the next few years, with expansion in the tourism sector offsetting the expected fiscal consolidation (Table 4). Barring a spike in global commodity prices, inflation is expected to stay around 2 percent over the medium term.

8. Downside risks dominate and mainly stem from external factors. If a severe downturn spreads to Asia, the main tourist source region for Palau, the tourism sector could take a big hit (Box 1). This would have significant adverse effects on broader economic activity. An appreciation of the U.S. dollar amid heightened risk aversion could also reduce Palau’s external competitiveness and further affect the tourism sector. Although the renewed Compact grants are unlikely to be affected, other aid flows may be delayed as donors face tighter finances. Given Palau’s heavy dependence on imports, a sharp rise in food and fuel prices could depress domestic demand and weaken both the fiscal and external positions. Finally, while losses in Palau’s overseas investments, notably the Compact Trust Fund, would not have an immediate fiscal impact,2 larger fiscal adjustments may be required over time to achieve sustainability. Given the sizable fiscal deficit and the absence of monetary and exchange rate policies, Palau has very limited policy space to counter these risks. In a downside scenario, Palau may need to seek concessional external assistance.

Authorities’ Views

9. The authorities agreed with staff’s assessment of the economic prospects and risks. They were particularly concerned about the impact of higher fuel prices on Palau’s inflation and fiscal position. They concurred that Palau may have to seek concessional external assistance in the event of large negative shocks.

Palau’s Tourism Sector

Tourism contributes considerably to the economy of Palau, one of the world’s top diving destinations. Travel receipts amount to about 50 percent of GDP, more than twice the Pacific island average and among the highest in the world. Tourism is also a main source of growth in Palau, through employment generation and spillover to broader economic activity. A one percentage point increase in the growth rate of tourist arrivals is estimated to raise real GDP growth by 0.2 percentage points on average.

Visitors from Japan and Taiwan Province of China account for the bulk of tourist arrivals. In contrast, other Pacific island economies, such as Fiji and Vanuatu are dominated by tourists from Australia and New Zealand. During the last decade, visitors from Korea and Taiwan Province of China to Palau have risen sharply, while tourists from Japan remain an important source. Tourists from other Asian markets such as China have also grown rapidly during the last two years, albeit from a very low base.

Global economic and financial conditions have profound implications on tourist arrivals and growth in Palau. Palau’s visitor arrivals were hit hard during the recent downturn, suffering a cumulative decline of about 20 percent over the period FY2008-09. Tourist arrivals have since rebounded—reflecting the global recovery, more scheduled flights, strengthened marketing, and the U.S. dollar’s weakness relative to Asian currencies—and capacity constraints in the tourism sector are emerging. The literature on tourism suggests that tourist arrivals to small island countries are affected by economic developments in source countries, price considerations, external shocks, and supply factors, such as foreign direct investment and airlines services. Going forward, Palau’s tourism sector could benefit from further efforts to improve the business climate and attract more investment. Preserving Palau’s pristine environment will also go a long way toward ensuring sustainable development of the tourism sector.

A01ufig01

Travel Receipts for Tourism-Dependent States, Average 2001-2010

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Source: IMF, International Financial Statistics.
A01ufig02

Tourist Arrivals and GDP Growth

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Source: Palauan authorities.
A01ufig03

Tourists by Country of Residence

(In percent of total)

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Source: Palauan authorities.

POLICY DISCUSSIONS

A. Fiscal Policy

10. Palau needs sizable adjustment to achieve long-term fiscal sustainability. When the renewed Compact grants expire in FY2024, government expense will need to be financed mainly by domestic revenue and withdrawals from the Compact Trust Fund. To prevent a sharp correction in spending or a depletion of the Compact Trust Fund, an average annual reduction in the current fiscal deficit (excluding grants) of 1½ percent of GDP through FY2019 is warranted (Appendix I). This would lead to a sustainable deficit of 3 percent of GDP and almost double government net worth (largely the Compact Trust Fund) to 90 percent of GDP, which will provide a sustainable source of financing going forward.

