Republic of Palau: Staff Report for the 2016 Article IV Consultation
Author:
International Monetary Fund. Asia and Pacific Dept
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Publication Date:
19 Oct 2016
eISBN:
9781475545937
ISBN:
9781475545937
Language:
English
Keywords:
ISCR; CR; government; government reform effort; infrastructure investment; Palau; government deposit; net worth position; government support; CTF assets; government cash
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Palau is a middle-income micro state in the Pacific (population: 18,000) that relies heavily on tourism and grants, and is exposed to natural disasters. The economy grew strongly at 9.4 percent in FY2015 led by robust tourism and construction activity, but the surge in tourist arrivals strained infrastructure and was tilted to low budget tourism. The fiscal position has improved, but further efforts are needed to ensure long-term fiscal sustainability. The outlook is favorable although subject to significant downside risks. The discussions focused on

Abstract

Palau is a middle-income micro state in the Pacific (population: 18,000) that relies heavily on tourism and grants, and is exposed to natural disasters. The economy grew strongly at 9.4 percent in FY2015 led by robust tourism and construction activity, but the surge in tourist arrivals strained infrastructure and was tilted to low budget tourism. The fiscal position has improved, but further efforts are needed to ensure long-term fiscal sustainability. The outlook is favorable although subject to significant downside risks. The discussions focused on

Context

1. Palau is a middle-income micro state in the Pacific that relies heavily on tourism and grants, and is exposed to natural disasters and climate change. The country was hit by a severe drought early this year associated with El Niño weather conditions, which led the authorities to ration water consumption and declare state of emergency in March and April (Appendix I). Palau’s political system is based on the U.S. model, the presidential term is four-year, and the next elections are in November 2016. President Remengesau Jr. is well regarded for his environmental initiatives such as the world’s first shark sanctuary created in 2009 and the world’s largest marine sanctuary created in 2015 (Appendix II). Palau’s legal tender is the U.S. dollar and its fiscal year ends in September.

2. Palau became independent in 1994 after being under U.S. administration. As part of a 50-year Compact of Free Association, the United States provided US$580 million in financial aid to Palau during 1994-2009 for infrastructure investment, budget support, and the establishment of a Compact Trust Fund (CTF). The CTF, with an initial investment of US$70 million, was to provide Palau with US$5 million in FY1999–09 and US$15 million in FY2010–44. But the CTF funds proved insufficient and a new agreement extending financial assistance for another 15 years was signed in 2010. The new assistance included US$30 million for the CTF, US$122 million in current grants, and US$67 million for infrastructure. However, the agreement has not been ratified by the U.S. Congress, although Palau continues to receive current grants and CTF withdrawals. The projections below assume that the agreement is ratified in FY2017, with the funds evenly disbursed during FY2018–24. Palau would face a drop in government revenue after FY2024 when the Compact grants expire, but it would continue to receive US$15 million in CTF withdrawals until the CTF is exhausted.

3. Palau’s economic policies in FY2014-15 were broadly in line with past IMF advice (Appendix III). The fiscal position has improved thanks to spending restraint, and a tax reform bill was sent to Congress in FY2014, which is pending approval. Basic infrastructure and internet connectivity are being upgraded through ongoing projects. Efforts to expand financial supervision to the National Development Bank of Palau and other non-bank financial institutions are also underway.

Current Developments, Outlook and Risks

4. Growth. The economy grew strongly in FY2015 at 9.4 percent, significantly faster than other Pacific island countries, with tourist arrivals and construction activity expanding by 35 percent. But the boom in tourism strained infrastructure (water, sanitation, and waste disposal), was tilted to low budget tourists, led to a rise in low quality hotels, and put the environment at risk (Appendix IV). As a result, the authorities have limited the number of charter flights and tourist arrivals have slowed in FY2016. Construction was buoyant in FY2015 due to the development of infrastructure and new hotels. The recent drought had a limited impact on growth due to its short duration and the small size of the agricultural sector. Growth is projected at zero in FY2016 due to lower tourist arrivals and a modest impact from the drought, but to rise to 5 percent in FY2017 as tourism recovers with the entry of new hotels and construction picks up. In the medium term, growth would gradually moderate to 2 percent as hotel developments are restricted until infrastructure has been upgraded.

A01ufig1

Palau: Tourist Arrivals

(In thousands)

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Sources: National authorities; and IMF staff estimates.

5. Inflation and credit. In line with global trends, inflation fell to 2.2 percent in FY2015 as food and fuel prices declined and it is expected at 2 percent in FY2016–17 as commodity prices stabilize. Banks continue to lend little domestically despite the rapid rise in deposits, investing most of their assets abroad. Domestic loans fell by 2.5 percent in FY2015, with the loan-to-deposit ratio declining to 13 percent. The ceiling on lending rates for commercial loans and the lack of business plans and financial statements for small and medium size enterprises (SMEs) are likely at the root of this issue.

6. External Stability. The external position has improved. The current account deficit shrank from 12 percent of GDP in FY2014 to 0.5 percent in FY2015, mostly due to a fall in fuel imports by 10 percent of GDP, but lower food imports and higher tourism receipts also helped. Capital grants and FDI inflows exceeded the current account deficit by a wide margin. The current account deficit is expected to rise to 7 percent of GDP in FY2016-18 due to higher imports relating to fiber optic cable and sanitation projects financed with AsDB loans; and it is projected to stabilize at 5.5 percent of GDP in the medium term due to higher commodity prices and infrastructure related imports financed with Compact grants. These deficits would remain fully financed with capital grants and FDI inflows.

7. Risks. Palau’s positive outlook is subject to substantial downside risks due to its high reliance on tourism, grants, and commodity imports (Appendix V). U.S. dollar appreciation, a slowdown in key trading partners, and natural disasters could hurt tourism. Higher commodity prices could make food and fuel imports costlier. Further delays in ratifying the Compact agreement with the United States could complicate financing of fiscal and external balances. A continued strong influx of low budget tourists and further increase in low quality hotels could position Palau as a mass tourism destination and thus hurt the environment. Failure to implement a tourism strategy and diversify the economy could reduce growth in the medium term. Given the lack of monetary and exchange rate policies, Palau’s policy tools would be limited to fiscal and structural policies should risks materialize.

