Republic of Palau: Staff Report for the 2014 Article IV Consultation
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International Monetary Fund. Asia and Pacific Dept
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Publication Date:
06 May 2014
eISBN:
9781484370230
ISBN:
9781484370230
Language:
English
Keywords:
ISCR; CR; reform; authority; Palau; private sector development; gradual adjustment; public finance; return on assets; infrastructure project; pristine environment; Tourism; Fiscal consolidation; Asia and Pacific
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This 2014 Article IV Consultation highlights that after two years of strong expansion, growth is estimated at about zero percent in the fiscal year 2013 (FY2013, ending in September) in the Republic of Palau owing to declines in construction and tourism. Inflation moderated to 2¾ percent (annual average) in FY2013 thanks to stable international food and fuel prices, and it is expected to stay at about 3 percent in FY2014. Growth is projected to increase to 1¾ percent in FY2014 and to 2¼–2½ percent over the medium term driven by the recovery in tourism and infrastructure developments.

Abstract

This 2014 Article IV Consultation highlights that after two years of strong expansion, growth is estimated at about zero percent in the fiscal year 2013 (FY2013, ending in September) in the Republic of Palau owing to declines in construction and tourism. Inflation moderated to 2¾ percent (annual average) in FY2013 thanks to stable international food and fuel prices, and it is expected to stay at about 3 percent in FY2014. Growth is projected to increase to 1¾ percent in FY2014 and to 2¼–2½ percent over the medium term driven by the recovery in tourism and infrastructure developments.

Outlook and Risk

1. Growth. After two years of strong expansion, growth is estimated at around zero in FY2013, lower than other Pacific Island Countries (PICs), owing to declines in construction and tourism (Figures 1 and 4, Table 1). Construction activities slowed down due to delayed capital grants and lower capital spending during the change in administration in early FY2013. Contributing factors to the decline in tourism include the cessation of some flights from Asia, the increase in tourism-related fees, and the U.S. dollar appreciation. Typhoon Haiyan last November had minimal impact on growth, which is projected to increase to 1¾ percent in FY2014 and to 2¼–2½ percent over the medium term. The sources of growth include the recovery in tourism driven by new hotel developments and resumption of direct flights, and infrastructure developments financed by foreign loans and grants (Table 2).1

Figure 1.
Figure 1.

Palau: Real Sector Developments and Outlook

Citation: IMF Staff Country Reports 2014, 110; 10.5089/9781484370230.002.A001

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

Palau: External Sector Developments and Outlook

Citation: IMF Staff Country Reports 2014, 110; 10.5089/9781484370230.002.A001

Sources: Country authorities; and Fund staff estimates and projections.
Figure 3.
Figure 3.

Palau: Fiscal Sector Developments and Outlook

Citation: IMF Staff Country Reports 2014, 110; 10.5089/9781484370230.002.A001

Sources: Country authorities; and Fund staff estimates.
Figure 4.
Figure 4.

Palau: Comparison with Other Pacific Island Countries

Citation: IMF Staff Country Reports 2014, 110; 10.5089/9781484370230.002.A001

Sources: Country authorities; and Fund staff estimates.
Table 1.

Palau: Selected Economic Indicators, 2008/09–2014/15 1/

Nominal GDP for FY2012: US$232 million

Population (2012): 17,611

GDP per capita for FY2012: US$13,191

Quota: SDR 3.1 million

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

Fiscal year ending September 30.

Staff projections.

Incorporates the authorities’ revised estimates of GDP and balance of payments, and the audited government financial statements.

Defined as Revenue less Grants and Expense.

Includes unspent external loans.

Table 2.

Palau: Medium-term Projections, 2010/11–2018/19 1/

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Sources: Palau authorities; and Fund staff estimates and projections.

Fiscal Year ending September 30.

Staff projections.

Includes capital spending financed by loans from the Asian Development Bank (ADB) since 2011/12.

Defined as Revenue less Grants and Expense.

Defined as Revenue less Expenditure.

2. Inflation and credit growth. Inflation declined to 2¾ percent (annual average) in FY2013 thanks to stable international food and fuel prices, and it is expected to stay around 3 percent in FY2014 and increase slightly during FY2015–16 due to the expected implementation of a value-added tax (VAT). Bank credit increased 11½ percent in 2013, while the nonperforming loan ratio remained broadly flat at 3¾ percent.