11. Staff analysis of the draft FY2012 budget under deliberation suggests no adjustment. 3 The latest budget draft proposed to hike the hotel room tax from 10 to 12 percent (compared to the government’s initial proposal of 15 percent) and raise the environment protection fee (i.e., green fee), with implementation set toward the end of the fiscal year. While the draft kept nominal current expenditure (i.e., expense) broadly unchanged from last year, a likely supplemental budget could raise annual expenditure growth to about 5 percent. If no additional revenue measures are enacted, staff projects the current deficit to remain unchanged. Financing the deficit could considerably reduce the government’s cash reserves.

12. Staff recommended a reduction in the current deficit of 2 percent of GDP in FY2012 relative to FY2011. The reduction is necessary and feasible, given the positive near-term outlook and the need to boost government cash reserves. This would raise cash reserves or reduce arrears by about US$1 million. Revenue windfalls should be saved. In a downside scenario, there is only limited room to lower the size of adjustment, given the large deficit and the need for fiscal sustainability.

  • Ahead of concerted efforts on comprehensive tax reform (see below), staff supported the initial proposal to hike the hotel room tax from 10 to 15 percent, while allowing needed preparation time. Staff also encouraged quick implementation of the green fee increase. Additional measures should include raising water tariffs as scheduled and continuing to strengthen revenue administration (including upgrading the IT system), with assistance from the Pacific Financial Technical Assistance Centre (PFTAC). Altogether, these measures are estimated to lead to revenue gains of ½ percent of GDP relative to FY2011.

  • Staff advised capping expense at FY2011 levels, resulting in a reduction of 1½ percent of GDP. The reduction would require prioritizing spending among all government arms and agencies on the national budget, given the needed transfer of US$1.2 million to the Palau Public Utilities Corporation (PPUC) following a major fire. In light of a public wage bill out of line with peers, staff encouraged the authorities to reduce the number of temporary workers and continue to freeze hiring, enforce mandatory retirement, and allow only incremental salary increases.4 There is also scope to cut goods and services, particularly operational costs, and government transfers (excluding the one-off transfer to the PPUC), while protecting targeted social spending to low-income households.

13. Beyond FY2012, Palau needs to embark on comprehensive revenue and expenditure reforms. These reforms are essential for resolving long-standing fiscal imbalances and achieving the needed adjustment of 7½ percent of GDP over the next 5 years.

  • At only 14½ percent of GDP, Palau’s tax revenue is among the lowest in the Pacific. Staff advised the authorities to continue improving revenue administration, eliminate import duty exemptions, and move to cost, insurance, and freight (CIF) evaluation for imports. These measures could be implemented relatively quickly and yield gains of 2-3 percent of GDP.

  • Comprehensive tax reform is long overdue. The current inefficient system needs to be overhauled, replacing the gross revenue tax with a corporate income tax and moving from taxing imports to consumption, by introducing for example a value-added tax (VAT) of 10-15 percent. These measures could potentially raise revenue by 1-2 percent of GDP over the medium term. Consideration should be given to initiating efforts soon to build a national consensus on tax reform.

  • More than half of Palau’s domestic budget (including only the Compact budget assistance) is spent on wages and salaries, which is unsustainable as the Compact assistance winds down. Palau’s public wage bill also exceeds the average of non-Compact Pacific island countries by about 4 percent of GDP. Anecdotal evidence suggests that the average public sector wage is higher than that of workers with similar skills in the private sector. With assistance from development partners, civil service reform in a phased manner is needed to improve the efficiency and effectiveness of public services while reducing the wage bill. However, this process will need to be carefully planned and managed to minimize adverse social impact. With assistance from the Asian Development Bank (AsDB), commercializing water and sewage services as planned and outsourcing certain government functions are also vital for achieving a sustained reduction in expenditure.

Fiscal Reforms for FY2013-17

(In percent of GDP)

article image
Source: Fund staff estimates.

The increase in the hotel room tax and green fee in FY2012 is estimated to raise additional revenue of ½ percent of GDP in FY2013 due to a full-year effect.