Authorities’ views

8. The authorities agreed with staff’s assessment of the economic outlook and risks. They noted that their objective is to achieve a level of growth that is sustainable and consistent with their goals of maintaining a pristine environment and positioning Palau as a high-end tourism destination. In this regard, the surge in tourist arrivals in FY2015 was excessive as it strained infrastructure, was tilted towards package tour low budget tourists, and led to an increase in low quality hotels. These trends go against their goals, and justified the introduction of limits on charter flights and restrictions in hotel developments until infrastructure has been upgraded. The authorities also noted that although the increase in the airport departure tax from US$50 to US$100 per tourist from April 1, 2017 seeks to replace lost revenue from fishing licenses due to the creation of the marine sanctuary, it may also help discourage tourist arrivals, particularly for low budget tourists. However, they expect the impact of this measure on tourist arrivals to be limited.

Key Policy Issues

9. Sustainable Development Goals (SDGs). The authorities seek to achieve a number of SDGs to make development economically, socially, and environmentally sustainable. The SDGs prioritized by the authorities are: (i) Promoting sustained, inclusive and sustainable economic growth (SDG #8); (ii) Building resilient infrastructure (#9); (iii) Combating climate change and its impacts (#13); and (iv) Conserving the ocean and marine resources for sustainable development (#14). The key policy priorities in this regard are ensuring fiscal sustainability, raising potential growth and enhancing resilience, and preserving financial stability and facilitating credit extension.

A. Ensuring Fiscal Sustainability

10. Developments. Palau’s fiscal position has improved noticeably. The current fiscal deficit (expense less domestic revenue) fell from 11 percent of GDP in FY2014 to 5.5 percent in FY2015. Tax revenue rose by 1 percent of GDP due to higher receipts from the airport departure tax as tourist arrivals soared, while expense declined by 4.5 percent of GDP due to spending restraint. The overall balance rose only by 1.5 percent of GDP due to a drop in grants. The CTF reached 64 percent of GDP in FY2015, while government deposits rose to 8.1 percent of GDP, domestic accounts payable fell to 5.4 percent of GDP, and government external debt declined to 10.4 percent of GDP.

A01ufig2

Palau: Current Fiscal Deficit, FY2013-15

(In percent of GDP)

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Sources: Country authorities; and IMF staff estimates.

11. Medium-term outlook. Fiscal adjustment is set to continue due to sustained spending restraint, with the current fiscal deficit falling from 5.5 percent of GDP in FY2015 to 4 percent in FY2018. The current deficit would stay at 5.5 percent of GDP in FY2016 as the fall in tourism related revenue is offset by spending restraint. From FY2017, domestic revenue would remain stable as percent of GDP but for the rise in the airport departure tax from US$50 to US$100 per tourist from April 1, 2017. This measure would raise 2.4 percent of GDP in revenue, half of which is reserved for the Civil Service Pension Fund (CSPF) and is not reflected in the government accounts.1 Government revenue would rise by 1.2 percent of GDP (0.6 percent in FY2017 and FY2018), but expense would also rise by the same amount as the extra revenue is reserved for the state governments and marine sanctuary, with no impact on the current fiscal balance. Spending restraint is expected to continue, with the current fiscal balance falling by 0.7 percent of GDP in FY2017 and FY2018. Public investment would be limited to that financed with capital grants and AsDB loans, with the overall fiscal balance temporarily moving into deficit due to higher capital spending funded with AsDB loans, but returning into surplus afterwards due to the lower current fiscal deficits and higher Compact grants.

12. Long-term outlook. The current fiscal deficit is expected to remain at 4 percent of GDP from FY2018 onwards. Capital spending in FY2019-24 would continue to be set by capital grants and AsDB loans, with the overall fiscal balance staying in surplus as the current grants exceed the current fiscal deficit. As part of the FY2018-24 windfall is saved, the government’s net worth—defined as the CTF plus government deposits, less domestic accounts payable, government external debt, and CSPF’s unfunded liabilities—would rise from 48 percent of GDP in FY2015 to 59 percent in FY2024. The CTF would fall to 51 percent of GDP in FY2014 due to the larger withdrawals allowed under the renewed Compact agreement, while other government assets net would increase to 8.5 percent of GDP. Staff analysis suggests that the current fiscal deficit can be sustained at 4 percent of GDP post FY2024, provided that public investment is capped at 5.6 percent of GDP (Appendix VI). The overall fiscal balance falls after FY2024 as the Compact grants expire, but the government net worth stabilizes at 59 percent of GDP as the rise in other government assets net offsets the decline in the CTF.

A01ufig3

Palau: Long-term Fiscal Sustainability in the Baseline Scenario

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Staff’s Reform Scenario

13. Strengthening the fiscal framework. Staff recommends targeting a net worth position of the public sector as the fiscal anchor, and using the current fiscal balance as the operational target. Targeting a net worth level would ensure fiscal self-sufficiency when the Compact grants expire in FY2024 by building sufficient government non-CTF assets to offset the decline in the CTF balance, thus keeping ample buffers. Using the current fiscal balance as the operational target would not only help achieve the desired government net worth position, but also reach a desired level of capital spending by restricting the level of current expenditure relative to domestic revenue.

14. Ensuring long-term fiscal sustainability. Staff recommends further fiscal adjustment in the medium term and to shift the composition of public expenditure towards investment to support the growing tourism industry and enhance resilience to natural disasters and climate change. In the baseline scenario, public investment is only 6.2 percent of GDP in FY2019–24 and 5.6 percent of GDP after FY2024—lower than Palau’s historical average (8.3 percent of GDP) and below that of other Pacific islands (11 percent of GDP). Moreover, Palau needs buffers because: (i) tax revenue is volatile given its reliance on taxes on tourism; (ii) the country is exposed to natural disasters and climate change; (iii) there are contingent liabilities in the CSPF and other public entities; and (iv) the CTF and other government assets are subject to market risk. Staff recommends targeting at government net worth position of 70 percent of GDP after FY2024, 11 percentage points more than in the baseline scenario. Staff also recommends cutting the current fiscal deficit to 1 percent of GDP by FY2020, which would not only help achieve the government’s net worth target, but also increase public investment to 8.3 percent of GDP from FY2019. Real GDP growth would fall in FY2017–18 due to the fiscal adjustment, but it would increase in FY2019–21 as the gains from higher public investment more than offset the negative impact from fiscal consolidation. After FY2020, growth would increase by about 1 percentage point in line with the rise in public investment.

A01ufig4

Palau: Long-term Fiscal Sustainability in Staff’s Reform Scenario

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

15. Attaining a balanced fiscal adjustment. Further fiscal adjustment should rely on revenue and expenditure measures. Staff supports a reform that replaces the gross revenue tax (GRT) with a single rate value added tax (VAT) with no exemptions, and raises the net income tax on financial institutions and all VAT-registered businesses. Staff also recommends strengthening tax compliance and using a bidding mechanism to manage charter flights instead of quantitative limits. Expenditures should be contained by prioritizing spending and gradually eliminating subsidies. Staff recommends splitting the fiscal adjustment equally between revenue and expenditure measures. The VAT and net income tax reforms could yield 1.5 percent of GDP in additional revenue by FY2020, while the wage bill could be reduced by 1 percent of GDP and government subsidies by 0.5 percent of GDP.

