This 2016 Article IV Consultation highlights that the economy of the Marshall Islands is estimated to have expanded by about 0.5 percent in FY2015 (ending September 30), as the fishery sector recovered. Following a moderate inflation of 1.1 percent in FY2014, headline inflation dropped to -2.2 percent in FY2015 amid falling oil and utility prices. The fiscal balance is estimated to have recorded a surplus of about 3 percent of GDP in FY2014-15, owing to record-high fishing license fees. Growth is expected to rise to about 1.5 percent and inflation to about 0.5 percent in FY2016, as the effects of the drought in earlier 2016 are offset by the resumption of infrastructure projects.

Abstract

This 2016 Article IV Consultation highlights that the economy of the Marshall Islands is estimated to have expanded by about 0.5 percent in FY2015 (ending September 30), as the fishery sector recovered. Following a moderate inflation of 1.1 percent in FY2014, headline inflation dropped to -2.2 percent in FY2015 amid falling oil and utility prices. The fiscal balance is estimated to have recorded a surplus of about 3 percent of GDP in FY2014-15, owing to record-high fishing license fees. Growth is expected to rise to about 1.5 percent and inflation to about 0.5 percent in FY2016, as the effects of the drought in earlier 2016 are offset by the resumption of infrastructure projects.

Background

1. The Republic of the Marshall Islands (RMI) is a small and sparsely-populated country, comprising low-lying atolls vulnerable to climate change (Box 1). Its economy is highly dependent on external aid, as the base for private sector growth is limited by its small size, remoteness from major traffic routes, dispersion over a vast ocean area, and weaknesses in the regulatory framework. Over the medium term, the country needs to adapt to rising fallouts from climate change, to prepare for a sharp reduction in the U.S. grants in FY2023, and to enhance the platform for sustainable private-sector growth. A new government was formed in January 2016, headed by the first female head of state elected in the Pacific.

2. Most of the budget grants provided under the U.S. Compact of Free Association (Compact grants) will expire in FY2023, posing a major medium-term fiscal challenge.1 The RMI will receive annual grants averaging US$36 million (20 percent of GDP) over FY2004–23.2 Thereafter, investment earnings from the Compact Trust Fund (CTF)—currently being accumulated—are intended to replace the expiring portion of Compact grants (12 percent of GDP) as a revenue source. While the projected balance ($550 million in FY2023) is likely to generate investment earnings to replace the expiring grants, it will not be sufficient to preserve the real value of CTF (Appendix I). The preservation of the real value of CTF is needed both to safeguard an important resource for future generations and to cope with the market volatility in investment returns.

A03ufig1

Annual Grants Assistance Under the Compact of Free Association

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Sources: Authorities; IMF staff calculations.

3. Relative to the past Fund recommendations, progress has been made including in SOE reforms (Appendix II). Some reforms now await follow-up implementation, while several delayed reforms—tax and social security—need to be resuscitated. Over a longer term, the RMI needs to make progress toward Sustainable Development Goals (SDGs), building on the progress with core Millennium Development Goals (MDGs) (Appendix III). The RMI’s progress in most MDGs was broadly in line with other Pacific islands, while the two MDGs in health areas were achieved fully. This reflected above-average health (and education) expenditures, partly due to a wide geographical dispersion of the population.

Developments, Outlook and Risks

A. Recent Developments and Outlook

4. Real GDP growth is estimated to have returned to a positive territory in FY2015, while CPI inflation has been falling. Overcoming the contraction of the previous year, the economy is estimated to have expanded by 0.4 percent in FY2015, as the fishery sector recovered. Following a moderate inflation of 1.1 percent in FY2014, headline inflation dropped to -2.2 percent in FY2015 amid falling oil and utility prices. Going forward, growth is expected to rise to 1.4 percent and inflation to 0.7 percent in FY2016, as the effects of the drought earlier this year are offset by the resumption of Compact-funded infrastructure spending.3 After several years of growth rebound fueled by the delayed implementation of infrastructure projects, GDP is projected to grow at the potential rate of 1–1.5 percent over the medium term, absent structural reforms.

5. The overall fiscal balance, in surplus over FY2014–15, will likely deteriorate to a deficit over the medium term. The fiscal balance is estimated to have recorded a surplus of about 3 percent of GDP in FY2014–15, due to record-high fishing license fees. It is projected to decline to a smaller surplus in FY2016 and, without reforms, to a deficit of 2 percent of GDP over the medium term owing to the steady decline in Compact grants until FY2023, and sizable transfers to SOEs and the social security system.

6. The current account deficit (including official grants) would likely worsen in FY2016 from an estimated 1.6 percent-of-GDP deficit in FY2015. Weak copra and oil prices4, and higher imports due to the resumption of infrastructure projects are projected to worsen the deficit in FY2016–17. Current account deficits are financed by a stable source of funding largely from the United States and grants from other donors.