14. Staff welcomed the government’s efforts to clear arrears in a transparent and prioritized manner. At end-FY2011, the bulk of government arrears (defined as accounts payable) were payments owed to other public entities, with arrears to private businesses at about US$2 million (1 percent of GDP). Staff welcomed the settlement of US$3.2 million arrears to the PPUC in early 2012 and supported the plan to use part of the AsDB loan to pay down arrears.5 Discussions have also been underway on how to use arrears clearance grants under the renewed Compact agreement. Staff stressed that improving the budget process is critical in preventing new arrears.

15. Weak budget planning and execution as well as the lack of fiscal space are at the root of long-standing arrears. The government has made revenue projections more realistic in budget proposals, but the projections are sometimes inflated during deliberation. Moreover, final approved budgets often do not take into account all obligations, such as grant co-payments and arrears clearance. Budget execution is based on appropriations rather than cash availability, resulting in the drawdown of cash reserves and/or the accumulation of arrears. The use of supplemental budgets to increase spending has also weakened budget credibility. Palau’s structural fiscal issue (low tax revenue and high wage bill) and the lack of consensus on how to resolve it place additional pressure on the budget process.

16. A medium-term budget framework (MTBF) and better cash management would help the budget process. Staff welcomed the authorities’ efforts to implement an MTBF in FY2013, with assistance from the AsDB. The MTBF would entail a more comprehensive and realistic approach consistent with a sound fiscal policy strategy, thereby enhancing budget credibility. To prioritize spending, the MTBF would need to involve all government arms and agencies on the national budget. Staff also emphasized the importance of cash planning and spending controls. A priority is to make budget execution contingent on cash availability. Establishment of a cash management committee could also help ensure transparent cash allocations based on spending priorities.

17. Staff welcomed ongoing efforts to reform government-owned utilities. With assistance from the AsDB, progress has been made in commercializing water and sewage services. Water tariffs should continue to be raised as scheduled so as to achieve cost recovery by FY2016. Electricity tariffs have been charged at below cost recovery levels, reducing incentives for energy conservation and contributing to maintenance shortfalls and the PPUC’s financial challenges. Staff encouraged timely implementation of the new tariff structure, which will reduce subsidies to middle to high-income households and increase tariffs to cost recovery levels.6 Doing so could also lower Palau’s reliance on fuel imports and reduce external vulnerability.

18. Palau’s Civil Service Pension Fund (CSPF) and Social Security Fund face large unfunded liabilities, last estimated at about US$130 million (60 percent of GDP). In particular, the CSPF has been running negative cash flows since 2000 and is expected to deplete its reserves within ten years. To put both plans back on a viable path, staff advised the authorities to seek technical assistance and adopt measures early on, including increasing employee contributions, raising the social security entitlement age, adjusting the benefit structure, and moving to a defined-contribution scheme.

19. An effective fiscal and legal framework centered on a petroleum fund is essential for managing potential oil and gas revenue. With assistance from the World Bank, the National Petroleum Revenue Management and Sharing Act and the Petroleum Act were recently passed. Given the large uncertainty associated with the timing and size of petroleum revenue, staff supported the authorities’ decision that it is too early to factor in such revenue when deriving fiscal adjustment needs.

Authorities’ Views

20. The authorities reiterated their commitment to achieving fiscal sustainability. They noted that it was important to get all stakeholders on board a comprehensive tax reform, which could take time. The authorities also acknowledged the need for public sector rationalization, but underscored its political difficulty.

21. The authorities pointed to improvements in the budget process in recent years. Revenue projections have become more realistic. The authorities were keen to implement a medium-term budget framework in FY2013. They noted that the substantial arrears built up over the last decade would require some years to clear. Incoming cash is used to pay down arrears to ensure continued service delivery, keeping cash reserves thin while generating new arrears. In their view, the US$10 million Compact assistance earmarked for arrears clearance is key to improving the budget process.

22. The authorities were mindful of the need to ensure the sustainability of the pension funds. They have been seriously considering converting the CSPF from a defined-benefit to a defined-contribution scheme. An actuarial study of the CSPF will be conducted soon, which will help them make an informed decision, including whether additional measures are warranted.

