Mr. Sterland and Mr. Cafrine submitted the following statement:

We thank the Fund and staff for the constructive discussions during the 2016 Article IV consultation and a very useful staff report. We largely agree with staff views expressed in the report, which effectively highlight the government reform efforts, as well as the remaining challenges to preserve macroeconomic stability and ensure long-term growth. The authorities remain highly appreciative of the valuable technical assistance provided by the Fund, including under PFTAC, and anticipate continued engagement and support.

Palau, is a small middle-income island state in the North Pacific, with a narrow production base and heavy reliance on tourism and grants. As such, the economy is both highly vulnerable to natural disasters as well as external economic shocks. To ensure macroeconomic stability, the government is determined to build adequate buffers against downside risks, address structural impediments to growth and maintain prudent macroeconomic policies. Given the inherent challenges faced by Palau, my authorities are very grateful for the continued assistance from the international community, in particular the United States which has been providing financial support through the Compact of Free Association.

Economic Development and Outlook

The economy expanded by close to 9½ percent in 2015, driven by a massive increase in tourist arrivals and a significant expansion in construction activity. This brought both positive and negative effects. While beneficial for short-run economic growth, the unexpectedly large increase in tourists, concentrated in Koror State, strained the limited infrastructure base of the island. This, in turn, raised concerns about long-run sustainability and, if unmonitored, Palau’s reputation as a pristine tourist destination could be at risk from a degraded environment.

The authorities, in recognition of these pressures, announced a few measures to safeguard the tourism sector’s long-run sustainability while still supporting economic activity. In the short-term, the authorities limited the number of charter flights, as well as imposing restrictions on new hotel developments in Koror State unless that development meets certain environment and infrastructure standards (including its own water, sewerage and electricity). Furthermore, to help relieve the pressure on Koror’s infrastructure, while still supporting tourism and economic activity, tourism investments outside of Koror are exempt from these restrictions. Over the medium- and long-term, Koror’s infrastructure will be better able to handle private sector development as the authorities are scaling up infrastructure investment. The authorities are committed to implementing a comprehensive tourism strategy that both preserves the fragile environment and lays the basis for a soundly based long-term growth.

While the outlook remains positive, growth is expected to be flat in 2016 owing to the expected temporary decline in arrivals following these restrictions before accelerating in 2017 and 2018. Our authorities are confident that growth will quickly rebound as new hotels and infrastructure are brought on line together, achieving the authorities’ objective of high long-term growth, and consistent with staff’s economic growth forecasts. Likewise, the authorities agree that downside risks to the outlook predominate and recognize that risk mitigation measures are limited to fiscal and structural policies in the absence of monetary and exchange rate policies. As such, the authorities remain intent on building fiscal buffers (see below). They are also actively considering how to diversify the economy, especially given the current infrastructure bottlenecks as well as the longer-term risks associated with climate change.

Fiscal Sustainability

The authorities agree with staff on the necessity for additional medium-term fiscal adjustment to ensure fiscal self-sufficiency, especially after the US Compact grant ends in 2024. In 2015, commendable fiscal discipline brought expenditure savings of 4.5 percent of GDP, which helped lower the deficit significantly. At the same time, revenues increased by about 1 percent of GDP.

The authorities will continue to build fiscal space over the medium-term. This will involve careful decisions to ensure that the authorities reach both their goal of a zero current fiscal balance by 2024 and are able to continue to invest in public investment to support the tourism industry and enhance the country’s resilience to natural disasters. To achieve this outcome, the authorities will build on existing progress with new revenue measures, including through increasing the existing airport departure tax in the short-term and, in the medium-term, more comprehensive tax reform that is projected to mobilize over 4 percent of GDP in additional revenue. This will be supported by the careful monitoring of investment projects to avoid fiscal slippage, and expenditure constraint (itself supported by improved implementation of Public Financial Management (PFM) principles).

Staff views with respect to potential contingent liability risks from the Civil Service Pension Fund (CSPF) and the SOEs were also acknowledged by the authorities. The authorities have taken steps to correct the large unfunded liabilities within the CSPF, with the Congress already considering legislation that will improve the sustainability of the system. The authorities are considering cost recovery strategies for SOEs and are committed to removing subsidies once service quality has been adequately upgraded. In the meantime, planned investment to improve water distribution are underway.

Banking and Financial Sector Stability

Palau’s banking system remains strong and resilient, with banks well capitalized and liquid, with a low non-performing ratio of about 2 percent. The presence of three U.S. FDIC-insured banks is the back-bone of the banking system in Palau, holding 93 percent of the loans and 99 percent of the deposits. With regards to supervision, the Financial Institutions Commission (FIC) continues to enhance its capabilities through technical assistance and training from the Fund, while the Financial Intelligence Unit (FIU) has also improved its ability to undertake anti-money laundering investigations. The authorities are pleased that de-risking, which poses a real threat in other pacific island countries, has been assessed and reported by staff not to be a problem in Palau, owing to the three U.S. banks doing the majority of transactions. The authorities continue to undertake efforts to improve businesses’ access to credit. This includes advisory services working with applicants to improve their business plans and financial statements, as well as the Development Bank taking a more active role in providing credit to smaller borrowers.

Growth and Private Sector Development

The authorities remain committed to improving the business environment to allow the private sector to play a larger role in economic activity. To this end, the authorities are focused on reducing impediments to setting up new businesses which will improve investor confidence and lift potential growth. In this area, the ADB and other development partners continue to provide useful assistance, assisting the Government’s development agenda to improve infrastructure and reduce business costs. The government, and these development partners, are also ensuring that all new infrastructure projects undergo assessments of their resilience to natural disasters and climate change. However, the challenges faced by the authorities are structural in nature and common with other small states. This underlines the importance of continued assistance and taking a long run view on these reforms.

The recently established Economic Advisory Group (EAG) – comprising both public and private sector representatives – underlines the importance that the Government places on promoting private sector development. Whilst the focus for the short-term will be to ensure that the country continues to benefit through tourism growth that is environmentally sustainable, the EAG would be addressing pertinent policy and structural matters with the objective of attracting investment and boosting private sector development.