7. Banks provide only limited corporate credit despite ample deposits. Private sector credit reached nearly 50 percent of GDP in FY2015, mainly on account of consumer loans (corporate loans represent only 30 percent of total loans). A legislative framework for bankruptcy is missing, and posting property as collateral is hindered by complex land ownership issues. The loan-to-deposit ratio of the banking system remained low, at around 60 percent as of end-FY2015. Interest rate spreads (between lending and deposit rates) were around 5 percent for corporate loans and 13 percent for consumer loans, reflecting high credit risk.

B. External Stability

8. The RMI’s external position is assessed to be broadly consistent with underlying fundamentals, with limited risk of external instability due to stable external funding (Box 2). The current account deficit, once adjusted for a temporary factor, is close to the current account norm as estimated by the standard Fund methodology. The real exchange rate so far in FY2016 is 7 percent above the historical average (FY2004–15), narrowing the scope of possible undervaluation of the past, and is now assessed to be broadly in equilibrium albeit subject to a sizable statistical uncertainty. The U.S. dollar is used as the legal tender adequately reflecting the small economic size and close economic ties with the United States. The risks from a heavy reliance on external financing are limited by stable funding, including the Compact grants until FY2023. Nevertheless, it is desirable to strengthen buffers, in preparation for the post-FY2023 period, including by building up the CTF balance to a level sufficient for preserving its real value and by shoring up government deposits which are the first recourse for absorbing short-term liquidity shocks.

Marshall Islands: Implications of Climate Change

Marshall Islands is one of the most vulnerable countries to climate change and rising sea levels. The related fiscal costs can be large and are explicitly recognized in the macro-framework and the DSA.

Many small island states—especially the atoll nations of the Pacific—are among the most vulnerable to climate change and sea-level rise. Because of their low elevation and small size, low-lying atolls (e.g., Kiribati, the RMI, and Tuvalu) are threatened by future rises in sea level. Depending on carbon emissions, the global mean sea level could rise by up to a meter by 2100 according to the 2014 report of the Intergovernmental Panel on Climate Change (IPCC). This would pose serious risks to the RMI, as a rise of 1 meter could lead to a loss of 80 percent of the land in the capital city of Majuro (IPCC 2001; Calderon and others, 2015).

A03ufig2

Sea-Level Rise Projections for the Marshall Islands

(centimeters)

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Source: Marshall Island National Weather Service Office.Note: The projections for the A1B (medium) emissions scenario (representing 90 percent of the range of models) are shown by the shaded green region. Changes are relative to the period 1980-99.

RMI is already becoming more vulnerable to extreme weather events. With average elevation of just 2 meters above sea level, inundations and large storms are already becoming an increasing threat to the Marshall Islands. In 2008, extreme waves and high tides caused widespread flooding in Majuro, resulting in the government declaring a state of emergency. In 2013, the northern atolls experienced serious drought, resulting in the U.S. President declaring an emergency that activated US$5.5 million (3 percent of GDP) of drought relief from the United States under the Compact Agreement. In February 2016, the government declared a state of emergency, citing severe drought conditions, consequence of a protracted El Niño system that started building up in early 2015, which was followed by a declaration of emergency by the U.S. President, activating support from the Federal Emergency Management Agency (FEMA).

In this context, climate change can lead to both structural and cyclical fiscal costs.

  • The structural component (2.5 percent of GDP per year) is related to the cost of preparing for climate change, including by building coastal protection. The relative costs of coastal adaptation vary strongly among regions, but small island states are expected to face costs of several percentage points of GDP a year, since most of their population and infrastructure are in the coastal zone (IPCC, 2014). The ADB has estimated these costs in the order of 1½–2½ percent of GDP annually for the Pacific region (ADB, 2013). We take the higher end of this range for the RMI, given its higher vulnerability.1

  • The cyclical component (10 percent of GDP over 20 years) is related to the fact that climate change is a contributing factor to extreme weather events. The Pacific Catastrophe Risk Assessment and Financing Initiative (PCRAFI) reports that disaster-related losses and damages of 10 percent of GDP could occur once every 20 years in the RMI (PCRAFI, 2011).

1 The IPCC (2014) models suggest that the costs of sea level rise impacts as a percentage of GDP would be highest for the Federated States of Micronesia, Palau, Marshall Islands, and Nauru in the Pacific and Bahamas in the Caribbean.

Marshall Islands: External Sector Assessment

On balance, the external position appears to be broadly consistent with underlying fundamentals and risks to external stability are limited owing to stable source of funding from the United States and other donors.

Exchange rate Assessment. The current account balance, once adjusted for the effect of a temporary hold of capital grants (in FY2014–15), is close to the current account norm estimated by the standard Fund methodology (the EBA-lite). While the ELRER approach suggests a moderately weak external position, a larger-than-usual margin of statistical variation may be warranted, given data limitations of the RMI. On balance, the level of the exchange rate is assessed to be broadly consistent with the macroeconomic situation, with little evidence of substantial exchange rate misalignment.

Marshall Islands: Real Exchange Rate Assessments for 2015 (in percent)

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Source: Fund staff caluclations

ECA approach calculates the difference between the CA balance and an estimated CA “norm”.

Adjusted for the import compression induced by a temporary hold on Compact capital grants.

CA numbers are in percent of GDP.