16. Strengthening public financial management (PFM). Robust PFM is key to contain fiscal risks and support fiscal adjustment. Staff advises sound public debt management and project administration to secure debt sustainability. Staff analysis shows that public debt remains sustainable despite the recent AsDB loans by US$52 million to finance the upgrade of the Koror-Arai waste management system and the submarine fiber optic cable (Appendix VII). However, public debt remains highly sensitive to a real GDP growth shock such as those that Palau could experience if faced with large natural disasters. Staff also recommends prioritizing infrastructure that supports tourism growth and resilience to natural disasters and climate change, adopting a medium-term budget framework, improving budget execution and planning, and strengthening cash management.

17. Reforming public entities. Some public entities need to be reformed. The Civil Service Pension Fund (CSPF) is estimated to have unfunded liabilities by 8.3 percent of GDP even after considering the extra revenue from the increase in the airport departure tax. Staff recommends reducing benefits and raising contributions to ensure its long-term sustainability. The Palau Public Utility Corporation (PPUC) relies on government subsidies for its provision of water services. Staff advises raising tariffs and lowering operational costs to ensure full cost recovery of its operations, while providing adequate protection to the most vulnerable. The other two state owned enterprises, the Palau National Communications Corporation and the Belau Submarine Cable Corporation, have been able to cover their costs with their own revenue, without requiring government support.

Authorities’ views

18. The authorities welcomed staff’s recommendation to strengthen the fiscal framework and analysis of long-term fiscal sustainability. They noted that the recommendation of further fiscal adjustment in the medium term is well aligned with their own goal of self-financing expense with domestic revenue (zero current fiscal balance) by FY2024. They also welcomed staff advice of replacing the GRT with a VAT and rising the net income tax for financial institutions and all VAT-registered businesses. They noted that a bill replacing the GRT with a VAT was sent to Congress in FY2014, but has not yet been approved. They also stressed ongoing efforts to strengthen PFM and the medium term budget framework. The authorities also acknowledged the existence of unfunded liabilities in the CSPF, and noted that a bill shifting the CSPF from a defined-benefit to a defined-contribution system was sent to Congress in FY2014, but has also not yet been approved. They stressed that this reform would ensure the long-term sustainability of the CSPF, with the new funds from the increase in the airport departure tax used to pay for the benefits during the transition. The authorities also want to make PPUC self-sufficient by rising tariffs and reducing costs. However, they noted that service quality needs to be improved in line with planned upgrades to the water system before tariffs can be raised.

B. Raising Potential Growth and Enhancing Resilience

19. Context. Palau faces several structural constraints common to small island states: a narrow economic base, remote location, small population, inadequate infrastructure, weak business climate, and exposure to natural disasters and climate change. The projects in the pipeline funded by AsDB loans and grants are aimed at lessening some of the infrastructure bottlenecks. The 2016 World Bank’s Doing Business Report points to a number of weaknesses in Palau’s business climate, such as resolving insolvency, trading across borders, enforcing contracts, paying taxes, getting electricity, and access to credit.

A01ufig5

Doing Business 2016: Detailed Ranking

(Ranking, from 1 (best) to 189 (worst))

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Sources: World Bank, Doing Business 2016.

20. Achieving sustainable tourism development. Tourism remains Palau’s main growth engine, but the lack of a tourism policy and weak regulation have led to excessive growth of the low budget segment. To align tourism development with the authorities’ long-term goal of positioning Palau as a high-end tourism destination, staff recommends implementing a comprehensive tourism strategy that clearly outlines land zoning rules, protects the environment, regulates service quality, has adequate infrastructure planning, and improves the skills of the labor force. Several initiatives in this direction have been tried in the past, but lack of political will, limited resources, and coordination problems have limited their implementation (Appendix VIII). New tourism developments in Koror should be avoided until infrastructure has been upgraded, but developments outside Koror and green tourism could continue. The regulatory environment also needs to be strengthened to enhance scrutiny and enforcement of regulations. Better coordination among the national and state governments is necessary to ensure effective implementation of the authorities’ long-term vision.

21. Diversifying the economy. Economic diversification would help reducing volatility and broadening the sources of growth. To lower tourism volatility, the mission recommends promoting tourism from new destinations, including growing Asian markets. Developing domestic business activities that can supply the tourism industry such as agriculture and aquaculture, and tourism activities that would increase tourist spending, would also help diversify the sources of growth.

22. Improving the business environment. A strong business environment would help private investment growth. Palau foreign investment approvals are decided by a Foreign Investment Board, which operates in a case by case basis. Staff recommends adopting a new foreign investment regime to simplify investment approval and open all business to foreign investment through joint ventures provided that proper regulations are in place. Staff also supports the role of the Economic Advisory Group—which includes representatives of the government, Congress, and the private sector—in coordinating the dialog between the private and public sectors to improve policy formulation and planning, including on measures to improve Palau’s business environment.

23. Enhancing infrastructure. Infrastructure bottlenecks are limiting tourism growth. The recent surge in tourism strained water supply, sanitation, and waste disposal, while poor internet quality has been the main dissatisfaction of Palau’s visitors in tourist exit surveys. These bottlenecks will ease as the projects funded with AsDB loans and capital grants are completed, but appropriate infrastructure planning as part of a broader tourism strategy is needed. New infrastructure should also seek to increase resilience to natural disasters and climate change, which is a significant risk as the recent drought showed. Priorities include limiting developments in areas at risk of tropical storms and rising sea levels, and improving the water system. Staff welcomes the authorities’ plans to upgrade the water pipeline system in Koror and to broaden the sources of water to make it more stable.

Authorities’ views

24. The authorities concurred with staff on the need to implement a comprehensive tourism strategy consistent with the long-term view of making Palau a high-end tourism destination and keeping a pristine environment. They noted that the bureau of tourism is preparing a plan along these lines, which should be finalized in the coming months. They also agreed that new hotel developments in Koror should be avoided until infrastructure has been upgraded, although they are open to high-end hotel developments that build their own treatment plants. The authorities agreed with staff on the need to prioritize infrastructure that helps tourism growth and resilience to natural disasters and climate change. On the latter, they highlighted a new project financed with grants from Japan to upgrade the water pipeline system in Koror, which should reduce leakages and make water distribution more efficient. In addition, they are evaluating different alternatives to broaden the sources of water to avoid shortages such as the one experienced during the recent drought.