3. External stability. The current account deficit deteriorated slightly last fiscal year due to lower tourist arrivals and large reconstruction imports associated with typhoon Bopha, but tourism recovery and moderating food and fuel prices are expected to reduce the deficit in FY2014–15 (Figure 2, Table 3). After worsening slightly in FY2016–18 due to imports related to infrastructure projects, the deficit would narrow to 5½ percent of GDP over the medium term and remain fully funded by grants, loans, and FDI. Palau’s food and fuel imports partly depend on tourism receipts, and this serves as an automatic stabilizer to the current account. The real effective exchange rate increased 4½ percent (y/y average) in FY2013 owing to the U.S. dollar appreciation, but it is in line with the PIC average, and the exchange rate assessment provides little evidence of fundamental misalignment. However, heavy reliance on tourists from a few economies would remain a vulnerability, and weaknesses in infrastructure and investment climate could hinder development of tourism-related businesses. Therefore, strengthening fiscal consolidation and improving competitiveness by improving infrastructure and the business climate are essential for maintaining external stability going forward. The use of the U.S. dollar as Palau’s legal tender remains appropriate.2

Table 3.

Palau: Balance of Payments, 2008/09–2017/18 1/

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

Fiscal year ending September 30.

Staff projections.

Palau: Real Exchange Rate Assessments 1/

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Source: Fund staff estimates.

These assessments are subject to large measurement errors given data limitation and Palau’s specific circumstances such as heavy reliance on tourism and grants.

4. Risks, spillovers, and policy responses. Palau’s modest outlook is subject to downside risks. Financial market volatility and growth slowdown in Asia, U.S. dollar appreciation, and natural disasters, including those related to climate change, could hurt tourism and growth, weakening external and fiscal positions (Annex I). Palau’s heavy reliance on food and fuel imports also makes it susceptible to commodity price volatility. Given the absence of monetary and exchange rate policies, Palau will continue to rely on fiscal measures and structural reforms to address these risks. Successful fiscal consolidation is needed to build adequate fiscal buffers and ensure long-term fiscal sustainability and external stability. Improving investment and business climate would help diversify the economy, reduce economic vulnerability, and support growth.

5. The authorities’ views. The authorities shared the staff’s views on the economic outlook, risks, and policy responses. They indicated that the decline in construction played a more important role than tourism in explaining last year’s growth slowdown. They noted that the priority is not increasing the quantity but the quality of tourists in order to preserve Palau’s pristine environment, while at the same time raise tourist spending. The authorities considered that natural disasters constitute the main risk, pointing to the recent typhoons.

Ensuring Fiscal and Debt Sustainability

6. Context. Without substantial consolidation, Palau’s fiscal position will become unsustainable after the Compact grants expire in FY2024.3 Revenue collection relies heavily on tourism, contributing to volatility and vulnerability, and the disbursement of infrastructure loans in the next few years would raise the debt burden.

7. Developments and near-term outlook. Fiscal consolidation slowed in FY2013 partly due to natural disasters, but the authorities intend to put the fiscal adjustment back on track this year.

  • The current fiscal deficit excluding grants (fiscal anchor) is estimated to have remained unchanged at 12¼ percent of GDP in FY2013 (Figure 3, Table 4). Despite the slowdown in tourism, tax revenue continued rising thanks to increases in tourism-related taxes, higher prices in the tourism industry, as well as improvements in tax compliance. However, current spending was also larger than budgeted due to typhoon Bopha in December 2012. The cash buffers, excluding the CTF, increased to 5 percent of GDP and the domestic accounts payables declined to 11 percent of GDP.4

  • The FY2014 budget reflects the authorities’ commitment to fiscal consolidation by maintaining prudent spending and creating a reserve fund to build fiscal buffers. After typhoon Haiyan hit the country in November 2013, the authorities reallocated the planned savings of about ½ percent of GDP for reconstruction expenses. Staff supported the authorities’ intention to replenish the reserve fund by containing spending and saving additional revenue gains that are expected with the adoption of a new IT system in customs, the recent increase in the tobacco tax, and the recovery of tourism. In view of these, the current fiscal deficit (excluding grants) is projected to narrow by 1½ percent of GDP, putting the fiscal consolidation back on track.

Table 4.

Palau: Statement of Government Operations, 2008/09–2014/15 1/

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Sources: Palau authorities; and Fund staff estimates and projections.

Fiscal year ending September 30.

Based on the Budget Law, Supplemental Budget, and Bopha Relief.

Staff projections.