Competitiveness. The RMI’s manufacturing unit labor cost has increased steadily, outpacing the United States in recent years. This is due to shortage of skilled workers, aggravated by ongoing migration of workers to the United States, reflecting the wage differential which is a strong incentive for migration for the Marshallese citizens who can work and study in the United States without a separate permit under the Compact Agreement. Such developments do not necessarily worsen external stability as manufacturing exports are already very small and because migration to the United State can increase remittance inflows.

Net Migration from the RMI to the U.S.

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Source: RMI FY2014 Economic Review (PITI).
A03ufig3

Unit Labor Cost (FY1997-2015)

(1997 = 100)

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Source: Authorities, FRED.
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Average Public and Private Sector Wages

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Sources: Authorities; FRED.1/ Public sector refers to RMI government and local government only.2/ Increased migration to Arkansas, U.S. has been identified.

Reserves. With no central bank or local currency, government’s deposit serves as the means to absorb short-term liquidity shocks. The government’s deposit was around 0.5 months of imports in 2015, slightly lower than the historical average (0.7 months over 21 years), although the steady flow of external grants has shielded the RMI from liquidity squeezes.

External Financing. Current account deficits are financed by a stable source of funding largely from the United States. External debt is expected to decline as concessionary loans are paid down in the coming years.

C. Risks and Spillover

9. Risks to the outlook are tilted to the downside, albeit limited by several mitigating factors (Appendix IV). External risks stem from extreme weather-related events, faster-than-anticipated rise in fuel prices, persistently low rates of return on financial assets in the CTF, and potential loss of a correspondent banking relationship. Domestic risks include delays in the implementation of infrastructure projects and inadequate fiscal consolidation. Finally, DSA analysis indicates that the RMI continues to remain at a high risk of external debt distress, but these risks are mitigated by a number of factors, including concessionality of most obligations, stable flow of funds from Compact grants until FY2023, and future investment income from the CTF (after FY2023). On the upside, a decisive push for structural reforms could stimulate growth (see below). Moreover, if downside risks were to materialize, the authorities could accelerate infrastructure spending, financed by allocated but unused funds for capital spending (cumulated sum of 18.5 percent of GDP by FY2015).

10. Repercussions on the RMI from global developments after the Brexit vote are anticipated to be limited. Due to limited international linkages other than to the United States via the Compact agreement, the RMI remains fairly isolated from spillovers from external developments. Even if U.S. growth were to slow or the currency to appreciate, the U.S. grants to the RMI would remain unchanged at their pre-allocated levels until FY2023. While the RMI’s ship registry business could be affected by a slowdown in global trade, the registry business itself is conducted by an offshore entity which is linked to the domestic economy by a pre-determined annual payment to the RMI government (to be renegotiated in 2019). A possible long-term decline in global asset returns adds to the existing risk factors for managing the CTF.

The Authorities’ Views

11. The authorities broadly agreed with the staff assessment on economic outlook. Economic activity was expected to pick up in 2016, albeit gradually owing to possible delays in the disbursement of Compact infrastructure grants and the drought in early 2016. They agreed that, over the medium term, the execution of Compact infrastructure projects will help support growth, while also agreeing with the view that long-term growth potential will remain limited in the absence of a decisive structural reform. The authorities agreed that foreign grants would continue to provide stable funding for current account deficits.

12. The authorities considered climate change, social security fund liabilities, and public debt to be the main risks to the outlook. Extreme weather episodes due to climate change, such as droughts, have adversely affected the country in recent years and are becoming more frequent. They noted the large looming contingent liabilities from the social security fund, in the absence of a reform that puts the system on a sustainable path. The authorities also highlighted the still relatively high level of public and publicly-guaranteed debt as a constraint on future prospects.

Securing Fiscal Sustainability

13. A medium-term fiscal adjustment is needed to achieve long-term sustainability and build buffers against existing vulnerabilities. Staff analysis indicates that a fiscal surplus of 3 percent of GDP by FY2023 could help ensure the long-term sustainability of the CTF by preserving its real value, under the expected nominal return of 5 percent per year.5 This would entail a cumulative fiscal adjustment of 5 percentages points of GDP over seven years, relative to the baseline under which the fiscal balance would deteriorate to a deficit of 2 percent of GDP by FY2023. An adequate adjustment could strengthen fiscal buffers against vulnerabilities including: an outstanding debt which is one of the highest among Pacific small states, substantial contingent liability from SOE subsidies and social security system, the volatility in CTF returns, and prospective costs from climate change.

14. The staff-recommended surplus target can be attained by undertaking the fiscal adjustment envisioned in the Decrement Management Plan (DMP), complemented by additional reforms. The authorities developed the DMP as an indicative outline in the face of declining Compact grants but have yet to incorporate it in medium-term budget plans. Fully implemented, the DMP can generate a gradual fiscal adjustment of 4 percentage points of GDP over the remaining seven years of the amended Compact agreement. Additional adjustment of at least 1 percentage point of GDP can come from further reducing SOE subsidies, enhancing tax administration and strengthening tax reforms.