C. Preserving Financial Stability and Facilitating Credit Extension

25. Context. Palau’s banks remain sound, with nonperforming loans at 2.1 percent, liquid assets at 90 percent, and return on assets at 1.4 percent. The presence of three foreign owned U.S. FDIC-insured banks that hold 93 percent of the loans and 99 percent of the deposits helps mitigate risks. But banks continue to lend little domestically despite the rapid rise in deposits, with domestic loans falling as percent of deposits and as percent of GDP. The legislation allowing the National Development Bank of Palau (NDBP) to take deposits was passed in Congress and once licensed, the NDBP will be regulated by the Financial Institutions Commission (FIC) and will be subject to the same regulations of commercial banks. The loss of correspondent banking relationships has not been an issue in Palau as the three foreign owned U.S. FDIC insured banks do all the international transactions in the country. Anti-money laundering investigations have also improved with the enhanced role of the Financial Intelligence Unit (FIU).

A01ufig6

Palau: Banks’ Domestic Lending

(In percent)

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Sources: Country authorities; and IMF staff estimates.

26. Preserving financial stability. Keeping a sound financial sector is key to mitigate risks. The FIC has improved bank examinations, data collection, and reporting; while the FIU has enhanced anti-money laundering investigations. Staff recommends broadening the FIC’s supervision to all non-bank financial institutions, including credit unions, and encourages the legislators to approve the Credit Union Act that put all credit unions under FIC supervision. Staff also welcomes the authorities plan to put the NDBP under FIC supervision, subject to the same regulations of commercial banks, while allowing it to take deposits and expand its lending activities. The authorities are also encouraged to continue improving the AML/CFT regime in line with the FATF standard.

27. Facilitating credit extension. To mobilize domestic credit, staff advises relaxing the interest rate ceiling for commercial loans to better reflect riskiness, and helping SMEs prepare business plans and financial statements. The NDBP can also help fill the financing gap for SMEs, especially in the agriculture sector. The NDBP lending activities have been constrained by the availability of financing from international financial institutions, and limited to the areas for which these funds are targeted, including agriculture, aquaculture, and housing. Once the NDBP is licensed to take deposits, it will be able to expand its lending activities to other areas of the economy.

28. Improving statistics. Palau’s statistics are broadly adequate for surveillance thanks to technical assistance from IMF PFTAC and the Graduate School USA. Staff recommends improving tourism statistics and strengthening the statistics office to continue improving data quality.

Authorities’ views

29. The authorities agreed with staff’s assessment that Palau’s banks remain sound. They noted that deposits have increased rapidly, which should help banks keep high profit levels. They also acknowledged that banks continue to lend little domestically, investing most of their assets abroad. They noted that the number of individuals loans has increased significantly, but the total loan stock has fallen because of the repayment of some large commercial loans. The authorities also observed that commercial lending has not picked up partly because foreign investors do not require domestic financing for their investment projects, but instead bring their own funds. The authorities are not convinced that the limit on lending rates to commercial loans is a key constraint to domestic credit growth. They believe that the lack of business plans and financial statements for SMEs is a more important factor. The authorities expect that the NDBP will help closing the financing gap for SMEs once it starts taking deposits and expanding its lending activities. However, it may take a few years for the NDBP to satisfy all the FIC’s requirements to be licensed as a deposit taker. The authorities welcomed staff’s advice to broaden FIC supervision to all financial institutions and appreciated staff’s support to get the Credit Union Act passed in Congress.

D. External Sector Assessment

30. Palau’s external sector is broadly in equilibrium. Although the real effective exchange rate appreciated by 22 percent between FY2011 and FY2015, in line with the strengthening of the U.S. dollar, the current account deficit has fallen reflecting lower commodity prices and strong tourism receipts. Looking ahead, the U.S. dollar is expected to strengthen further as the Fed rises policy rates and Palau’s current account deficit is projected to increase somewhat due to higher commodity prices and infrastructure related imports. But these deficits would remain fully covered by FDI inflows and capital grants, suggesting that Palau’s external sector is broadly in equilibrium.2 However, heavy reliance on tourists from a few countries is a vulnerability, and weaknesses in infrastructure and investment climate could hinder development of tourism 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 as it provides an important nominal anchor.

31. Government deposits, as a measure of foreign reserves, remain appropriate covering 2.7 months of spending, including debt service. Fully dollarized economies may need liquidity buffers in U.S. dollars to support domestic financial institutions, to repay short-term external debt, and as a buffer for government financing.3 For Palau, the first two arguments are not very relevant. The liquid asset ratio in the banking sector is high at 90 percent, and Palau does not borrow short-term externally, with all of its external debt being long-term with international organizations. However, government revenue volatility is a risk. A useful rule of thumb for the minimum size of fiscal reserves is one month of spending. Palau’s government deposits in FY2015 stood at 8.1 percent of GDP or 2.7 months of government spending, well above the minimum requirement. Moreover, they are projected to increase to about 6 months of spending by FY2021.

A01ufig7

Palau: Key External Sector Indicators

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Authorities’ views

32. The authorities agreed with staff’s external sector assessment, and noted that the current account deficits are expected to remain lower than in the past, with FDI inflows and capital grants fully covering them. Moreover, government deposits are projected to increase in line with fiscal consolidation, thus providing additional buffers.

Staff Appraisal

33. Palau’s economy has performed well in recent years and the outlook is favorable. Real GDP growth has been robust, inflation has been low and stable, and the external and fiscal positions have improved. The outlook is positive, with growth temporarily declining to zero in FY2016 due to lower tourist arrivals, but rebounding to 5 percent in FY2017–18 as tourism activity recovers and construction activity picks up. Inflation is expected to remain low due to stable commodity prices, while the current account deficit would rise due to larger infrastructure related imports. The fiscal position would improve further due to continued spending restraint.

34. This positive outlook is subject to large downside risks. Further U.S. dollar appreciation, a slowdown in key trading partners, and natural disasters could hurt tourism. Higher commodity prices would make food and fuel imports costlier. A continued strong tourist influx could position Palau as a mass tourism destination and hurt the environment. Given the lack of monetary and exchange rate policies, Palau would need to rely on fiscal and structural policies should risks materialize.

35. The fiscal framework should be strengthened by targeting the public sector net worth as a fiscal anchor and using the current fiscal balance as an operational target. This framework would not only help ensure fiscal self-sufficiency when the Compact grants expire in FY2024, but also increase public investment and keep ample buffers for future contingencies.