Grants for the Compact Road and the Palau-Japan Friendship Bridge are treated off-budget.

Includes capital spending financed by loans from the Asian Development Bank.

Defined as Revenue less Grants and Expense.

Defined as Revenue less Expenditure.

8. Medium-term fiscal framework. Moving ahead, continued fiscal consolidation is needed to build non-CTF deposits and ensure fiscal self-sufficiency, as otherwise domestic revenue and withdrawals from the CTF will not be sufficient to maintain a steady level of spending after the Compact grants expire.5 Staff’s assessment shows that a gradual reduction in the current fiscal deficit excluding grants by about 8 ppt of GDP during FY2014–19 would raise the government’s net worth to a level that will provide a sustainable source of financing going forward, and offer an adequate fiscal buffer to address future shocks (Annex II).6 If there are any fiscal slippages over this period, the authorities would have additional five years, before the Compact grants expire in FY2024, to put the fiscal consolidation back on track. In view of this, a slower fiscal consolidation that spreads the adjustment until FY2023 is not recommended because it would be more sensitive to risks of slippages and adverse shocks. In addition, a longer adjustment period would lead to a lower level of sustainable government’s net worth and, thus, a lower fiscal deficit that can be financed. The recommended gradual fiscal adjustment would require efforts to reduce spending in terms of GDP, in addition to the revenue measures envisaged in the baseline scenario.

A01ufig1

Palau: Options for Fiscal Adjustment

(Current fiscal balance excluding grants, percent of GDP)

Citation: IMF Staff Country Reports 2014, 110; 10.5089/9781484370230.002.A001

Source: Fund staff estimates.

9. Comprehensive tax reform. The authorities are committed to a comprehensive tax reform aimed at simplifying the tax framework, increasing its fairness, and raising revenue capacity over the medium term. They have conducted intensive public consultations in all states, and expect to pass the tax reform bill in congress by April/May 2014 and have it implemented over the subsequent year. Implementing all components as recommended by IMF/PFTAC technical assistance (TA) is critical: (1) move to c.i.f. (cost, insurance and freight) valuation for imports for tax purposes; (2) replace the gross revenue tax (GRT) with a single rate VAT with no exemptions except for exports; (3) reduce the wage and salary tax rates for low income household to offset any price increases from VAT adoption; and (4) raise the net income tax (NIT) for financial institutions, and expand it to all VAT-registered business. If the passage of tax reform bill is delayed, staff recommended adopting c.i.f. valuation, removing import tax exemptions, broadening excise taxes, and raising the NIT for financial institutions as intermediate actions. Staff also noted the importance of communicating all aspects of the reform package to engage stakeholders and improving revenue administration capacity to support this major reform. In view of the authorities’ strong commitment to implement the comprehensive tax reform, domestic revenue is projected to increase by about 4 ppt of GDP during FY2014–19 under the baseline scenario.7

10. Expenditure reform. Medium-term fiscal adjustment also requires containing current spending while ensuring adequate public services. Since the wage bill represents about half of current spending, controlling its growth continues to be the top priority. Staff estimated that containing the increase in wage bill below the inflation rate, complemented by civil service reforms, could reduce current spending by 4 ppt of GDP during FY2014–19. By implementing both expenditure and revenue reforms under the gradual adjustment scenario, Palau would be able secure long-term fiscal sustainability.8

The Impact of Fiscal Reforms, FY2014–19

(ppt. of GDP)

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Source: Fund staff estimates.

11. Public finance management. Given the disbursement of new infrastructure loans, sound management of public debt and strong governance of loan-funded infrastructure projects would help ensure debt sustainability and minimize fiscal risks. The debt sustainability analysis indicates that Palau’s public debt risk remains low after the disbursement of Asian Development Bank (AsDB) water and sanitation loans. However, continued fiscal consolidation is needed to place the debt on a downward path (Annex III). Staff advised the authorities to continue directing external loans and grants to infrastructure projects that will promote tourism and growth. Staff also encouraged the authorities to implement the medium-term budget framework, supported by AsDB TA, and continue improving budget execution and planning and strengthening cash management. Prudent management of the newly established reserve fund would also help safeguard fiscal buffers.