Fiscal Savings under the Decrement Management Plan (DMP), Cumulative Savings by FY2023 Compared to end-FY2014 Outturn

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Sources: Republic of the Marshall Islands, Decrement Management Plan (FY2015-23); IMF staff estimates.
  • Expenditure compression. Major components are cuts in the government’s goods and services current expense, SOE subsidies, and utility transfers, which would add up to savings of 3½ percent of GDP by FY2023 (text table). Staff supports the authorities’ initiative for rationalizing current expenditures (including costs of travel, supplies and personnel) through efficiency improvement. This can be best achieved when implemented gradually—to smooth growth impact—and in combination with public financial management (PFM) reforms. Staff also encourages reducing SOE subsidies—6 percent of GDP in FY2015—further than planned under the DMP.

  • Revenue mobilization. The DMP incorporates a tax reform with an estimated revenue impact of ½ percent of GDP, while a larger revenue mobilization will be possible once the new tax system is in place. In line with the Pacific Financial Technical Assistance Centre (PFTAC) recommendations, staff encourages the authorities to push ahead with the reform which includes: (i) reforming the personal income tax; (ii) introducing a net profits tax; (iii) introducing a consumption tax to replace the Gross Revenue Tax (GRT); and (iv) replacing the existing import duties on alcohol, tobacco, motor vehicles and fuels with excise taxes. While the tax reform is still under review, the authorities incorporated into revenue a substantial portion of fishing license fees collected by the Marshall Islands Marine Resource Authority—80 percent of surplus revenues beyond US$3 million—starting in FY2015.

  • To facilitate domestic revenue mobilization further, staff also advocates further enhancing tax administration along the latest PFTAC recommendations, by improving core tax functions such as tax payers’ services, collection of tax arrears and outstanding returns, and the audit function.6

A03ufig5

Fiscal Balance Path

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Source: Authorities; IMF staff calculations.

15. As a precondition for these medium-term fiscal adjustments to succeed, the social security system needs to be put on a sustainable path and avoid adding a large fiscal drain. Under the current structure, the social security fund (SSF) could deplete its reserves after FY2022. Staff supports adopting a reform plan with the following main elements: (i) raise the normal retirement age from 60 to 65; (ii) phase in a less costly benefit scheme plan over several years, with some grandfathering of current retirees; and (iii) strengthen enforcement of contributions and increase the contribution rates. An increase in government funding may be inevitable during the transition to a new system, but caution is strongly urged to guard against institutionalizing it or delaying the reform.7

A03ufig6

Marshall Islands: Social Security Fund

(In million USD)

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Sources: MISSA; IMF staff calculations.

16. Improving PFM will play a critical role in implementing fiscal adjustment and safeguarding fiscal sustainability. Staff welcomes the authorities’ renewed focus on PFM reforms, including on process and human resources management. It is important to move expeditiously toward the full implementation of this reform, which is much needed given existing weaknesses in tax administration, budget execution, reporting, and planning that can hamper fiscal adjustment.

The Authorities’ Views

17. The authorities agreed with the need for fiscal adjustment to preserve the real value of CTF. They recognized the necessity to maintain a sizable fiscal surplus and to keep contributing to the CTF, as recommended by the staff. In FY2016, the authorities contributed US$2.2 million to the CTF. The authorities agreed that a comprehensive reform is required to make the SSF sustainable and in May 2016 set up a task force to recommend reform options to the Cabinet and Parliament. The Ministry of Finance (MoF) was focusing on the human resources management improvement plan as a cross-cutting foundation to ensure the sustainability of PFM reforms, while rallying broader and greater support for many other reforms. In particular, tax reform—deemed necessary by the authorities—might require a recalibration that addresses key concerns of the private sector, before being resubmitted to the new parliament.

Adapting to Climate Change

18. The RMI is one of the countries expected to be most affected by climate change and rising sea levels. Climate change is expected to lead to both structural and cyclical fiscal costs. The structural component (2.5 percent of GDP per year) is related to the ex-ante cost of preparing for climate change, including by building coastal protection, and is recognized in the baseline medium-term fiscal projections and the DSA. The cyclical component (10 percent of GDP over 20 years), due to extreme weather events, is recognized as a contingent liability shock in the DSA.

19. Staff supports the authorities’ intensified efforts to mitigate disaster risk and build resilience. Recognizing that most disasters that would hit the RMI would be climate-change related, the authorities have prepared a Joint National Action Plan (JNAP), which includes climate-change adaptation and disaster risk-management strategies comprising both ex ante and ex post measures. The disaster-response costs could be covered by contingency buffers, disaster risk insurance, and emergency support. The RMI has a maximum amount of US$15.6 million (8 percent of GDP) available in ex-ante instruments to facilitate disaster response, and can also access emergency support from relevant U.S. agencies (FEMA/USAID) per the Compact agreement.

Marshall Islands: Ex-Ante and Ex-Post Resilience Mechanisms

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Sources: Pacific Catastrophe Risk Assessment and Financing Initiative (PFRAFI); and IMF staff estimates.

