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.
Our Palauan authorities wish to express their utmost appreciation to the Fund and its Staff for the constructive engagements and concise report. The authorities broadly concur with the staff views expressed in the 2014 Article IV report which effectively highlighted the current economic status as well as the remaining challenges to preserve macroeconomic stability and ensure long term growth.
Palau, as a small island nation in the remote North Pacific, has a narrow production and export base and remains highly vulnerable to external shocks and natural disasters. To ensure macroeconomic stability, the government is determined to build adequate buffers to mitigate downside risks, address structural impediments to growth and to maintain prudent macroeconomic policies. Given the inherent challenges including resource constraints, my authorities are very grateful for the continued assistance from the international community, in particular, the United States, who has been providing financial support through the Compact of Free Association.1
Economic Development and Outlook
Growth slowed down in FY2013 mainly due to the decline in construction and tourism. The recent typhoon Haiyan had a small adverse effect on GDP, with reconstruction activity offsetting some of the impact. Inflation has moderated to 2¾ percent, thanks to stable international food and fuel prices. However, growth is seen recovering in the near-term as tourism recovers.
There are promising signs that economic activity has picked up in the first few months of 2014, thanks to a strong recovery in tourism. Over the medium-term, growth is expected to gain momentum as tourism recovers and the benefits of recent reforms begin to materialize. Real GDP is forecast to grow at around 1¾ percent in FY2014 and 2¼ - 2½ percent over the medium-term.
While the outlook is positive for 2014 and favorable in the medium-term, important risks to the forecasts remain. Risks remain weighted to the downside if a severe downturn emerges in Asia, Palau’s main source of tourists. A sharp rise in food and fuel prices would also have a negative impact on the economy, given Palau’s heavy reliance on imports. Furthermore, the absence of monetary and exchange rate policies (the economy is using dollar as a legal tender), limit policy space to counter the risks.
The authorities are fully aware of Palau’s daunting fiscal challenges from the expiration of the Compact grants in 2024. They indicated that along with current fiscal adjustments, strengthened private sector development is crucial in the near term as the Compact of Free Association with the United States winds down.
Given the anticipated 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 negotiated an increase in the number of scheduled and chartered flights in response to the demand from Asia, particularly China. They have also revamped tourism-related activities and continue to identify ways to diversify the tourism industry, Palau’s bread and butter.
Fiscal Sustainability
The authorities agree that continued fiscal consolidation is needed to build non-Compact Trust Fund (CTF) savings and ensure fiscal self-sufficiency in the future. Given the burden of adjustment, the authorities are looking to embark on a comprehensive revenue and expenditure reforms, which are essential to resolve long-standing fiscal imbalances. The mid-term priority is to pass the tax reform bill, followed by expenditure reforms to be done gradually at a later stage. While current spending was larger than budgeted due to typhoon Bopha in December 2012, the cash buffers, excluding the Compact Trust Fund (CTF), increased to 5 percent of GDP due to stronger revenue and the domestic accounts payables fall to 11 percent of GDP.
The authorities credit the slowed fiscal consolidation in FY2013 as a result of two natural disasters. After typhoon Haiyan hit the country in November 2013, the authorities reallocated the planned savings of about ½ percent of GDP for reconstruction expenses. The authorities intend 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.
Despite the slowdown in tourism in FY2013, tax revenue continued rising thanks to increases in tourism-related taxes, higher prices in the tourism industry, as well as improvements in tax compliance. The current fiscal deficit excluding grants is estimated to have remained unchanged at 12¼ percent of GDP in FY2013. The FY2014 budget reflects the authorities’ commitment to fiscal consolidation by maintaining prudent spending and creating a reserve fund to build fiscal buffers.
Reform Agenda
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.
Palau’s economy is in the midst of a period of extensive reform that has broad implications for the wider population. Comprehensive reforms are being pursued along many fronts, and the authorities are aware that the social safety net for the most vulnerable must be protected to compensate for the social impact of reforms.
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. The authorities expressed that comprehensive tax reform will strengthen their effort to re-build the fiscal position. The authorities’ are pushing forwarding with the tax reform bill which is expected to pass in Congress by May 2014.
In line with the IMF/PFTAC technical assistance (TA) recommendations, the authorities emphasized the need to replace the gross revenue tax with a single rate VAT with no exemptions except for exports, moving to c.i.f. valuation for imports, raising net income tax (NIT) for financial institutions from the current 4 percent to 20 percent in gradual stages, and expanding it to all VAT registered business. Furthermore, as staff noted, the wage and salary tax rates for low income household could be reduced to offset a potential adverse impact of price increases due to VAT adoption. The authorities also stressed the need to improve revenue administration capacity to support this major reform. This comprehensive tax reform package will bring revenue gain by about 4 percent of GDP during FY2014-19.
Medium-term Fiscal Framework
Sizable adjustment is required in order to achieve long-term fiscal sustainability. As staff projected, a gradual reduction in the current fiscal deficit by about 8 percent of GDP through FY2019 will provide a sustainable source of financing and offer an adequate fiscal buffer. The authorities recognize the task that lies ahead but are also trying to balance the adjustment with the need for political support for the required reforms. This is particularly important with the expiration of Compact grants in FY2024, which have averaged more than 20 percent of GDP over the past decade.
The authorities have taken steps to implement a medium-term budget framework (MTBF) in order to ensure 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, 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 ensuring that the banking system is stable and safe for depositors. The Financial Institutions Commission (FIC) has been proactive in its mandate and has increased monitoring of the banks’ loan write-offs. Private credit growth rebounded to 11½ percent in 2013. The authorities agree with the need to include the development bank under the FIC’s oversight.
The authorities are committed to continue their effort against money laundering and in combating the financing of terrorism (AML/CFT). The Financial Intelligence Unit in collaboration with the FIC has the mandate to investigate any criminal activities within the financial sector and has strengthened its capacity to conduct AML/CFT examinations.
Private Sector Development
The authorities will continue to undertake critical growth enhancing investment and implement strong structural reforms that will support growth. In their efforts to strengthen economic development the authorities are seeking to develop a vibrant private sector as evidenced by the recent establishment of the Economic Advisory Group. They are of the view that private sector development is a key complement to the planned fiscal consolidation.
The authorities have taken critical steps to create a business environment that would allow businesses, both foreign and domestic, to operate successfully through regulatory improvements to the FDI regime and simplification of the regulations on land-use and the labor market. To this end, our authorities are committed to improving the business environment and reducing bottlenecks to improve investor confidence and to lift potential growth.
Finally, our Palauan authorities would like to express their gratitude to Management, the IMF mission chief and his team, and the TA mission teams for their continued efforts and dedication.
The Compact of Free Association, which was ratified in 1994 and was then renewed and amended in 2010. The new agreement will last until FY2024 totaling US$229 million, a substantial decrease from the initial US$580 million compact funding in FY1994-FY2009, of which passage, however, has been delayed in US Congress due to lack of offsets to the proposed budget.