12. Reforming public entities. Staff welcomed recent reforms to make the Civil Service Pension Fund (CSPF) and Social Security Fund (SSF) more sustainable, including by replacing the 30-year service mandatory retirement with a mandatory retirement age for civil servants, increasing the social security entitlement age, and adjusting benefit structures. The authorities made further progress in clearing government arrears to these funds and improving contribution compliance. The upcoming actuarial valuations should assess the impact of the recent measures on the funds’ financial positions.9 The merger of Palau Public Utilities Company and Palau Water and Sewer Corporation was completed in June 2013. The new public utility company is mandated to improve water and sewer services and raise tariffs accordingly in order to reach full cost recovery of water and sewer operations in 2016. Nonetheless, electricity operation will continue to rely on subsidies, grants, and/or loans to finance capital spending. Staff encouraged the authorities to continue reforming the utility company to achieve full cost recovery in all operations.

13. The authorities’ views. The authorities reiterated their commitment to fiscal consolidation and prudent debt management, and confirmed that staff’s recommendations are broadly in line with their medium-term budget framework. They appreciated the IMF/PFTAC TA in designing the tax reform, and remained cautiously optimistic that the tax reform bill, including a value added tax, would be passed. The reform is also expected to raise the NIT for financial institutions and expand its coverage to all-VAT registered business, but the authorities indicated that this would be done in stages given capacity consideration and the need to build ownership among stakeholders to support the reform. The authorities agreed with staff’s advice to contain the wage bill growth but noted that the priority at this stage is to pass the tax reform bill. Looking forward, potential measures for civil service reforms could include enforcing mandatory retirement, upgrading the work ladder to attract better qualified candidates, aligning salaries with performance, reducing temporary workers, and retraining of public servant to prevent new hiring. The authorities plan to further strengthen the CSPF by switching it from a defined-benefit to a defined-contribution framework and expanding it to include the private sector. They also shared staff’s assessment that the risk of debt distress remains low, but it is sensitive to fiscal slippages and a growth slowdown.

Raising Growth Potential

14. Context. Palau faces a number of structural constraints common to small islands: a narrow economic base, remote location, small population, insufficient infrastructure, and weaknesses in investment climate. The banking system remains sound, but the National Development Bank of Palau (NDBP) remains outside the Financial Institution Commission’s (FIC) supervision.10 Commercial banks continue to provide limited credit and place most of their assets abroad due to credit risks and narrow domestic investment opportunities.

15. Private sector development. Fiscal adjustment to preserve macroeconomic stability should work jointly with structural reforms to raise competitiveness, promote private sector development, and sustain growth. In this context, diversifying the economy, addressing infrastructure bottlenecks, and improving business and investment climate remain key priorities.

  • Diversifying the sources of growth. Since tourism will remain the main source of growth, promoting diversification within and outside the tourism industry could improve economic resilience (Box 1).

  • Addressing infrastructure bottlenecks. Expansion of basic infrastructure, such as water and sanitation system, is needed to promote development of new hotels and raise tourism growth. Although Palau compares favorably to peers, further improvements in the road network, aviation connectivity, and telecommunication infrastructure would support economic diversification and enhance growth potential.

  • Improving business and investment climates. Adopting a new foreign investment regime to simplify investment approval and open all business activities to foreign investment through joint ventures, continue to be the priorities.11 The recent establishment of the Economic Advisory Group comprising representatives of the government, congress, and the private sector would strengthen coordination between the private and public sectors and improve policy formulation and planning. The authorities’ plan to pass labor reforms aimed at guaranteeing fair compensations, safer working conditions, and steadfast resolution of labor disputes, should help protect employees and improve business climate. The initiative to improve foreign workers’ flexibility to switch jobs would also improve productivity and promote inclusive growth.

Palau: Promoting Tourism and Growth

Tourism plays an important role in Palau’s economy. As a world class diving destination, Palau receives tourists more than five times of its population every year. In the recent years, tourism has contributed about three quarters of GDP growth, more than 80 percent of exports of goods and services, 15 percent of total tax revenue, and 40 percent of total employment. Cross-country data indicate that Palau fares well compared to its peers in terms of tourism’s contribution to the economy, although the availability of hotel rooms is more limited.

Palau’s heavy reliance on tourism contributes to economic volatility and vulnerability. Tourism is susceptible to global economic and financial conditions, and the reliance on tourists and direct flights from only a few Asian economies leads to tourism volatility. In addition, a limited number of hotel rooms, partly due to infrastructure bottlenecks, hamper tourism and GDP growth. Meanwhile, spending per tourist has remained flat for the past decade, suggesting limited increase in higher-income tourists. In addition, heavy reliance on food and fuel imports makes Palau vulnerable to sharp fluctuations in global commodity prices.