20. Staff also recommends explicitly recognizing the adaptation cost in budget and seeking donor funding. Explicit budgeting will help ensure the continuity—despite medium-term fiscal adjustment—and efficiency on both spending and funding fronts. The structural expenditure should incorporate climate-related costs implicit in other line items, including extra construction costs for flood-proof structures. Where possible, donor funding (including from the new Green Climate Fund) should be sought, considering fiscal constraints of the RMI. Related, the Ministry of Finance has established a new office—Division of International Development Assistance (DIDA)—to coordinate all international development assistance, including for climate change. The authorities are working with the World Bank on the preparation of a Climate Resilience Project for FY2017, which would help strengthen disaster early warning, improve coastal protection and planning, and provide contingency funds for emergency response to medium-size hazards, including drought and flooding.

The Authorities’ Views

21. The authorities agreed on the benefit of strengthening planning capacity, including by explicitly recognizing climate change related expenditure in the budget. They noted that there were already many related expenditures, for example in the form of climate-proofing the airport and schools, but it was viewed to be difficult to track the exact amount for all such expenditures. The authorities also noted that they would continue to participate in the Pacific Catastrophe Risk Assessment and Financing Initiative (PCRAFI) pilot insurance program, which provides coverage against tropical cyclones until October 2018. But they would also seek other recourses—self-insurance, other donors (e.g. FEMA), or other insurance arrangements—that could cover “medium-size” risks such as droughts.

Facilitating Private Sector Growth

22. SOE reforms will be the first step to facilitating private sector development, a necessity for sustainable growth as external funding declines. The underperforming SOE sector has not only added to the fiscal burden but may also have limited business opportunities for the private sector. The authorities made progress by restructuring the Marshall Energy Company (MEC), and by legislating the State-Owned Enterprise Act in October 2015 (Box 3). The Act, supported mainly by the ADB, purports to strengthen the corporate governance and monitoring framework, and to turn SOEs at least as profitable and efficient as comparable businesses. Staff commends the authorities for the progress made and recommends additional steps: clarifying the justification of subsidies based on the community service obligations (CSOs) of SOEs, and introducing a centralized monitoring unit for SOE performance. By increasing the transparency of the communal and commercial operations of SOEs, these measures would help improve the efficiency of SOEs and reduce government subsidies. And limiting SOE subsidies to CSOs will strengthen the discipline on SOEs, level the playing field for commercially viable businesses and improve the environment for private sector growth. On these grounds, staff advocated upholding the efficiency-enhancing goal of the SOE Act. However, some counterparts expressed reservations about an amendment to the SOE Act in March 2016, which raised the limit on the number of public officials who can serve on SOE Boards from one to three, noting that it may intensify political interference.

23. The environment for investments could be further improved by reducing other impediments to doing business. Based on the World Bank’s ease of doing business survey, registering property and resolving insolvency were two major concerns.8 Land registration reforms can help collateralize properties—thereby improving access to credit—and lower hurdles for long-term land leases by nonresidents—thereby facilitating foreign direct investment (FDI). Introducing an insolvency law will provide a missing legislative framework for bankruptcy. In that context, some private sector representatives expressed optimism on potential niche tourism and aquamarine projects, albeit pending the improvement in tourism-related infrastructure and ease of travel. Staff agreed that the RMI appeared to have potential comparative advantage in those areas.

Marshall Islands: SOE Reforms

SOEs—currently 11 in the RMI—have been incurring losses and receiving government subsidies since FY2004, with significant macroeconomic consequences due to their size. SOEs have total assets of about US$150 million (80 percent of GDP) and generate 7.5 percent of total employment.1 They had in FY2014 a loss of US$9.9 million and subsidies of US$7.4 million (5.3 percent and 4 percent of GDP).

  • The Marshalls Energy Company (MEC) implemented a comprehensive reform covering governance and financial performance. Through continuous effort and ADB support since 2008, the MEC registered a net operating income of US$0.1 million in FY2014. In 2011, MEC adopted a new tariff template that better aligned the costs and revenues of electricity business. The MEC retired its commercial debt with an ADB loan improving cash flow, improved the efficiency of electricity generation, and retrofitted all Majuro public streetlights to more efficient LED lights (reducing its nonrevenue generation ratio). The recent decline in oil prices was partly passed on to consumers through an electricity tariff cut in December 2014—even lowering CPI inflation—while the tariff rates are still below the cost-recovery level.

  • The State-Owned Enterprise Act was approved by the parliament in October 2015. This Act strengthens the corporate governance and monitoring framework, which has been identified as a priority for better performance. Given the evidence that good corporate governance rests on a foundation of law and regulation in the long run, many countries are introducing legislation, ownership rules and guidelines, and monitoring structures to place SOEs on a firm commercial footing (ADB, 2011).

A03ufig7

SOEs Operating Losses and Subsidies

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Sources: IMF staff calculations.
1 Four large SOEs that account for 88 percent of total SOE assets are: Marshall Island Ports Authority, National Telecommunications Authority, Marshall Islands Development Bank (MIDB), and MEC.