B. Financial Sector

23. The overall banking system remains sound. Banks are liquid and profitable, but provide limited credit to the private sector. The presence of FDIC-insured U.S. banks helps mitigate risks to the financial sector. Three U.S. bank branches hold about 90 percent of total assets and 95 percent of total deposits, and have a non-performing loan ratio of less than 1 percent. Palau’s domestic banks are relatively weak, with an average non-performing loan ratio of 40 percent. This largely reflects their operational weaknesses and business models of a small deposit base and more risky lending. Nevertheless, domestic banks maintain adequate provisions and do not pose a systemic risk to overall financial stability due to their small size (about 3 percent of total bank assets).7

24. Staff commended the FIC’s proactive approach to bank regulation and supervision. The well-funded FIC has strengthened its capacity to conduct on-site examinations. It also implemented a new off-site monitoring program and submitted Palau’s first annual banking report to Congress in 2010. Staff supported the FIC’s efforts to further strengthen capacity, particularly regarding the supervision of problem banks and conducting in-depth analysis. Domestic banks need to continue strengthening lending policies and writing off bad loans. As an independent and well-functioning FIC is crucial to sound supervision, the remaining vacancy on the FIC Board should be filled quickly with a qualified candidate.

25. Oversight of non-bank financial institutions needs to be strengthened. A priority is for the FIC to have the mandate to supervise the government-owned National Development Bank. Although the bank does not take deposits, its lending activities have implications for overall financial stability. It is the only residential mortgage lender and the largest commercial lender in Palau, with assets amounting to ¼ of total banking sector assets. Although currently small, potential fiscal risks could also arise from the bank’s loan guarantees. Regarding other non-banks such as finance companies, while anecdotal evidence suggests that these institutions are small, the lack of information and inadequate supervision do not allow proper assessment of their potential risks. Staff advised that these non-banks also be brought under the oversight of the FIC, the only institution in Palau with the ability to conduct financial supervision. The FIC will need to be equipped with adequate resources should its mandate be expanded to non-banks.

26. Staff welcomed continued efforts in anti-money laundering and combating the financing of terrorism (AML/CFT). An amendment to the AML legislation has been sent to the Office of President and takes on many of the recommendations contained in the 2008 AML/CFT assessment report. The Financial Intelligence Unit has also continued to build up its ability to conduct examinations. Staff encouraged the authorities to continue their efforts to align the AML/CFT regime with the 2008 recommendations and to ensure its effective implementation.

Authorities’ Views

27. The authorities saw merits in bringing non-bank financial institutions under the FIC’s oversight. They would like to study the cost and benefit before making a final decision. With continued capacity building and adequate resources, the FIC expected to be able to fulfill a mandate expanded to non-banks. There was some concern in Congress that too strict regulation and supervision may put local financial institutions at a disadvantage. The authorities agreed that an effective FIC is essential for sound supervision and would fill the remaining FIC Board vacancy soon.

C. Private Sector Development

28. Blessed with natural beauty and located close to fast-growing Asian markets, Palau has great potential to further develop a vibrant private sector. Palau lags behind many of its peers in the World Bank’s ease of doing business indicators. According to the AsDB, key obstacles include a restrictive FDI regime, foreign labor regulations that distort hiring practices, complex and opaque licensing arrangements, the lack of secured access to land, as well as inadequate access to bank credit. Foreign companies face minimum investment requirements and are subject to restrictions on the type of business activities. They are also required to pay higher foreign worker fee than domestic companies and to employ a minimum share of Palauan employees while domestic businesses are not. These distortions create incentives for front businesses (foreign companies with a Palauan as a front). Foreign workers have a lower minimum wage than Palauans, likely contributing to higher unemployment among Palauans. Regarding land, obtaining leases can be a long and burdensome process for foreign investors and titles can be contested. Finally, due to high credit risks and limited domestic investment opportunities, banks place most of their assets abroad and provide limited credit to the private sector.