Developing the private sector by promoting economic diversification would strengthen economic resilience and enhance growth potential. Diversification within the tourism industry includes developing new tourist attractions (for example, golf courses, aquatic sports), increasing flight connectivity with more countries, and attracting a larger number of higher-income tourists to increase tourists’ spending. Diversification outside the tourism industry could entail developing agriculture and aquaculture (for example, fish or clam farming) to supply the tourism industry with domestic products and expanding the service industry. Moreover, the domestic value added would be greater if a larger share of the supply chain of tourism-related operations such as production and marketing of products and services was based in Palau instead of overseas. In this context, Palau’s efforts to diversify the economy and promote private sector development should be underpinned by structural reforms that open up the restrictive foreign investment regime and solve pressing infrastructure bottlenecks, such as deficient water and sewer system and limited internet connectivity.

A01ufig2
Sources: Country authorities; World Travel and Tourism Council, Country Reports; The Compendium of Tourism Statistics, World Tourism Organization; and Fund staff calculations. For Palau some data are from the 2012 Statistical Yearbook.

16. Financial sector developments. Financial indicators suggest that the commercial banks remain sound, reflected by ample liquidity, strong earnings with large interest rate spreads, a stable return-on-assets ratio, and a low nonperforming loans ratio.12 Banks’ balance sheets have improved thanks to FIC’s increased monitoring and banks’ loan write-offs, and as a result, private credit growth rebounded to 11½ percent in 2013. Banks’ ample liquidity reflects the fact that deposits have been growing faster than loans, and banks continue to invest their excess liquidity in the United States. Although bank officials have expressed their willingness and capacity to expand their domestic loan portfolios, they indicated several factors that inhibit further expansion, including the small market size, the lack of secured lending for real estate, and customers’ limited capacity to present business plans and financial statements. The ongoing land registration program and the initiative to provide loans for housing built on leased government land are expected to promote real estate lending. The authorities’ efforts to help small businesses make business and financial plans with assistance of the Small Business Development Center are also on the right direction. The secured transaction registry that was established in 2013 with AsDB’s support has had limited impact in promoting collateralized lending, but the authorities plan to continue working to improve its effectiveness.

Palau: Commercial Bank Indicators, 2011–13

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Source: Financial Institutions Commission (FIC).

17. Preserving financial stability. Ensuring that the overall financial sector remains sound and stable is essential to promote credit growth and support private sector development. With the support of TAs by IMF/PFTAC and the U.S. FDIC, the FIC has made good progress in conducting bank examinations of all banks, strengthening data collection and reporting, and publishing quarterly and annual reports. The Financial Intelligence Unit (FIU) was established in 2012, previously within the FIC but now operating as an independent body, and has continued developing capacity to investigate Anti-Money Laundering and Combating the Financing of Terrorism (AML/CFT) issues. Staff reiterated the importance of broadening financial supervision to include the NDBP and other non-bank financial institutions in order to minimize potential risks, particularly in view of the plan to allow NDBP become a deposit-taker institution. Staff also welcomed recent progress in amending AML/CFT legislation and urged its prompt passage in order to address most of the deficiencies identified by the Asia/Pacific Group on Money Laundering. Strengthening the FIU’s capacity is also important to implement its mandate.

18. Statistics. Better data statistics would facilitate policy formulation and decision making by the private sector. Data statistics are now broadly adequate for surveillance thanks to substantial improvements over the past two years as a result of effective TA provided by IMF/PFTAC and other donors as well as hiring of new staff in the Office of Planning and Statistics (OPS). Further areas for improvement include broadening the coverage and providing more frequent reporting. Continued efforts to strengthen OPS’s capacity also remain critical in order to continue implementing TA recommendations going forward and reduce reliance on external assistance.

19. The authorities’ views. The authorities agreed that promoting private sector development and diversifying the economy are essential to support growth. They emphasized the importance of preserving a pristine environment in order to promote sustainable development. The establishment of the Bureau of Tourism, whose mandate is to ensure compliance with regulations, maintain and set standards in the tourism industry, and safeguard the quality of services, is expected to improve the quality of tourism. The authorities also indicated that the expansion of the water and sanitation systems would help address infrastructure bottlenecks which are hampering the development of new hotels. They are also making efforts to promote aquaculture and agriculture, which are outside the tourism industry, but could form part of its supply chain. The authorities agreed with the inclusion of NDBP under the FIC’s oversight and indicated the importance of improving NDBP’s capacity to comply with FIC’s requirements, including through undertaking a preliminary on-site examination before the bank becomes a deposit-taker institution.