The Authorities’ Views

24. There was general agreement about the need to accelerate SOE reforms, in particular on delineating CSOs and reducing government subsidies. The authorities noted that the clarification of CSOs is key for the legitimacy of continuing SOE subsidies, and was preparing for the creation of a monitoring unit within the MoF. This would need to be reinforced with PFM reforms, in particular in the areas of program audit and budgeting. The SOE Act amendment on the board composition was to retain the flexibility to tap expertise resident in the public sector. While acknowledging that there was limited voluntary participation in land registration, the authorities hoped that registration would get more active with the re-funding of the registry office in FY2017.

Enhancing Financial Stability

25. Strengthening the regulatory framework will be critical to safeguard financial stability, including by strengthening the capacity and oversight authority of the Banking Commission. Household debt is high, estimated at about 60 percent of total employee’s compensation as of FY2015. The Banking Commission could consider a ceiling on the debt service ratio, and introduce stricter criteria on non-performing loan classification. Staff continues to urge the authorities to broaden the Banking Commission’s oversight to the Marshall Island Development Bank (MIDB) and supports the MIDB’s effort to refocus on its core mandate of providing commercial lending rather than consumer loans.

26. Some progress is being made to respond to challenges related to withdrawal of correspondent banking relationships (CBRs) (Box 4). The RMI’s sole domestic commercial bank could lose its CBR with a U.S.-based bank as a result of heightened due diligence by banks in the United States. The consequent loss of access to the U.S. payment and settlement services, given the use of the U.S. dollar as legal tender, could disrupt cross-border payments and economic activity, as well as weaken financial inclusion for outer islands serviced by the domestic bank. In response, the authorities are drafting a new Anti-Money Laundering (AML) legislation in line with Financial Action Task Force (FATF) standards and United Nations Convention against Corruption (UNCAC) rules, have hired external consultants and met with U.S. officials, and also attended in early April a LEG/STI-organized workshop on implementing the international AML/CFT (Combating the Financing of Terrorism) standards. Staff encouraged the authorities to strengthen the implementation of AML/CFT requirements, particularly in relation to Know-Your-Customer requirements, and have an open and regular dialogue with U.S. regulators.

The Authorities’ Views

27. The authorities agreed on the need to enhance the capacity of the Banking Commission to carry out inspections. They agreed with the merit of a ceiling on the debt service ratio and stricter criteria on non-performing loan classification. The Banking Commission shared staff’s view that the MIDB should be brought under its oversight but highlighted that this would require legislative action. The authorities also noted that they were making progress on measures against money laundering, and preparing a legislation to have wider oversight power on AML/CFT related matters.

Marshall Islands: Withdrawal of CBRs

Marshall Island’s sole commercial bank’s CBR with a U.S.-based bank has recently become more difficult.

Background. The RMI’s only domestic commercial bank has had a CBR with a U.S.-based bank (First Hawaiian Bank, a subsidiary of BNP Paribas), and was recently notified that it may terminate the relationship, due to concerns about the cost of complying with new U.S. regulations, including on AML. As of May 2016, however, the planned termination of the relationship was put on hold.

Drivers. A recent IMF survey found that many Pacific islands are experiencing negative effects from the withdrawal of CBRs. Outside the Pacific, there is evidence that similar developments are also taking place in the Caribbean, Middle East, and North Africa. The terminations of CBRs are due to several factors, including the enforcement of stricter global regulatory standards, prudential regulations, sanctions, and tax and AML/CFT requirements. As a result, some business lines are being perceived as too costly in terms of compliance, and therefore being cut off by global banks.

Offshore companies. According to the latest AML/CFT assessment by the Asia Pacific Group (APG), the FATF-style regional body of which the RMI is a member, vulnerabilities derive mainly from RMI’s offshore company registration sector. For registered non-resident entities, there is no mandatory requirement for legal persons to provide information either on the legal or beneficial ownership of shareholders.

Remittances. The cost of transferring remittances to Pacific islands has increased as global banks have closed bank accounts of small money transfer operators, forcing transfer of remittances only through banks. This could be an additional issue for the RMI, given its high reliance on remittances. So far, however, the cost of transferring remittances to the RMI has not been affected significantly, as almost all the remittances come through two large operators (MoneyGram and Western Union) that have existing partnerships with banks.

Staff Appraisal

28. The economy faces the medium-term challenge of coping with the reduction in Compact grants from the United States after FY2023, climate change, and limited private sector growth. The fiscal balance is likely to fall into deficit in the medium term without a sustained fiscal adjustment, undermining long-term self-sufficiency.

29. Ensuring fiscal sustainability over the medium term calls for decisive fiscal adjustment and social security reform. Staff encourages that the medium-term budget plans incorporate the fiscal adjustment plan (envisioned in DMP) in response to the scheduled decline in U.S. Compact grants until FY2023, complemented by reforms of the social security and tax systems. Welcoming the formation of a taskforce for social security reform, staff urges timely action to eliminate the risk of a potentially large drain on the government budget. Staff supports the renewed focus on PFM and looks forward to further progress.

30. Continued vigilance is warranted for both structural and cyclical fiscal costs stemming from climate change. Staff supports the authorities’ intensified efforts to mitigate natural disaster risk and build resilience, including through the Joint National Action Plan (JNAP). Explicit budgeting of adaptation costs would also improve the efficiency on both spending and funding fronts.