29. Staff discussed a range of measures to promote private sector-led growth in the face of needed fiscal adjustment. The type of business activities could be managed through licensing arrangements rather than the source of capital (foreign or domestic). On labor regulations, consideration needs to be given to unifying the minimum wage for foreign and domestic labor, applying the same foreign worker fee for foreign and domestic employers, and controlling foreign worker inflows through the foreign worker fee instead of quotas. Staff advised the authorities to establish a one-stop arrangement for state and national investment licensing requirements. There is also a need to make land leases precedent over a change in title to provide greater legal security for investors. Staff welcomed the authorities’ efforts to strengthen the legal framework for movable collateral and encouraged timely passage of the secured transaction legislation, which will help improve access to bank credit.

A01ufig04

Ease of Doing Business Index, 2012 1/

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Source: World Bank, Doing Business.1/ Lower number indicates higher ranking.

Authorities’ Views

30. The authorities also viewed private sector development as a key complement to fiscal consolidation. They agreed in principle with many of staff’s recommendations and pointed to recent progress in making Palau more business friendly, including regulatory improvement to the FDI regime and simplification of the approval process by individual government agencies. The authorities noted the difficulty in building a national consensus on land and labor reforms. They underscored the importance of preserving Palau’s cultural and social identity while attracting foreign investment and labor. The government supported the secured transaction legislation and anticipated its passage through Congress soon.

D. External Stability

31. Using the U.S. dollar as Palau’s legal tender remains appropriate. Palau is a small economy that maintains close financial and trade linkages with the United States. Moreover, Palau has very limited capacity to conduct its own monetary and exchange rate policy. The U.S. dollar has provided an important nominal anchor.

32. The economy has maintained external competitiveness and stability. Palau’s real effective exchange rate is in line with long-term average. During the last decade, tourist arrivals to Palau grew by 7 percent per year, compared to an average of 2½ percent in other Pacific island countries. Furthermore, the renewed Compact assistance is expected to continue providing a relatively stable source of funding over the medium term, while fiscal adjustments will improve the current account balance (excluding grants). A decline in grants could also improve the balance to some extent by reducing imports.

33. Continued fiscal consolidation is crucial for sustaining external stability. Risks to external stability are limited in the near term, given Palau’s external debt of about 35 percent of GDP and large financial assets. Over the longer term, insufficient fiscal adjustment in the context of declining grants could lead to an eventual depletion of the Compact Trust Fund and/or an unsustainable buildup in external debt. In addition, high export concentration in tourism and reliance on imports of food and fuel render Palau vulnerable to external shocks.

Authorities’ Views

34. The authorities shared staff’s assessment. They noted that Palau’s external competitiveness cannot be taken for granted, as Palau faces strong competition from other tourism-based economies in the Pacific. They were mindful of the importance of fiscal prudence in maintaining external stability.

A01ufig05

PICs: Current Account Balance in 2010

(Excl. grants; percent of GDP)

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Sources: Country authorities; and Fund staff estimates.

E. Statistics

35. There is an urgent need to improve the coverage, timeliness and quality of statistics. Palau’s statistical capacity has deteriorated in recent years due to severe understaffing and inadequate capacity building. Data need to be used with caution and have serious shortcomings that hamper surveillance and policy formulation. Staff welcomed the authorities’ commitment to producing quality and timely statistics as well as the work program laid out in a draft Statistics Master Plan for 2012-17. The Office of Planning and Statistics (OPS) should be adequately staffed and funded. Capacity building should also be strengthened, particularly in the areas of economics statistics and macroeconomic analysis and framework.

Authorities’ Views

36. The authorities reiterated their commitment to improving statistics. They were hopeful that, with the recent return of two capable staff members to the OPS, essential statistics can be produced more timely and with better quality. They indicated that continued technical assistance from development partners and PFTAC is key to capacity building.

STAFF APPRAISAL

37. The outlook remains positive, but downside risks dominate. The economy has emerged strongly from the 2008-09 downturn, led by record tourist arrivals. Expansion in the tourism sector is expected to continue supporting the economy. Nevertheless, in the context of a slowing global economy, Palau faces strong external headwinds due to its heavy reliance on tourism, imports of food and fuel, and foreign aid. Policy space to counter these risks is limited.