Staff Appraisal

20. Economic outlook. Growth is projected to rebound driven by tourism recovery and infrastructure developments over the medium term, and inflation is expected to remain low thanks to moderating international food and fuel prices. The external balance is stable as the current account deficit would be fully financed by official grants, loans, and FDI, and the real effective exchange rate is broadly in line with fundamentals.

21. Risks and policy responses. Palau’s modest outlook is subject to downside risks from financial market volatility and growth slowdown in Asia, a U.S. dollar appreciation, natural disasters, and the heavy reliance on food and fuel imports. In the absence of monetary and exchange rate polices, Palau will continue to depend on fiscal measures to preserve macroeconomic stability and on structural reforms to diversify the economy and promote private sector development.

22. Fiscal consolidation. The authorities’ commitment to substantial fiscal adjustment over the medium term and passing a comprehensive tax reform bill this year are welcome. Staff emphasize that all components of the tax reform are critical and improvements in revenue administration capacity is needed to support this major reform. Since tax reform alone is not sufficient to ensure long-term fiscal sustainability, staff also recommend expenditure reform to contain current spending growth and support the fiscal consolidation.

23. Structural fiscal reforms. Strengthening public financial management would support fiscal consolidation and improve fiscal discipline and transparency. Sound management of public debt and strong governance of loan-funded infrastructure projects would ensure debt sustainability and minimize fiscal risks. Staff encourage the authorities to continue strengthening the pension and social security systems and reforming the public utility company to achieve full cost recovery.

24. Private sector development. Promoting diversification within and outside the tourism industry would improve economic resilience. Further improvements in infrastructure and structural reforms to strengthen investment climate, including by reforming the foreign investment regime, would support economic diversification, enhance growth potential, and promote inclusive growth.

25. Financial sector. The financial sector remains sound, and continued progress in strengthening financial supervision is welcome. Broadening financial supervision to include the NDBP and other non-bank financial institutions is crucial to preserve the sector’s stability going forward.

26. It is recommended that the next Article IV consultation take place on a 24-month consultation cycle. Staff support the authorities’ request that Fund surveillance missions take place during the budget preparation in the second half of the fiscal year.

Annex I. Risk Assessment Matrix (RAM)1

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Annex II. Long-term Fiscal Sustainability Analysis1

This analysis updates the estimates from the 2012 Article IV consultation. The results suggest that reducing the current deficit excluding grants by about 8 percentage point (ppt) of GDP during FY2014–19 would ensure Palau’s long-term self sufficiency after the Compact grants expire in FY2024.

The analytical framework is based on the government’s intertemporal budget constraint. This framework requires that the government’s net worth plus the net present value (NPV) of future revenue streams equals the NPV of future expenditure streams. This is expressed in the following equation:

W + G + R = C + K

where the government’s net worth (W) and the NPVs of grants (G) and domestic revenue (R) are balanced against the NPVs of fiscal expense (C) and net acquisition of non-financial assets (K).

The current balance excluding grants (R-C) is set as the policy variable to balance the budget constraint. The government’s initial net worth (W), grants (G), and capital spending (K) are exogenous. The government’s initial net worth (W) is inherited and comprises the Compact Trust Fund (CTF) and government domestic deposits, less the government’s domestic accounts payable and external debt. Grants (G) are to a large extent determined by development partners. Capital spending (K) should be maintained at a level that ensures growth. In contrast to these three variables, domestic revenue (R) and current spending (C) can be influenced by policy makers, leaving the current deficit excluding grants as the policy variable to satisfy the above equation.

The government’s initial net worth is estimated at 60½ percent of GDP at end FY2013. The CTF is estimated at 77 percent of GDP, government domestic deposits at 5 percent of GDP, domestic accounts payable at 11, and government external debt at 10½ percent of GDP.

The following assumptions are made:

  • Nominal GDP growth: 4 percent (real GDP growth: 2 percent).

  • CTF nominal rate of return: 6 percent (real rate of return: 4 percent). The average annual return was 5¾ percent during FY2000–12 and 8 percent since the CTF’s inception in 1995.

  • U.S. Compact grants: US$146.2 million over FY2014–24 (total direct assistance of US$229 million minus the advances of US$52.5 million received during FY2010–13 and US$30.25 million in contributions to the CTF which are not part of the government’s budget).