36. Further fiscal adjustment is needed to ensure fiscal sustainability. The authorities have made significant progress in improving Palau’s fiscal position in recent years. However, further fiscal adjustment is necessary over the medium term to ensure fiscal self-sufficiency when the compact grants expire in FY2024. This adjustment should rely on both revenue and expenditure measures, and the composition of government expenditure should be shifted towards infrastructure investment.

37. The fiscal adjustment should be complemented with reforms to fiscal institutions and public entities. Strengthening public financial management is key to support fiscal adjustment and maintain fiscal discipline. Sound public debt management and project administration would help secure debt sustainability and contain fiscal risks. Staff advises reforming the CSPF to eliminate its unfunded liabilities, and restructuring the PPUC to ensure full cost recovery of its operations and reduce the need for government subsidies.

38. Implementing a comprehensive tourism strategy is key to achieve sustainable tourism development. Tourism remains Palau’s main growth engine, but the recent surge in tourist arrivals strained infrastructure and was tilted towards low budget tourists. This goes against the authorities’ goal of positioning Palau as a high end tourism destination and is a threat to the environment. Staff welcomes the authorities’ plans to implement a comprehensive tourism strategy that sets clear rules for sustainable tourism development. Staff also recommends avoiding new hotels developments until infrastructure has been upgraded, improving the regulatory environment, and strengthening the coordination among the national and state governments.

39. Diversifying the economy would help reducing volatility and broadening the sources of growth. Staff recommends promoting high end tourism from new destinations, including growing Asian markets, developing domestic business activities that can supply the tourism industry such as agriculture and aquaculture, and stimulating activities that would increase tourist spending.

40. Infrastructure development is needed to support the growing tourism industry and enhance resilience to natural disasters and climate change. Infrastructure bottlenecks are limiting tourism growth, highlighting the need for appropriate infrastructure planning as part of a broader tourism strategy. Infrastructure investment should also aim to increase resilience to natural disasters and climate change, including by limiting developments in areas at risk of tropical storms and rising sea levels, and improving the water system to avoid shortages in the future.

41. Improving the business climate would support private sector investment. Staff advises adopting a new foreign investment regime to simplify investment approval and open all business activities to foreign investment through joint ventures. Staff also supports the coordinating role of the Economic Advisory Group in the dialog between the private and public sectors to improve policy formulation and planning, including on measures to improve the business climate.

42. Preserving financial stability and increasing domestic credit would support private sector activity. Palau’s banks remain sound, but continue to lend little domestically. Staff welcomes the authorities’ plans to broaden the FIC’s supervision to the credit unions, and advises relaxing the interest rate ceiling for commercial loans to better reflect riskiness, and helping SMEs prepare business plans and financial statements. Staff also welcomes the authorities’ plan to put the NDBP under FIC supervision, subject to the same regulations of commercial banks, while allowing it to take deposits and expand its lending activities more broadly in the economy.

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

Figure 1.
Figure 1.

Palau: Real Sector Developments

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

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

Palau: Tourism Sector Developments

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Sources: Graduate School USA, Pacific and Virgin Islands Training Initiatives; and IMF staff estimates.
Figure 3.
Figure 3.

Palau: External Sector Developments

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

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

Palau: Fiscal Sector Developments

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

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

Palau: Selected Economic Indicators, 2013/14–2020/21 1/

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 tax and other revenue less expense.

Includes unspent external loans.

Table 2.

Palau: Medium-term Outlook, Baseline and Reform Scenarios, 2013/14–2020/21 1/

article image
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.

Staff’s reform scenario assumes that the current fiscal deficit is reduced by 1.1 percent of GDP each year during FY2017-20 to 1 percent of GDP in FY2020. This is achieved by raising taxes and cutting current expenditure, and the additional savings are used to increase public investment to 8.3 percent of GDP from FY2019 onwards. The extra fiscal adjustment reduces growth in the initial years, but leads to higher growth by about 1 percentage point in the medium-term due to the

Table 3

Palau: Balance of Payments, 2013/14–2020/21 1/

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

Fiscal year ending September 30.

Staff projections.

Table 4

Palau: National Government Operations and Balance Sheet, 2013/14–2020/21 1/

article image
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.

Defined as Revenue less Grants and Expense.

Defined as Revenue less Expenditure.

The government net worth excludes the Compact Trust Fund, which is governed by the Compact of Free Association.

Table 5.

Palau: Deposit Money Banks Balance Sheet, 2009/10–2014/15 1/

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Sources: Palau authorities; and IMF staff estimates.

Fiscal year ending September 30.

Appendix I. Risks of Natural Disasters

The Pacific island countries are among the most exposed to natural disasters in the world. Their location and small size make them vulnerable to earthquakes and tsunamis, and weather-related disasters such as cyclones, droughts, and floods (IMF 2015). But Palau has been less affected than other Pacific island countries in the past. Figure 1.1 shows that among 12 Pacific island countries, Palau had the lowest average number of natural disasters per year during 1960-2014, and the lowest probability of occurrence of natural disasters calculated over 1970-2014. Still, the Pacific Catastrophe Risk Assessment and Financing Initiative estimates a 50 percent chance that Palau could experience large losses (US$30 million or 10 percent of GDP) due to natural disasters in the next 50 years.

Figure I.1.
Figure I.1.

Pacific Island Countries: Incidence and Probability of Natural Disasters

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

This year, Palau was hit by one of the strongest droughts in its history due to El Niño weather conditions. A report from the National Oceanic and Atmospheric Agency in March 21, 2016 placed Palau in extreme drought level 3 of 4, with the cumulative rainfall in the previous four months at the lowest level since 1951. The two main sources of water had been declining since late 2015, and the Ngerimel Dam, which provides 80 percent of water consumption in normal times, was shut down in April. As a result, the government restricted water consumption to three hours a day since March 29. This restriction was lifted in May 9 when the weather conditions normalized.

The recent drought showed the need for fiscal buffers and investment to make infrastructure more resilient to natural disasters and climate change. The government’s plan for this emergency included importing drinking water and water test kits, improving water distribution in some areas, buying medications in case of disease outbreaks, and promoting public awareness. The cost was estimated at US$3 million (1 percent of GDP). Going forward, Palau will need to broaden its sources of water, especially because of unpredictable weather conditions due to climate change and the rapid growth in water demand due to the expanding tourism industry. Alternative options include developing underground water sources, enhancing water storage facilities, and using desalination plants for sea water. Palau’s government deposits, currently at 8.1 percent of GDP, are insufficient to finance the response to potentially large natural disasters with losses close to 10 percent of GDP as estimated by the Pacific Catastrophe Risk Assessment and Financing Initiative.