38. Palau’s current economic upturn presents an opportunity to rebuild fiscal buffers. The authorities’ efforts to reduce the current fiscal deficit markedly in recent years are commendable. A further reduction of 2 percent of GDP in FY2012 is advisable, given the positive near-term outlook and the need to boost cash reserves. In a downside scenario, there is only limited room to reduce the size of adjustment.

39. Achieving fiscal sustainability calls for comprehensive reforms. An average annual reduction in the current fiscal deficit of 1½ percent of GDP through FY2019 is needed. The adjustment would require an overhaul of the current inefficient tax system, replacing the gross revenue tax with a corporate income tax and moving from the import tax to a consumption tax, as well as sizable reductions in wage bill and subsidies. Measures to address the large unfunded liabilities of the CSPF and the Social Security Fund are also needed.

40. The authorities’ efforts to improve the budget process and clear arrears are welcome. Implementing a medium-term budget framework in FY2013 would make the budget more comprehensive and improve its credibility. Execution needs to be contingent on cash availability and a cash management committee could be established to help ensure transparent allocation of cash resources.

41. Oversight of non-bank financial institutions needs to be enhanced. The banking system remains sound. The FIC has made commendable progress in strengthening banking regulation and supervision. To safeguard financial stability, non-bank financial institutions, including the National Development Bank, should be brought under the FIC’s oversight. The FIC will need to be equipped with adequate resources should its mandate be expanded.

42. By unlocking higher growth, private sector development serves as a key complement to the needed fiscal consolidation. Further efforts to create a level playing field for domestic and foreign investors and to make land leases more secure are advisable. Staff encourages the authorities to establish a one-stop arrangement for investment licensing and adopt the Secured Transaction Act. Consideration also needs to be given to labor reforms that help improve employment opportunities and skills development for Palauans.

43. The U.S. dollar remains the appropriate legal tender for Palau. The economy has maintained external competitiveness, but is vulnerable to shocks. Continued fiscal consolidation is key to sustaining external stability.

44. Data shortcomings hamper surveillance and policy formulation. The deterioration in Palau’s statistical capacity needs to be addressed quickly. The authorities’ commitment to improving statistics is welcome.

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

Figure 1.
Figure 1.

Palau: Recent Developments

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Sources: Country authorities; and Fund staff estimates.
Figure 2.
Figure 2.

Palau: Fiscal Sector Developments

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Sources: Country authorities; and Fund staff estimates.1/ On fiscal year basis for Palau, Marshall Islands, Micronesia, and Tonga.
Figure 3.
Figure 3.

Palau: External Sector Developments

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Sources: Palauan authorities; World Tourism Organization; and Fund staff estimates.
Table 1.

Palau: Selected Economic Indicators, 2006/07-2011/12 1/

article image
Sources: Palauan authorities; and Fund staff estimates and projections.

Fiscal year ending September 30.

Staff proposals.

PFTAC estimates.

Defined as Revenue less Grants and Expense.

As of end-year.

As of end-year. Includes loan disbursements of $9.8 million from AsDB in FY2012.

Table 2.

Palau: Statement of Government Operations, FY2007-12 1/

article image
Sources: Palauan authorities; and Fund staff estimates and projections.

Fiscal year ending September 30.

Based on the conference budget draft. Includes transfer and arrears clearance to PPUC, as well as a possible supplemental budget of $4 million.

Staff proposals.

Defined as Revenue less Grants and Expense.

Defined as Revenue less Expenditure.

Includes annual withdrawals of $5 million from the Compact Trust Fund.

Table 3.

Palau: Balance of Payments, 2006/07-2011/12 1/

(In millions of U.S. dollars, unless otherwise indicated)

article image
Sources: Palau authorities; PFTAC estimates; and Fund staff estimates and projections.

Fiscal year ending September 30.

Table 4.

Palau: Medium-term Projections, 2009/10-2016/17 1/

(In percent of GDP, unless otherwise indicated)

article image
Sources: Palauan authorities; and Fund staff estimates and projections.

Fiscal Year ending September 30.

Staff proposals.

Assumes on-lending of $6 million to the Palau Water & Sewer Corporation (PWSC) in FY2013.