31. SOE reforms should continue, including to facilitate private sector growth. Staff commends the authorities for restructuring the Marshall Energy Company and enacting the State-Owned Enterprise Act in October 2015. Building on the Act, staff recommends clarifying community service obligations of SOEs and introducing a centralized monitoring unit for SOE performance.

32. To ensure financial stability, the regulatory and supervisory framework should be strengthened. Strengthening the Banking Commission’s regulatory capacity, including by broadening its oversight to development banks and other entities, continues to be a priority. To deal with potential challenges related to withdrawal of correspondent banking relationships, the authorities should continue to address regulatory gaps, including by bringing the AML legislation in line with international standards, and maintain a close dialogue with the U.S. regulators.

33. The external position is broadly consistent with underlying fundamentals and risks of external instability remain limited. The estimated current account gap is small and relatively stable external funding is available for current account deficits at least until FY2023. Thereafter, external stability can be enhanced by stronger buffers including an adequate CTF balance (enough to preserve its real value).

34. The quality of official statistics is broadly adequate for surveillance, but should be improved. Efforts to improve the coverage and timeliness of official data, in particular for external and financial sector statistics would help strengthen surveillance and policy formulation.

35. It is recommended that the next Article IV consultation take place on the current 24-month cycle.

Figure 1.
Figure 1.
Figure 1.

Marshall Islands: Real Sector Developments

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Sources: Country authorities; and IMF staff estimates.
Figure 2.
Figure 2.
Figure 2.

Marshall Islands: Fiscal Developments

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Sources: Country authorities; and IMF staff estimates.
Figure 3.
Figure 3.
Figure 3.

Marshall Islands: External and Credit Developments

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

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

Marshall Islands: Basic Data, FY2012–21 1/

Nominal GDP for FY2015 (in millions of U.S. dollars): 184.6

Population (2015 est.): 52,900

GDP per capita for FY2015 (in U.S. dollars): 3489.6

Quota: SDR 3.5 million

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Sources: RMI authorities; and IMF staff estimates and projections.

Fiscal year ending September 30.

Includes capital grants.

Public and publicly-guaranteed external debt.

Table 2.

Marshall Islands: Statement of Government Operations, FY2012–21 1/

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Sources: RMI authorities; and IMF staff estimates and projections.

Fiscal year ending September 30.

Does not include Compact funds earmarked for Kwajalein rental payments and Trust Fund contributions.

Net operating Balance is the difference between revenue and expense

Table 3.

Marshall Islands: Balance of Payments, FY2012–21 1/

(In millions of U.S. dollars)

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Sources: RMI authorities; and IMF staff estimates and projections.

Fiscal year ending September 30.

Includes capital grants.

Errors and omissions averaged $20 million during FY2004-2014.

Table 4.

Marshall Islands: External and Financial Sector Vulnerability Indicators, FY2012–21

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Sources: RMI authorities; and IMF staff estimates and projections.

The deposit decline in FY2012 is due to expatriation of rent income received by Kwajalein landowners in previous years.

Includes capital grants

Measured by the end-of-period stock of government financial assets held in commercial banks.

Public and publicly-guaranteed external debt.

Table 5.

Marshall Islands: Deposit Money Banks, FY2012–15

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Sources: RMI authorities; and IMF staff estimates.

Fiscal-year basis - 5 quarter average.

Includes deposits of Social Security administration and other trust funds.

Year average

Average of rates offered by deposit money banks.

Average of minimum rates offered by deposit money banks.

Average of maximum rates charged by deposit money banks.

Appendix I. The Compact Trust Fund and Its Long-term Outlook

The Compact Trust Fund is expected to build sufficient resources to compensate for expiring Compact grants in FY2023. But, to preserve the value of the fund in real terms, fiscal surpluses are needed.

The Compact Trust Fund (CTF) was created in 2004 to contribute to the long-term budgetary self-reliance of the RMI. The fund aims to provide the RMI with an ongoing source of revenue after the Compact Agreement with the U.S. terminates in FY2023. In particular, US$27 million (12 percent of GDP) of Compact-related grants are expected to be terminated in FY2024.

Structure of the fund. The contributions to the CTF are not available for withdrawal prior to FY2024. From FY2024 onwards, annual investment earnings from the CTF can be withdrawn to finance budget needs up to a limit.1 In years when investment earnings are not sufficiently high, the C account of the fund can be used to make up for the shortfall.2 A separate account (Account D) to which the RMI and Taiwan Province of China (POC) have contributed can also be used as a buffer, as long as its assets exceed US$10 million.

Contributions to the fund. The value of the CTF (excluding the D account) was US$247 million as of end-FY2015. Of this amount, US$181 million came from contributions, particularly from the RMI (US$31 million), Taiwan POC (US$21 million), and the United States (US$129 million). Moreover, the D account of the CTF has received contributions from the RMI and Taiwan POC, and held US$12 million as of end-FY2015.

