The Federated States of Micronesia (FSM) is highly dependent on external aid. Following a recession in FY2006–08, the FSM economy has grown by 2–2½ percent for FY2010 and FY2011. The economy remains dependent on the large public sector, although the fisheries and agriculture sectors have shown signs of growth. Despite some deterioration in current account balance, external balance also has sustained a stable flow of official transfers. However, economic growth is likely to slow in the near term owing to a decline in public sector demand.
Federated States of Micronesia (FSM) authorities thank staff for the constructive policy dialogue and useful advice that was provided during the 2012 Article IV Consultation.
FSM is a small Pacific island country with a population of approximately 112,000 people and consisting of four island states, namely Yap, Chuck, Pohnpei and Kosrae, located across the Western Pacific Ocean.1 As a small island nation, the country has relied heavily on the US grants accounting for about a third of its GDP. The Compact grant, however, is on the decline and scheduled to end in 2023. The reduction in the Compact assistance presents the biggest challenge for the future outlook. Given FSM’s high dependency on public sector and the difficulties of the private sector to offset a decline in public sector demand from the scheduled reductions in Compact grant, achieving long-term self reliance of budget is becoming an urgent matter.
Despite the stepped up efforts in recent years, a number of challenges remain with more to be accomplished. The authorities broadly agree with staff recommendations on the way forward and reaffirmed their commitment to working with the Fund and development partners, in order to facilitate economic growth and reduce its dependency on external aid support beyond 2023.
Economic Developments and Outlook
Economic activities have been slow, with 2012 growth being forecast to drop to 1.4 per cent from 2.1 per cent in FY2011. Despite a pick up in the fisheries and agriculture sectors, the near-term outlook seems cloudy given the declining public sector demand due to Compact grant reduction. Inflationary pressure has been alleviated, but would remain volatile, being subject to fluctuations in the international commodities prices.
The consolidated government balance continued to record modest surplus at around 1 per cent of GDP. The results were uneven across the four states with two states recording deficits equivalent to 1 per cent of state GDP. Public debt remains relatively low at below 30 per cent of GDP, which can be compared against the Compact Trust Fund (CTF) assets amounting to 83 per cent of GDP. However, the insufficiency of the CTF assets to support budget self reliance beyond 2023 and aggravating social security balances will be putting increasing pressure on the budget over the longer term.
On the financial sector, commercial banks - the main financial players in the system - are well capitalized with sufficient liquidity. The level of non-performing loan is low but lending opportunities within the domestic market remain limited with foreign banks placing most of their funds and investments offshore.
Medium-term Challenge and Fiscal Policy Response
Over the longer term, the reduction in the compact grants disbursement, decreasing population due to continued outward migration and weak private sector growth will pose grave challenges on growth outlook and the public finance.
The FSM authorities agree with the staff recommendations on the strategy to reduce the revenue gap in line with the decline in the annual Compact grant support. They agree with the need to make significant fiscal adjustments over the medium term, as suggested by staff, while the pace of adjustments will be determined based on detailed assessments. In this context, the authorities set up the 2023 Planning Committee under the leadership of President Mori, whose task is to come up with a realistic action plan to address the looming budgetary shortfalls beyond 2023. They agree with the staff recommendation on the need for the government to quickly strengthen the capacity of the Committee by approving its budget.
Headway has been made in garnering broad support from state governments, business sector and the general public on the national government’s reform agenda. The authorities have recently conducted the very first conference with its stakeholders and development partners, hosting of which is seen as a breakthrough after many failed attempts. The conference provided a good starting point for the national government to discuss the seriousness of the challenges. The authorities welcomed the favorable outcome of the meeting, in particular the support received from the development partners group that confirmed their willingness to work with the authorities in moving forward the reform agenda. The authorities will keep the momentum to ensure that the forum is followed by concrete action plans with strong engagement from the stakeholders.
On the fiscal front, tax reform initiatives, aimed at enhancing revenue to put public finance on a sustainable level, continued in 2012. A Unified Revenue Authority (URA) has been set up to introduce a net profit tax that will come into effect in October 2013 and a value added tax that will become effective in October 2014. The URA will take over from the national and state revenues authorities. This reform is a big step forward and the national government is working hard with the state governments to establish consensus in adopting the new arrangement. So far, two out of the four states have agreed to the new tax regime. The new arrangement will come into force once all four states sign and agree to adopt the new arrangement. In line with that, the authorities will continue their efforts in strengthening tax administration through staff training and upgrading of IT system.
On the expenditure side, the authorities advise that they will continue their efforts in improving the operational efficiency of current and capital expenditure through better planning and coordination between the national and state governments. On wage spending, the authorities broadly agree that the public wage rates are high compared to some of the regional peers and thus reducing the rates would allow for fiscal savings. Nevertheless, they believe that it is also essential to balance the need to provide for appropriate compensation package as part of the efforts to address the challenge of outmigration of skilled workforce offshore. The authorities are also making their efforts to improve social security balance, which include the amendment to Social Security Act regarding adjusting the retirement age to Age 60 and allowing only 50 per cent of benefits until Age 65.
The authorities agree on the need to strengthen public financial management and to safeguard the benefits of fiscal reforms. They will continue to work with the Pacific Financial Technical Assistance Center (PFTAC) in strengthening and accelerating the reform work in this area.
On banking, the authorities will continue to focus their attention on addressing constraints related to collaterals in lending. The outcome of the enactment of the Secured Transaction Act in 2006 has been a step forward in the right direction. As there is a strong need for the long-term loan financing, the authorities will continue to address the land collateral issue.
The Development Bank of FSM provides financing to those sectors supported under the government development priorities and more generally those sectors that are essential but fall outside of the radar of the commercial banks’ lending policies. The authorities are well aware of the need to strengthen supervisory oversight over the development bank’s operations and will make constant efforts to ensure soundness of the Development Bank.
Private Sector growth
The private sector development is weak and needs to be strengthened to allow it to support the country’s economic growth as the US Compact grant slowly winds down. While noting the small size and remoteness of the country from international markets, the FSM presents a number of competitive advantages in some niche tourism markets, for which the authorities agree on the need to promote and attract inward FDIs.
There are signs of FDI interest in the tourism sector. A recent interest received includes a huge project proposal that presents challenges for the country to accommodate - particularly in the area of land tenure protection rights. An alternative approach would be to attract small-scale FDIs that will generate immediate benefits as it works towards strengthening the country’s capacity to attract and support bigger FDIs. Another sector of the economy that has potential is the agriculture sector. The increase in FDIs in the future would highlight the need for locally grown food to be produced to mitigate high volatility of imported food prices. Fisheries sector has also room to grow further, providing greater employment opportunities domestically.
The government will continue its efforts to improve the business environment – particularly reform to ease the cost of doing business. The authorities are committed to devising a nation-wide development plan, building on the momentum created by the first development Partners Forum held in the fall of 2012. An Investors’ and Bankers’ symposium is now planned for mid-Spring to harness support from both domestic and international lenders for financing of priority development projects.
Future prospects look challenging, given the unfavorable global market conditions and the winding down of the US Compact support on which the economy is heavily dependent. Nevertheless, the FSM authorities have been making positive strides in moving forward the much needed reform. The key is in fortifying the support from the state governments and the general public. The authorities reaffirm their strong commitment to the reform agenda, particularly strengthening the public finance and savings towards the 2023 deadline and fostering the private sector to support sustainable economic growth. The FSM authorities will continue to work closely with the Fund in this regard.
FSM has 607 islands, occupying a land mass of around 700 km2. FSM gained its independence in 1986 under a Compact of Free Association with the United States.