Abstract
KEY ISSUES Context. Raising growth and ensuring long-term fiscal sustainability remain the two critical issues of the FSM. The reform agenda, in particular, the tax reform package and growth-enhancing reforms, hinges on achieving a national consensus in a loosely federated nation. Outlook. The economy stagnated in FY2014 (ending September) with real growth estimated at 0.1 percent, reflecting a slowdown in the implementation of infrastructure projects. Inflation dropped to 0.7 percent in FY2014 on account of falling oil prices. The current account strengthened due to a tax windfall from a company’s sale of shares launched on a foreign stock exchange and an increase in fishing license fees. Growth in FY2015 is expected to remain almost flat at 0.3 percent, while damages caused by the recent typhoon Maysak could dampen the economy. Fiscal sector. The authorities have started some reforms in view of the expiration in 2023 of grants provided under the Compact of Free Association with the U.S. State governments have started fiscal consolidation while the Unified Revenue Authority (URA) has been established. The authorities agreed that more needs to be done to achieve fiscal sustainability, in particular, by implementing the tax reform package that includes replacing the state sales taxes with a VAT. They noted that further reforms hinge on achieving a national consensus. Investment climate. Land tenure issues continue to constrain private sector development and the authorities should redouble efforts in expediting the land survey and registration process. On tourism, the authorities expressed optimism that the recent extension of the runway at the main island airport in Pohnpei could lead to more eco- tourism that preserves the cultural heritage and pristine nature of the country. Financial sector. Credit unions are currently not being supervised and a new legislation is underway to put them under the supervision of the Banking Board. The authorities have requested further TA from PFTAC and the Legal Department of the Fund.
Background
On behalf of the Micronesian authorities, we appreciate staff’s well-organized and informative assessment of the developments in the economy and the constructive dialogue with the authorities.
The Federated States of Micronesia is a small Pacific island country which consists of four autonomous states guaranteed by its constitution. Such autonomy and the geographical dispersion among each state make it challenging to achieve social consensus on important issues.
The most serious challenges facing Micronesia include concerns related to grants from the United States which recently account for 25~30 percent of GDP. Grants are expected to expire in FY2023. Therefore, the FSM’s sustainable growth in the long term will hinge on moving forward the fiscal reforms in preparation for the expiration of grants, and fostering a larger role for the private sector as a new engine of growth.
To address these challenges, the authorities recently initiated “Action Plan 2023” which aims at addressing the fiscal and economic challenges leading up to and post FY2023. The Action Plan targets achieving the FSM’s annual real growth rate of 2 percent, creating an environment for private sector-driven growth, and strengthening fiscal consolidation over the remaining years at the Compact.
In this regard, while the authorities broadly agree with staff on the outlook, ambitious reforms and favorable development of global economy would play a pivotal role in helping to revive the economic activity.
In addition, pursuing sustainable growth, the authorities highly appreciate the staff’s assessment and recommendation. In particular, staff’s recommendations related to achievement of the sustainable growth are largely in line with the Action Plan 2023, which are to promote the country’s economic development, budgetary self-reliance, and economic self-sufficiency.
Economic Outlook
The authorities broadly agree with staff’s assessment of the outlook. However, the authorities believe that there is a range of upside risks that could materialize, particularly with implementation of reforms. Specifically, the authorities believe that the FSM’s economy will be able to regain the momentum to 2 percent per annum on average over the remaining periods of the Compact in case the country radically realigns its productive capacity by undertaking key factors contained in the Action Plan and being helped by favorable factors as follows:
Fishing and tourism are expected to benefit from favorable external factors such as lower oil prices and the gradual recovery of global economy.
The authorities continue to have dialogue with the stakeholders to address the unused balance of allocated Compact grants for infrastructure projects. The authorities seek to accelerate the spending on the infrastructure arrears of $126 million over the next four years, and thereby help to reinvigorate the economy.
Last but not least, the authorities believe that an additional upside risk could arise from the positive effects of the structural reforms on external and domestic confidence.
Pursuing Sustainable Growth
Fiscal Policy
Staff pointed out that from 2024 onwards, the FSM will face serious fiscal deficits without any interventions or reforms. A key challenge in fiscal reforms for the country is that the fiscal policy is implemented individually by the central and state governments, with separate expenditure and revenue policies. The authorities agree on the need to put in place both revenue and expenditure reforms that reflect the country’s long term objectives.
