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.
March 12, 2012
The authorities in the Republic of Palau would like to place on record their appreciation to the Fund staff for their constructive engagement which has led to an effective and productive 2012 Article IV Consultation. They found the discussions on various aspects of the Palau’s economy and the evolving outlook open-minded and useful. They concurred with the views expressed in the report as it correctly identifies the economic challenges and the way forward to address the challenges.
Economic Development and outlook
The economy has recovered strongly from the global crisis in 2008 and 2009, supported by an increase in tourist arrivals of 25 percent in FY 2011. As a result, real GDP growth is estimated to have reached 6 percent in FY 2011. The economy is expected to grow by 3 percent in 2012 and 2 percent over the next few years after that, driven by expansion in the tourism sector. The sharp rise in food and fuel prices has contributed to the acceleration in inflation to 3½ percent during the first half of this year.
Given the favorable increase in the number of tourists coming to Palau, the authorities have focused on development initiatives that would positively improve the tourism sector. New hotels are being constructed in order to accommodate increased tourist volumes. The authorities have also negotiated an increase in the number of scheduled flights to Palau in response to the demand. Tourism-related activities have also been increased and improved as well.
The authorities have also embarked on other developmental activities which include commercializing water and sewage services with the aim to achieve full cost recovery by 2016. The energy sector will also implement a new tariff structure that will reduce subsidies to middle- to high-income households and increase tariffs to full cost recovery level. The authorities will soon implement an increase in the ‘green fee’ (tied to visitor departure tax) as another initiative that would strengthen the fiscal position (see below). The upgrading of information technology systems is also part of the reform agenda.
While the outlook is positive for 2012 and favorable in the next few years thereafter, there are growing risks to the forecasts. Risks remain weighted to the downside if a severe downturn spreads to Asia, (the main tourist source for Palau). A sharp rise in food and fuel prices would also have a negative impact on the economy, since Palau heavily depends on imports. Furthermore, Palau’s requirement for ongoing fiscal austerity and the absence of monetary and exchange rate policies (the economy is dollarized), limit policy space to counter the risks.
In their efforts to strengthen economic development the authorities intend to develop a vibrant private sector. They have taken steps to create a business environment that would allow businesses, both foreign and domestic, to operate successfully through their regulatory improvement to the FDI regime and simplification of their regulations on both land-use and the labor market.
The authorities understand the importance of attracting foreign investment and labor, as well as creating a favorable business environment given the importance of the private sector in economic development. The ADB has identified some of obstacles for ‘doing business’ in Palau and through the steps mentioned above, hope to address these hindrances. They are of the view that private sector development is a key complement to the planned fiscal consolidation. They are also conscious of the need for a dynamic and competitive private sector to help spur self-sustaining long-term growth and continue to work on improving the business climate.
Fiscal Sustainability
As a result of five years of negative or near-zero GDP growth due to the downturn in tourism, the authorities face a considerable number of challenges on the fiscal front. Sizable adjustment is required in order to achieve long-term fiscal sustainability. Staff estimate that an average annual reduction in the current fiscal deficit (excluding grants) of 1½ percent of GDP through FY 2019 is warranted. In total a fiscal adjustment amounting to around 7½ percent of GDP (over the next 5 years) will be required. The authorities recognize the task that lies ahead but also try to balance the adjustment with the need for political support of the required reforms. These challenges are compounded by the expiration of Compact grants in FY2024 which have averaged 25 percent of GDP over the past decade.
Given the burden of adjustment, the authorities would need to embark on comprehensive revenue and expenditure reforms, which are essential to resolve long-standing fiscal imbalances. Another factor contributing to fiscal imbalances is that more than half of Palau’s domestic budget is spent on wages and salaries, which will become unsustainable as Compact assistance winds down.
The current economic recovery has allowed an opportunity for the authorities to begin the consolidation of the fiscal position. Immediate steps have been taken to strengthen revenue collection. They have continued to embark on several measures to implement structural, as well as revenue and expenditure reforms.
Structural reform involves energy sector reform and the current commercialization of water and sewage services. The authorities are in agreement with the staff that by implementing higher energy tariffs they will be able to achieve greater cost recovery. This could also lower Palau’s reliance on fuel imports and reduce external vulnerability. By 2016 water tariffs should also achieve the level of full cost recovery.
The revenue that would be generated from the ‘green fee’ initiative, as well as possible cuts in wages and subsidies, would also strengthen the fiscal position.
The authorities noted that comprehensive tax reform will strengthen their effort to re-build the fiscal position. However, they realize that the current tax system is inefficient and would need to be reformed. Given the importance of tax reform, the authorities have taken steps to propose an increase in the hotel room tax.
They further intend to improve tax administration, eliminate import duty exemptions, and move to cost, insurance, and freight evaluation for imports. Included with the tax reform as a measure of strengthening the fiscal position, the authorities also intend to replace the gross revenue tax with a corporate income tax and will consider moving from taxing imports to a value-added tax (VAT) as recommended by the Fund staff.
The authorities have taken steps to implement a medium-term budget framework (MTBF) given that this would entail a structured, comprehensive, and realistic approach that is consistent with a sound fiscal policy strategy. An added benefit from this approach would be enhancing budget credibility and governance. With the MTBF in place, the authorities hope to exert better control over budget execution (which is based upon cash availability, cash planning, and spending).
Financial Sector
The banking system remains profitable and well capitalized. The authorities are committed to ensure that the banking system is stable and safe for depositors. They have implemented prudential measures through the establishment of the Financial Institutional Commission (FIC). The FIC is mandated for the purposes of monitoring banking activities in accordance with the banking regulations. The FIC has been proactive in its mandate and has recently implemented its new off-site monitoring program.
The FIC continues to serve in its supervisory role and to safeguard the banking activities. While the FIC does not have the mandate to supervise the National Development Bank of Palau or other finance companies, the authorities intend to legally give this mandate to the FIC given that potential fiscal risks could arise without proper and independent supervision.
The authorities are committed to continue in their effort against money laundering and in combating the financing of terrorism (AML/CFT). They have established the Financial Intelligence Unit within the government with the mandate to oversee any criminal activities within the financial sector. Legislation has been introduced to further support and strengthen this work. The Financial Intelligence Unit has also strengthened its capacity to conduct AML/CFT examinations.
The presence of FDIC-insured US banks in Palau also provides a stabilizing influence on the financial system and helps mitigate risks.
Reform Agenda
The authorities have also initiated steps to reform government-owned utilities in order to reduce subsidies and improve services and revenue. The IT system is on schedule to be modernized as part of the reform agenda. The authorities are committed to continue with their ongoing reform program, including the restructuring of the public and private sectors.