Appendix II. National Marine Sanctuary

Background. Palau has been preserving its natural resources for many years, and is an active player in initiatives to preserve marine life among Micronesian states and the United Nations. Palau took another milestone in October 2015 when it passed the Palau National Marine Sanctuary (PMNS) Act, which will preserve 80 percent of Palau’s exclusive economic zone (EEZ) of 500,000 square kilometers as a no-take area that is protected from all exploitation. The reform will be executed gradually and the PMNS will be fully effective in January 1, 2020. Once implemented, the PMNS will be one of the largest protected ocean areas in the world.

Benefits and Costs. Studies find that that ocean protection is a more sustainable use Palau’s marine resources. Cheung and others (2010) project that Palau may lose 25 percent of its fish catch by 2050 due to climate change, making conservation vital. The PMNS will lower fishing rights revenue, but this will be offset by giving all revenue from fishing agreements and a part of the environmental impact fee (US$12.5 per tourist) to the state governments. Sala and others (2013) find that the value of well-enforced marine reserves in adjacent fishing and tourism exceeds the pre-reserve value. Looking at sharks alone, Vianna and others (2010) estimate that a reef shark has a life-time value of US$1.9 million through dive tourism, compared to US$10,800 if it were fished. Tourist appreciation of Palau’s protected marine life is also clear in tourist expenditure patterns, where diving is the third largest expense item.

Palau: Conservation Milestones

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Source: Pew Charitable Trusts (2016)
A01ufig8

Palau: Share of Tourism Expenditure by Market Segment

(In percent, average 2010-2015)

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

* Includes hotel occupancy tax, gross revenue tax and vessel cabin and foreign waterSource: Graduate School USA; Pacific & Virgin Islands Training Initiatives.

Surveillance and funding. Palau’s Ministry of Natural Resources, Environment and Tourism (MNRET) manages the PMNS, oversees foreign fishing agreements, issues fishing permits, monitors fish stocks and harvests within the DFZ, and coordinates enforcement. The Fisheries Protection Trust Fund (FPTF) was established under the National Treasury to fund surveillance, enforcement and related trainings. All fines, forfeiture proceeds, and part of the environmental impact fee (US$10 per tourist) are remitted to the FPTF. The government is also exploring a potential of debt-for-nature swap that would allow Palau to divert loan payments to activities that support the PMNS. Regional partners also fund Palau’s surveillance. Going forward, Palau released a 2016–2021 monitoring, control and surveillance (MCS) plan that will aid in fighting illegal activities and fishing violations in Palau’s EEZ. The MCS plan also aims to improve Palau’s search and rescue, pollution detection, weather forecasting, and resilience to climate change.

Appendix III. Staff Policy Advice, 2014 Article IV Consultation

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Appendix IV. Tourism Developments

Tourist arrivals surged by 34 percent in FY2015, with the bulk coming from China. Chinese tourists accounted for 54 percent of total arrivals, followed by Japanese (19 percent) and Taiwanese (9 percent). This contrasts with profile in 2009-14, when Chinese tourists accounted for 5 percent, while Japanese and Taiwanese accounted for 35 and 27 percent. High concentration of tourists from one country poses a risk the tourism industry, with potentially disruptive consequences for Palau if outward Chinese tourism flows were to decline.

The change in profile of tourist arrivals has altered expenditure patterns and visitor activities. The surge in tourists in 2015 led to a sharp rise in total visitor spending on accommodations, but receipts from the gross revenue and hotel taxes have not risen as fast, reflecting a shift to low-cost hotels (Figure 2). Occupancy rates of Chinese-based hotels rose from 44 percent in 2010 to 81 percent in 2015, with Chinese tourists spending US$87 on average per room, less than Japanese and Taiwanese tourists who spend US$160 and US$150 respectively. Spending on boat tours also rose, while diving expenditures declined. Boat tours, which cater to a bigger number of tourists per trip, tend to have a higher impact to the environment and lower gains per tourist compared with diving activities. More generally, tourism revenue per arrival declined to US$3,987 in 2015 from US$4,749 in 2014.

A01ufig9

Palau: Visitor Arrivals by Nationality

(In percent)

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Source: Gradua School USA; Pacific … Virgin Islands Training Initiative.
A01ufig10

Palau: Tourism Developments and Tax Revenue

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Recent tourism developments highlight the need for Palau to act on its national tourism strategy before the pristine environment and the quality of tourist experience deteriorate. The limits on charter flights and the legislated rise in the airport departure tax are concrete policies undertaken to address the growing capacity constraints in the tourism sector. However, a comprehensive tourism strategy is needed to ensure the sustainability of Palau’s main growth engine.

Appendix V. Risk Assessment Matrix 1/

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Appendix VI. Long-Term Fiscal Sustainability Analysis

Palau can sustain a current fiscal deficit at 4 percent of GDP after FY2024 if public investment is set at a low 5.6 percent of GDP. Staff recommends reducing the current fiscal deficit to 1 percent of GDP from FY2020 to increase public investment to 8.3 percent of GDP, while keeping ample buffers.

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 equals the NPV of future expenditure as follows:

W + G + R = C + K

where the government’s net worth (W), and NPVs of grants (G) and domestic revenue (R) are balanced against the NPVs of fiscal expense (C) and capital spending (K).

The current deficit (C-R) and capital spending are endogenous, while the government’s net worth and grants are exogenous. The government’s net worth is inherited and is equal to the Compact Trust Fund (CTF) plus government’s deposits, less domestic accounts payable, government’s external debt, and unfunded liabilities of the Civil Service Pension Fund (CSPF). Grants are determined by the donors and the Compact agreement. In contrast, capital spending and the current deficit are chosen by the policymakers to satisfy the government’s intertemporal budget constraint. In the baseline scenario, capital spending is chosen after FY2024 for a given current deficit. In the reform scenario, the current deficit is chosen to achieve a desired level of capital spending.

The government’s net worth in FY2015 was 48 percent of GDP, with the CTF balance at 64 percent of GDP, government deposits at 8.1 percent of GDP, domestic accounts payable at 5.4 percent of GDP, government external debt at 10.4 percent of GDP, and unfunded liabilities in the CSPF at 8.3 percent of GDP. The following assumptions were used in the baseline scenario:

  • Nominal GDP growth is 3 percent in FY2016, 7.6 percent in FY2017, 7.1 percent in FY2018, 6.1 percent in FY2019, 5.1 percent in FY2020, and 4 percent thereafter.