Defined as Revenue less Grants and Expense.

Defined as Revenue less Expenditure.

APPENDIX I: PALAU—LONG-TERM FISCAL SUSTAINABILITY

This appendix assesses Palau’s long-term fiscal sustainability, updating the estimates from the 2010 Article IV consultation. The results suggest that annual fiscal consolidation1½ of percent of GDP on average through FY2019 is needed to achieve sustainability over the long run.

A. Framework and Assumptions

Fiscal sustainability is defined in a way where government fiscal operations satisfy the intertemporal budget constraint. This is expressed in the following equation:

W + G + R = C + K,

where the government’s net worth (W) and the net present values of grants (G) and domestic revenue (R) are balanced against the net present values of current spending (C) and capital spending (K). The current balance (R-C) is set as the policy variable to satisfy the above equation, consistent with the authorities’ policy goals.1

Long-term macroeconomic and fiscal assumptions are in line with historical data. The nominal rate of return on the Compact Trust Fund (6 percent) serves as the discount factor to calculate net present values (NPV).

  • Macroeconomic assumptions:

    • article image
      Real GDP growth rate: 2 percent

    • article image
      Inflation: 2 percent

    • article image
      Real rate of return on the Compact Trust Fund: 4 percent

  • Fiscal assumptions:

    • article image
      U.S. Compact current grants: US$160 million over FY2010-24.

    • article image
      Other U.S. grants: 6 percent of GDP

    • article image
      Other country grants: 4 percent of GDP

    • article image
      Capital spending: 9 percent of GDP

A key exogenous variable is the government’s initial net worth (W). The net worth comprises the outstanding Compact Trust Fund and government cash deposits, less the government’s arrears and external debt. As of end-FY2011, government net worth was estimated at 54 percent of GDP, with the Compact Trust Fund, deposits, external debt and arrears at 67, 3, 9 and 7 percent of GDP, respectively.

B. Findings

Baseline Scenario

Two cases are considered in the baseline scenario:

Immediate adjustment. Assuming that the necessary fiscal adjustment is carried out entirely in the following fiscal year, the current balance will need to fall sharply from -14 percent of GDP in FY2011 to -3½ percent in FY2012. This calls for a deficit reduction of 10½ percentage points in a single year, highlighting the challenge to achieving fiscal sustainability. The government’s net worth would eventually reach 120 percent of GDP, twice as high as the current level.

Gradual adjustment. The 2010 Article IV consultation examined a ten-year period over FY2010-19 to gradually implement fiscal adjustments. Taking into account the fiscal consolidation already realized in FY2010-11, an adjustment of 1.4 percent of GDP per year is needed over the remaining eight years to ensure fiscal sustainability. This is similar to the findings of the 2010 Article IV consultation, as the impact of the lower growth assumption is offset by the lower real rate of return. The total adjustment is 11 percent of GDP during FY2012-19, slightly larger than an immediate adjustment (10½ percent of GDP in one year). Government net worth would rise to 90 percent of GDP over time.

Figure 1.
Figure 1.

Sustainable Current Balance, FY2011-FY2030

(percent of GDP)

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Sources: Palauan authorities and Fund staff estimates

Sensitivity Analysis. The above results are fairly robust to different parameter assumptions. The tables below illustrate the required adjustments per year under the gradual adjustment assumption with various combinations of parameter values. Variations in real growth, inflation and the real rate of return have a relatively minor impact on the needed adjustment. Lower valuations of the government’s initial net worth increase the needed annual fiscal consolidation.

Scenario with Broad Coverage of Public Debt The scope of public debt is broadened in this scenario to include public enterprise debt and maintenance backlog, estimated at US$44 million and US$80 million, respectively, at end-FY2011. As a result, government net worth falls to -2 percent of GDP.

Immediate adjustment. In FY2012, the current balance would need to improve to -2½ percent of GDP, from -14 percent in FY2011. The needed adjustment is slightly larger than in the baseline, reflecting lower initial net worth. The government’s net worth would rise to 70 percent of GDP over time.