  • Annual drawdown from the CTF: gradual increase from US$5 million to US$13 million during FY2014–23, US$15 million during FY2024–44, and 1¾ percent of GDP thereafter.

  • Other U.S. grants: US$170 million over FY2014–24, and 4½ percent of GDP thereafter.

  • Other country grants: 4½ percent of GDP.

  • Acquisition of non-financial assets: ranges between 6¾–9¾ percent of GDP in FY2014–25, and 9 percent of GDP thereafter.

The results show that reducing the current deficit excluding grants by 7¾–8½ ppt of GDP would ensure Palau’s fiscal sustainability. This adjustment should take place between FY2014 and FY2023, and it would increase the government’s net worth to a level that will generate sufficient income to finance a sustainable deficit over the long term. However, there is a trade-off between the speed of adjustment and the level of net worth that can be achieved: the longer the adjustment period, the lower the net worth that can be achieved (hence, the lower the sustainable deficit that can be financed).

A gradual reduction of the current deficit excluding grants by 8.1 ppt of GDP during FY2014–19 is recommended. Three possible adjustment scenarios (immediate, gradual, minimum) are presented for illustration. The total reduction in the current deficit excluding grants is too large to be implemented by an immediate adjustment in one year. On the other hand, the minimum adjustment that spreads the adjustment until FY2023, just before the Compact grants expire, would be more sensitive to risks of slippages and adverse shocks like typhoon Bopha in early FY2013, which prevented Palau from continuing on the needed adjustment path. Therefore, gradually reducing the current balance excluding grants by 8.1 ppt of GDP during 2014–19 (1.35 ppt annually on average) is more appropriate. This gradual approach will leave the government with extra years in case the needed consolidation is not achieved as planned. Since the fiscal adjustment in FY2014 is projected to be 1½ ppt of GDP, the adjustment in FY2015–19 should be about 1¼ ppt a year on average. The path of medium-term fiscal consolidation and long-term fiscal sustainability is illustrated in Annex 2 Figure 1.

Annex II. Figure 1.
Annex II. Figure 1.

Palau: Long-Term Fiscal Sustainability, FY2010–40

Citation: IMF Staff Country Reports 2014, 110; 10.5089/9781484370230.002.A001

Sources: Country authorities and Fund staff estimates and projections.

Scenarios of Adjustment in Current Fiscal Balance Excluding Grants (R-C)

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Source: Fund staff estimates

The above result is fairly robust to different parameter assumptions. Lower rates of return and lower valuations of the government’s initial net worth (for example, to reflect new external debt and/or to include public enterprise debt) increase the required annual fiscal adjustment. Higher real GDP growth rates and inflation also increase the needed adjustment. Overall, however, reasonable variations in these parameters have fairly small impacts on the estimated annual adjustment of 1.35.

Sensitivity Analysis under Gradual Adjustment

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Source: Fund staff estimates

Annex III. Public Sector Debt Sustainability Analysis

A01app3ufig1

Palau Public Sector Debt Sustainability Analysis (DSA) - Baseline Scenario

(in percent of GDP unless otherwise indicated)

Citation: IMF Staff Country Reports 2014, 110; 10.5089/9781484370230.002.A001

Source: IMF staff.1/ Public sector is defined as central government and includes public guarantees, defined as SOE debt.2/ Based on available data.3/ Long-term bond spread over German bonds.4/ Defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.5/ Derived as [(r - π(1+g) - g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation (measured by increase in local currency value of U.S. dollar).6/ The real interest rate contribution is derived from the numerator in footnote 5 as r - π (1+g) and the real growth contribution as -g.7/ The exchange rate contribution is derived from the numerator in footnote 5 as ae(1+r).8/ Includes changes in the stock of guarantees, asset changes, and interest revenues (if any). For projections, includes exchange rate changes during the projection period.9/ Assumes that key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.
A01app3ufig2

Palau Public DSA - Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2014, 110; 10.5089/9781484370230.002.A001

Source: IMF staff.1/ The results under the constant primary balance scenario are unrealistic as the FY2014 primary fiscal balance is projected to swing to a surplus due to frontloaded disbursements of Compact capital grants. Instead, a no fiscal adjustment scenario is included to show the potential debt trajectory under a scenario where revenue and expenditure reforms are not implemented, thereby leaving both revenue and expenditure almost flat in terms of GDP. The debt trajectory under the adjustment scenario that incorporates both revenue and expenditure reforms as recommended is also presented.
1

A new Asian Development Bank loan of US$29 million (12 percent of FY2013 GDP) to finance water and sanitation projects would be mostly disbursed during FY2015–19.