  • The CTF nominal rate of return is 6.5 percent, slightly higher than the 5.8 percent obtained during FY2000-15, but lower than the 7.3 percent attained during FY2009–15.

  • U.S. Compact grants total US$124 million in FY2018–24 (total direct assistance of US$229 million minus advances of US$105 million received during FY2010–17).

  • The CTF withdrawals are US$5 million in FY2016–17, increasing gradually after to US$13 million in FY2023, and US$15 million from FY2024 onwards. The CTF is exhausted in FY2082.

  • Other U.S. grants total US$184 million in FY2016–24 and 5.4 percent of GDP thereafter, while other country grants total US$ 104 million in FY2016–24 and 2.8 percent of GDP thereafter.

Baseline Scenario

Capital spending in FY2016-24 is set by the existing AsDB loans and capital grants (compact and other), averaging 11 percent of GDP in FY2016–18 and 6 percent in FY2019–24. After FY2024, capital spending is set to satisfy the government’s intertemporal budget constraint while keeping the current fiscal deficit at 4 percent of GDP from FY2018 onwards. The results show that the current deficit can be sustained at this level if public investment is capped at 5.6 percent of GDP after FY2024 (Figure 3.1). The government’s net worth stabilizes at 59 percent of GDP after FY2024 as the increase in other non-CTF government assets net offsets the fall in the CTF. Current and capital spending are financed with domestic revenue, investment income, CTF withdrawals, and non-compact grants.

Figure VI.1
Figure VI.1

Baseline Scenario: Main Fiscal Aggregates

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Palau needs more infrastructure investment to support its rapidly growing tourism industry and to enhance its resilience to natural disasters and climate change. A public investment rate of 5.6 percent of GDP is lower than Palau’s historical average (8.3 percent of GDP) and that of other Pacific island countries (11 percent of GDP). Palau also needs buffers as: (i) tax revenue is volatile given its reliance on taxes on tourism; (ii) the country is exposed to natural disasters and climate change; (iii) there are contingent liabilities in the CSPF and other public entities; and (iv) the CTF and other government assets are subject to market risk. For example, the CTF lost 5 percent of its value (3.5 percent of GDP) in FY2015 due to global financial volatility. Thus, staff recommends further cuts to the current fiscal deficit to allow for higher public investment and higher buffers as discussed below.

Reform Scenario

Staff recommends targeting a government net worth of 70 percent of GDP after FY2024 as the fiscal anchor, and cutting the current fiscal deficit to 1 percent of GDP from FY2020 as the operational target. In the reform scenario, capital spending in FY2016-18 is kept the same as in the baseline (11 percent of GDP in average), but it is increased to 8.3 percent of GDP from FY2019. The increase in capital spending makes it equal to its FY2000-15 average, and is motivated by the need to sustain tourism growth and make infrastructure more resilient to natural disasters and climate change. As a result, real GDP growth increases by 1 percentage point after from FY2020. The current fiscal deficit is chosen to ensure enough funding for the increased level of capital spending. The results show that cutting the current fiscal deficit by 1.1 percent of GDP each year in FY2017-20 to 1 percent from FY2020 onwards would allow raising public investment to 8.3 percent of GDP from FY2019, while achieving the government net worth target of 70 percent of GDP after 2024, thus keeping ample buffers (Figure 3.2). As in the baseline scenario, government current and capital spending would be financed with tax revenue, investment income, CTF withdrawals, and non-compact grants.

Figure VI.2
Figure VI.2

Reform Scenario: Main Fiscal Aggregates

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Medium-term fiscal adjustment should rely on both revenue and spending measures. Staff supports a tax reform that replaces the gross revenue tax (GRT) with a single rate value added tax (VAT) with no exemptions, and raising the net income tax for financial institutions and all VAT-registered businesses. Staff also recommends cutting expense, especially government consumption and subsidies, which account for about half of total expense. In the reform scenario, broadly half of the medium-term fiscal adjustment is achieved through higher revenue, and the other half through cuts to government’s consumption and subsidies.

Appendix VII. Public Sector Debt Sustainability Analysis

Palau’s public debt remains sustainable despite the recent AsDB loans by US$52 million to fund the upgrade of the Koror-Arai waste management system and the submarine fiber optic cable, which will be disbursed gradually during FY2014-20. Staff uses a broad definition of public debt in its analysis, including the central government’s external debt (10.4 percent of GDP in FY2015), the government’s domestic accounts payable or domestic arrears (5.4 percent of GDP in FY2015), and the SOEs’ debt, which is fully guaranteed by the government and is a contingent liability (11.6 percent of GDP in FY2015). Staff’s baseline scenario projects that the public debt will fall from 27.3 percent of GDP in FY2015 to below 20 percent in FY2021. Most of this decline is due to the large primary surpluses during FY2018-21 and the positive growth-interest rate differential.

One key element in the analysis is that Palau does not have access to private foreign capital markets. All of Palau’s external debt is from international organizations for specific projects, and thus there is no direct link between the fiscal balance and debt issuance in the private debt market. The baseline scenario’s public debt projections assume that the central government and SOEs do not take new foreign loans during FY2016-21, and thus the debt stock declines in line with the amortization of past loans. The path of public debt could be less favorable if the government or the SOEs take on new debt in the coming years. The central government’s debt stock increases temporarily during FY2016-18 due to the disbursements from the recent AsDB loans, but it declines afterwards. As the primary balances and flows from the growth-interest rate differential in FY2016-21 are larger than those required to pay for the debt service, the government uses the surplus to fully repay its domestic arrears and to build government deposits. If the primary balances and flows from the growth-interest rate differential were insufficient to cover for the debt service, public debt could rise in the form of larger domestic arrears, as it happened during the global financial crisis.

The alternative scenarios highlight the recent improvements in Palau’s fiscal position. The historical scenario, in which GDP growth, real interest rates, and primary balances are equal to their FY2006–15 averages, leads to higher public debt and gross financing needs than in staff’s baseline scenario. The scenario with a constant primary deficit at the projected FY2016 level of 1.9 percent of GDP also leads to higher debt-to-GDP ratios and gross financing needs than in staff’s baseline scenario. The alternative scenarios also highlight the sensitiveness of the public debt-to-GDP ratio to a growth shock. A decline in real GDP growth by 5.5 percentage points in FY2017-18 would increase the public debt-to-GDP ratio by 13 percent of GDP by FY2018, with the debt ratio declining by FY2021 to levels similar to that of FY2016. This result also highlights the sensitiveness of Palau’s public debt to large natural disasters, which not only could cause a decline in growth of this magnitude, but also lead to larger government expenditure for relief and reconstruction.