Gradual adjustment. To achieve fiscal sustainability by FY2019, fiscal adjustment of 1½ percent of GDP per year through FY2019 is required. Cumulatively, the adjustment is 12½ percent of GDP over eight years, larger than an immediate adjustment.

The government’s net worth would gradually rise to 30 percent of GDP.

Scenario with Oil-Related Revenue This scenario incorporates potential oil-related revenue of US$650 million in NPV terms, based on World Bank estimates. The revenue is assumed to come on stream in FY2013.

Immediate adjustment. Large fiscal adjustments are needed even with substantially more favorable revenue projections than the baseline scenario. In FY2012, the current (non-oil) balance would still need to improve by 5½ percentage points to -8½ percent of GDP, although the size of adjustment is much smaller. The government’s net worth climbs to 450 percent of GDP over the medium term.

Gradual adjustment. To achieve fiscal sustainability by FY2019, fiscal consolidation of ½ percentage points of GDP per year is required. The government’s net worth would rise to 400 percent of GDP.

Figure 2.
Figure 2.

Sustainable Current Balance, FY2011-FY2030

(percent of GDP)

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Sources: Palauan authorities and Fund staff estimates
Figure 3.
Figure 3.

Government Net Worth, FY2011-FY2030

(percent of GDP)

Citation: IMF Staff Country Reports 2012, 054; 10.5089/9781475502404.002.A001

Sources: Palauan authorities and Fund staff estimates

Sensitivity Analysis Under Gradual Adjustment

(In percent of GDP, unless otherwise indicated)

article image
Source: Fund staff calculations
1

The renewed agreement for FY2010-24 is pending U.S. Congressional approval.

2

Budget withdrawals from the Compact Trust Fund are specified under the Compact Agreement and have been US$5 million annually. The Fund is invested in U.S. equities (65 percent) and bonds (35 percent).

3

The FY2012 conference budget draft was adopted by the Senate, but not the House of Delegates. An open-ended continuing resolution has been put in place.

4

Salary increments are legally required and average about 2 percent annually.

5

The loan of US$16 million is for commercializing water and sewage services. Budget support amounts to US$6 million. Disbursement of US$9.8 million was received in early 2012.

6

Inflationary and social impacts are expected to be limited, as the bulk of adjustment comes from a reduction in the threshold for subsidized household tariffs. Electricity tariffs for businesses and low-income households will increase only slightly, while water and sewer tariffs for low-income households are not expected to have much impact on their monthly expenditure.

7

One domestic bank voluntarily ceased deposit-taking activity and transitioned into a finance company in late 2011. Due to limited business activity, the only uninsured foreign bank branch also notified the FIC of its decision to cease operations in Palau in 2012. Both banks are monitored and inspected by the FIC throughout the closure process. The number of banks in Palau will be reduced to 5, including 3 FDIC-insured U.S. bank branches and 2 domestic banks.

1

Details of this framework can be found in the Selected Issues Paper for the 2008 Article IV consultation (IMF Country Report No. 08/162). Domestic revenue refers to revenue less grants; current spending to expense; and capital spending to the net acquisition of non-financial assets.

Same Series

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Cover IMF Staff Country Reports
Republic of Palau: Staff Report for the 2012 Article IV Consultation
Author: International Monetary Fund
Volume/Issue:
Volume 2012: Issue 054
Publisher:
International Monetary Fund
ISBN:
9781475502404
ISSN:
1934-7685
Pages:
37
DOI:
https://doi.org/10.5089/9781475502404.002

Travel Receipts for Tourism-Dependent States, Average 2001-2010

(In percent of GDP)

Tourist Arrivals and GDP Growth

Tourists by Country of Residence

(In percent of total)

Ease of Doing Business Index, 2012 1/

PICs: Current Account Balance in 2010

(Excl. grants; percent of GDP)

Palau: Recent Developments

Palau: Fiscal Sector Developments

Palau: External Sector Developments

Sustainable Current Balance, FY2011-FY2030

(percent of GDP)

Sustainable Current Balance, FY2011-FY2030

(percent of GDP)

Government Net Worth, FY2011-FY2030

(percent of GDP)