On the revenue front, the authorities highly appreciate staff’s emphasis on the central importance of improved tax administration and tax reforms.
The authorities plan to lift a currently low tax-to-GDP ratio of 12 percent up to as high as 16 percent through a series of tax reforms, including through introduction of a value added tax and net profits tax.
Going forward, the authorities seek to extend the URA to the remaining two states, enhance the current operations of the state and national tax offices, and broaden personnel training in anticipation of the broader tax reform.
This will be supported by sustained utilization of technical assistance from the Pacific Forum Secretariat (PFTAC) and other development partners, incorporating wherever possible the lessons from the experiences of comparable Pacific island countries that have already undertaken such reforms. Complimenting these efforts and standing critical to the success of the reforms, will be a more targeted public awareness program regarding the reforms.
On the expenditure front, a key policy objective is the need for national and state governments to limit their expenditure growth to 2 percent per annum over the medium-to- long term and thereby see total expenditure of government continue to decline as a percent of GDP by allowing expenditure to keep track of inflation levels.
In particular, the authorities view the recent launch of state-level effort towards consolidation under the Long-Term Fiscal Frameworks (LTFF) as important progress, and moreover highlight their strong resolves to extend the LTFF to the national government level.
Concerning the large wage bill, the authorities note that salaries have been frozen since 1997 through a decision of Congress. The government recently undertook a public administration reform project, under which it reviewed not only the salary freeze but also number of staff, payment structures, and staff grading etc and is in the process of implementing the findings.
The authorities seek to strike right balance between revenue enhancing measures and revenue sharing. In considering any revenue sharing with the states, the national government will seek to ensure that the states take appropriate and corresponding measures, including enabling tax reform legislation, improving the investment environment, and implementing expenditure reforms.
Private Sector Development
The authorities fully agree with staff that improving the investment climate is key to achieving private sector-led growth. They also acknowledge that compact grants, no matter how efficiently administered, will not lead to better economic performances by 2023 without substantially rebalancing sector grant usage to focus on private sector growth, that leads to achieving budgetary self- reliance and economic self-sustainability. Despite the authorities’ steadfast resolve to generate a business-friendly climate, it will be challenging to achieve social consensus on the structural problems, including land tenure reform in the near term.
Specific issues for the FSM include dealing with insolvency, contract enforcement, investor protection, access to credit, property rights, and business start-up challenges as well as land leases and foreign investment. It is hoped that diverse measures for Regulatory reforms Covered by the Action Plan 2023 will provide a cornerstone for enhancing protection for foreign investors and reducing investment-related uncertainty. The Action Plan, in practice, contains diverse measures and initiatives to expedite the construction of infrastructure which will help to enhance the competitiveness of tourism and fishery sectors.
Regarding the ownership and leasing of land, the authorities also see merit in reviewing restrictions imposed by Foreign Investment Acts at both levels of government to harmonize and provide greater clarity on land tenure practices across the states, while respecting local investors’ legitimate interests. As is the case in other Pacific island countries, the land issue is so delicate and intricately connected to people’s perception of inheritance and community that it needs to be tackled sensitively to produce solution that are sustainable in the long term.
Financial Sector
The authorities welcome staff’s appraisal that the commercial banking sector is sound with adequate capital and ample liquidity. Nevertheless, the authorities continue to extend their regulatory efforts to credit unions. The authorities also note that continued reliance on the PFTAC for technical assistance is critical to prepare for a Credit Union Act which will expand the Board’s supervisory mandate of the Banking Board over credit unions. The newly created Insurance Board will also benefit from technical assistance from the Fund and other agencies, to enhance its supervisory capacity and strengthen foreign corporation auditing.
External Stability
We share staff’s view that risks to external stability are relatively contained given that its current account deficits have largely been financed by concessional foreign grants for infrastructure projects. Although this nature helps the FSM’s public debt to remain stable and low as a percent of GDP, the authorities remain mindful of the external risks posed by foreign denominated loans. Given this, the authorities are committed to closely monitoring the pressures from foreign loans and the scheduled reduction of Compact grants, on external stability, and will continue their efforts to reduce heavy external dependence for the energy and foods.