A01ufig11

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

(In percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.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.
A01ufig12

Palau Public DSA—Composition of Public Debt and Alternative Scenarios

Citation: IMF Staff Country Reports 2016, 328; 10.5089/9781475545937.002.A001

Source: IMF staff.1/ The results under the constant primary balance scenario are unrealistic as the primary fiscal balance is in deficit in FY2016 due to disbursements of an AsDB loan for the fiber optic and water and sewage projects. A no fiscal adjustment scenario is included to show the potential debt trajectory under a scenario where expenditure restraint stops in FY2017, thus leaving expenditure almost flat in terms of GDP. The debt trajectory under the adjustment scenario incorporates both revenue and expenditure reforms as recommended by staff.

Appendix VIII. Tourism Strategy

Palau has developed several tourism strategies over the years, including those laid out in the Tourism Action Plan (2008), the Presidential Management Action Plan (2001), the Study for Promotion of Economic Development in the Republic of Palau (2000), Sustainable Tourism Policies and Action Plan (1997), the 2020 National Master Development Plan (1996), the National Environmental Management Strategies (NEMS) (1994), and the Economic Development Plan (1994). The most recent one formed part of the 2009-2014 Medium Term Development Strategy which set out key strategies and actions for economic, social, environmental and cultural goals over the five-year period. Under the plan, the tourism strategy is to position Palau as an island of choice for environmentally conscious visitors and realize higher returns from tourism. Some of the key actions identified under the strategy are:

  • Clarify organizational roles, including those of the Palau Visitors Authority (PVA), the Chambers of Commerce, and the Belau Tourist Association.

  • Align the government agenda with that of tourism agencies.

  • Position Palau on the world tourism marketplace, through more targeted marketing as a high-end destination, by fostering ecotourism, and developing new attractions.

  • Increase investment into quality accommodation and encourage product upgrades.

  • Improve air access by making adjustments to bilateral air service agreements.

  • Create partnerships for environmental management of key tourism resources.

The actions identified in the current strategy are not new nor different to those set out in previous strategies. The aim to distinguish Palau as a high end destination, promote sustainable tourism and improve management of natural and cultural resources have been regular features of the various strategies since 1994. However, progress on achieving these objectives has been slow. A range of factors explain the slow progress, but the authorities’ failure to press ahead with implementation, allocate sufficient resources to advance reforms, and ensure policy consistency across government are important factors holding back progress. A lack of political will has also been cited as a factor, although confusion on the way forward has also been mentioned.

The separation of legislative powers among the states and the national government is another key obstacle to implementing the national strategy. While the national government controls the overall strategy on tourism and development, it is the state governments that control the implementation of certain policies within their states. This poses difficulties for the federal government to implement the overall national tourism strategy across all the states, particularly as not all states share the same vision of the national strategy.

The recent influx of tourist arrivals has posed further stress on the national strategy. Various agencies have noted that both the state and federal government have been in reacting to developments in tourism rather than proactively pursuing policies, for instance, the restrictions on charter flights and Koror State’s moratorium on hotel development were implemented to limit development of package tourism. The authorities’ concern has been that the rise in package-tourism is not consistent with the ‘high-end destination’ objective under the tourism strategy.

However, there is a lack of clarity among government and tourism agencies on the definition of ‘high-end’ tourism and the most effective policies to achieve that goal. Agencies are generally confused whether ‘high-end’ implies higher spending per day or whether they would like target tourists from certain destinations. Furthermore, government and tourism agencies appear to be working against each other. For instance, while the PVA has been marketing Palau as a high-end destination, there have been several low-quality and budget hotel establishments under construction in Koror. While the authorities point to a number of loopholes in existing legislation, particularly on hotel development, purchases of land-leases, and regulations, there has been little in the way of addressing the weaknesses in the legislative and regulatory frameworks to ensure that developing trends in the tourism industry are consistent with the overall national strategy.

That said, there has been notable progress on some areas of the tourism strategy, in particular, to preserve Palau’s marine assets. In 2009 Palau established the world’s first shark sanctuary banning any form of commercial fishing of sharks. Later in October, 2015, Palau’s congress approved the Palau National Marine Sanctuary Act to establish one of the world’s largest protected areas of ocean, and protect Palau’s key tourism resources. This are welcome developments, although greater efforts are needed to make progress on the other areas of the national tourism strategy.
1

This extra revenue is estimated to reduce the CSPF’s unfunded liabilities from 39 percent of GDP in 2015 prior to the reform to 8 percent after the reform. More generally, the fact that this large improvement in the fiscal position is not reflected in the fiscal accounts highlights the need to expand the perimeter in the fiscal statistics to include the state governments, the CSPF, the Social Security Fund, and the state owned enterprises.

2

Data gaps impede a more robust external sector assessment for Palau, such those based on the IMF’s External Balance Assessment (EBA) model or the IMF’s EBA-Lite model.

3

See IMF Policy Paper, “Assessing Reserve Adequacy—Specific Proposal,” April 2015.

1/

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.

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Cover IMF Staff Country Reports
Republic of Palau: 2016 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of Palau
Author:
International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2016: Issue 328
Publisher:
International Monetary Fund
ISBN:
9781475545937
ISSN:
1934-7685
Pages:
52
DOI:
https://doi.org/10.5089/9781475545937.002

Palau: Tourist Arrivals

(In thousands)

Palau: Current Fiscal Deficit, FY2013-15

(In percent of GDP)

Palau: Long-term Fiscal Sustainability in the Baseline Scenario

Palau: Long-term Fiscal Sustainability in Staff’s Reform Scenario

Doing Business 2016: Detailed Ranking

(Ranking, from 1 (best) to 189 (worst))

Palau: Banks’ Domestic Lending

(In percent)

Palau: Key External Sector Indicators
Figure 1.

Palau: Real Sector Developments
Figure 2.

Palau: Tourism Sector Developments
Figure 3.

Palau: External Sector Developments
Figure 4.

Palau: Fiscal Sector Developments
Figure I.1.

Pacific Island Countries: Incidence and Probability of Natural Disasters

Palau: Share of Tourism Expenditure by Market Segment

(In percent, average 2010-2015)

Palau: Visitor Arrivals by Nationality

(In percent)

Palau: Tourism Developments and Tax Revenue
Figure VI.1

Baseline Scenario: Main Fiscal Aggregates
Figure VI.2

Reform Scenario: Main Fiscal Aggregates

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