2

The U.S. dollar has provided an important nominal anchor. Palau maintains close financial and trade linkages with the United States and, as a small state, has limited capacity to conduct its own monetary and exchange rate policy.

3

The 2010 agreement following the Compact of Free Association with the United States that will provide US$229 million in grants during 2011-24 is pending ratification by the U.S. congress, but Palau has continued to receive advances and to withdraw from the Compact Trust Fund (CTF).

4

The stock of domestic account payables—mostly trade credits and late payment to contractors and suppliers—has been reduced from its peak of 15 percent of GDP in FY2010 but remains above the average of 7 percent of GDP observed before the global financial crisis. The prospective disbursement of US$10 million under the Compact’s fiscal consolidation fund is expected to be used to further reduce these liabilities.

5

Since withdrawals from the CTF will be capped at US$15 million annually during FY2024-44, Palau will have to rely on other revenue sources and/or expenditure reduction to prevent any financing gap.

6

By reducing the current deficit excluding grants to 4¼ percent of GDP by FY2019 and keeping it constant into the long run, the overall balance will continue in surplus until FY2025, allowing the government to build up deposits during this period. Beyond FY2025, as the Compact grants expire, the overall balance will switch into a deficit, which will gradually reach a sustainable level of 2¼ percent of GDP in FY2043 and will be financed by the deposits (and their returns) accumulated during the surplus years.

7

These potential revenue gains are achievable compared to the impact of VAT implementation in other countries and considering the fact that Palau’s income tax and goods and services tax in terms of GDP are currently among the lowest in the region

8

The impact of current spending reduction on growth is estimated to be small, at -¼ percent annually during the adjustment period (Table 2).

9

The CSPF and SSF are not part of Palau’s central government. The 2011 actuarial estimates, calculated as the difference between the present values of accrued liabilities and trust assets, are US$104 million in CSPF and US$91 million in SSF. A large part of CSPF’s unfunded liabilities are the result of the 30-year service mandatory retirement that was abolished recently.

10

The NDBP is a development finance organization, 100 percent government owned. Its loan portfolio amounts to about US$25 million (10 percent of FY2013 GDP) and it is directed mainly to commercial (tourism, retail stores, etc.) and housing loans, and a small amount to agriculture and fishing. Audited financial statements are publicly available, but the bank is exempt from FIC’s regulation and oversight.

11

Palau’s rank in the 2014 World Bank’s doing business indicators improved from 114 to 100, but there is ample room to strengthen investor protection, contract enforcement, and business-startup procedures.

12

The FIC supervises five banks: three branches of U.S. Federal Deposit Insurance Corporation (FDIC)-insured banks that hold more than 95 percent of total commercial banks’ assets, and two locally-chartered and uninsured banks. The capital adequacy ratios of the two uninsured banks stood at 98 percent (tier 1 risk-based) and 101 percent (total risk-based) in 2012.

1/

It shows events that could materially alter the baseline path. The RAM reflects staff’s views on the source of risks and overall level of concerns as of the time of discussions with the authorities.

1

This analysis uses the framework found in IMF Country Report No. 08/162 and updated in Appendix I: Palau—Long-Term Fiscal Sustainability of IMF Country Report No. 12/54.

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Cover IMF Staff Country Reports
Republic of Palau: Staff Report for the 2014 Article IV Consultation
Author:
International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2014: Issue 110
Publisher:
International Monetary Fund
ISBN:
9781484370230
ISSN:
1934-7685
Pages:
45
DOI:
https://doi.org/10.5089/9781484370230.002
Figure 1.

Palau: Real Sector Developments and Outlook
Figure 2.

Palau: External Sector Developments and Outlook
Figure 3.

Palau: Fiscal Sector Developments and Outlook
Figure 4.

Palau: Comparison with Other Pacific Island Countries

Palau: Options for Fiscal Adjustment

(Current fiscal balance excluding grants, percent of GDP)
Annex II. Figure 1.

Palau: Long-Term Fiscal Sustainability, FY2010–40

Palau Public Sector Debt Sustainability Analysis (DSA) - Baseline Scenario

(in percent of GDP unless otherwise indicated)

Palau Public DSA - Composition of Public Debt and Alternative Scenarios