Fund performance. The current investment strategy of the CTF (in place since October 2012) stipulates that 60 percent of the fund is invested in equities, while the rest is split between fixed income (20 percent) and alternative investments (20 percent). As of end-FY2014, the fund’s average annual nominal return rate since inception was 6.0 percent, net of fees. As of end-FY2015 (at a relatively low point in financial markets due to the summer market turmoil in 2015), the average return declined to 4.9 percent, although it has bounced back toward its previous historical average since then.

A03ufig8

Marshall Islands CTF: Weighted Annual Investment Return

(Percent)

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

Sources: Fiscal Year 2015 Annual Report.

Governance of the fund. The CTF is administered by an independent committee that exercises oversight and fiduciary responsibility over the fund (except for the D account). Four voting members on the committee are appointed by the United States (from Departments of Education, Interior, and State), two by the RMI, and one by Taiwan POC. A custodian bank (State Street Bank) and a professional investment advisor (Mercer Investment Management) help manage the fund.

Review. An independent external evaluation of the fund was conducted in FY2015. The review found the fund to be generally well governed and its service provider performance in line with industry standards. It recommended working with the investment adviser to apply a “glide path” toward a more conservative investment strategy to protect capital, as the build-up period nears its end. This may reduce the volatility and absolute level of returns over time.

Scenarios

Two scenarios are considered to assess the long-term outlook and the implications for RMI’s fiscal sustainability. Under the baseline scenario, the projected value of the CTF is likely to generate sufficient income to supplement the expiry of Compact grants in FY2023, but not preserve the real value of the CTF. In the policy action scenario, the real value of the CTF is preserved.

Baseline scenario. If the fund averages a 5 percent nominal return annually from FY2016 onwards, the distribution from the estimated assets for FY2024 would probably provide revenue equivalent to about 132 percent of the Amended Compact’s Section 211(a) FY2023 sector grant level. Under this scenario, however, long-term self-sufficiency would not be secured because the real value of the CTF will likely decline over time. Therefore, in the baseline scenario, the government would either need to erode the real value of the CTF or face a large budgetary shortfall (about 3 percent of GDP). Moreover, it should be noted that even achieving this simple level of sufficiency does not eliminate the risk of subsequent fiscal shocks if the CTF investment returns are weak for a number of years.

A03ufig9

Compact Trust Fund Balance1/

(In millions of FY2015 dollars)

Citation: IMF Staff Country Reports 2016, 260; 10.5089/9781475520521.002.A001

1/ Includes the market value of the CTF and accumulation of fiscal surpluses.2/ Assume 5 percent return from FY 2016, with no fiscal adjustment.3/ Assume 5 percent return from FY 2016, maintain fiscal surplus of 3.0 percent by FY 2023.4/ Assume 4 percent return from FY 2016, maintain fiscal surplus of 3.0 percent by FY 2023.Source: Fund staff estimates.

Policy action scenario. Under this scenario, the government is assumed to undertake a fiscal adjustment of 5 percent of GDP over the medium-term (from FY2017 to FY2023) to build a budget surplus of 3 percent of GDP by FY2023 and transfer the surpluses to the CTF. Under this course of action, the real value of the CTF would be preserved.

Sensitivity to investment returns. However, this outcome is sensitive to the assumption on CTF annual investment returns, which have been volatile in the past. By staff estimates, a 0.5 percentage point decrease in expected returns would increase the fiscal adjustment need to by 1 percentage point of GDP from the suggested policy action scenario.

Appendix II. Main Recommendations of the 2013 Article IV Consultation

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Appendix III. MDG and Strategic Surveillance Matrix

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Appendix IV. Risk Assessment Matrix /1

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The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly. The blue arrows indicate whether the risk is to the upside or downside.

1

The government’s fiscal year ends on September 30 of each calendar year. The amended Compact Agreement took effect in FY2004.

2

This grant amount has already been appropriated by the U.S. Congress and is thus allocated and secured, while annual disbursement follows steps required under the Compact agreement.

3

A temporary hold had been placed on Compact infrastructure projects, pulling down GDP growth over FY2014–15.

4

Oil re-exports are a major component of the RMI’s exports.

5

As discussed in Appendix I, a 0.5 percentage point decrease in expected returns would increase the fiscal adjustment need by 1 percentage point of GDP.

6

Strengthened tax audits uncovered tax under-reporting of about ½ percent of GDP per year in FY2013–14.

7

The impact on growth will be small, because the direct income effects of later retirement age and higher contributions largely offset each other, while indirect (second-round) income effects would be limited by low fiscal multipliers reflecting the very high openness of the RMI’s island economy.

8

These indicators should be interpreted with caution due to a limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints and information availability.

1

Annual distributions from the CTF, starting in FY2024, can only come from investment earnings from the previous year up to a maximum limit equivalent to expired grant assistance amount as of FY2023, fully adjusted for inflation.

2

Investment earnings above 6 percent are transferred to the C account of the fund. The C account is capped at three times the projected grant assistance in FY2023. As of end-FY2015, it held US$48 million (nearly two times the projected amount).

Republic of the Marshall Islands: 2016 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Republic of the Marshall Islands
Author: International Monetary Fund. Asia and Pacific Dept