Republic of the Marshall Islands: 2018 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Republic of the Marshall Islands

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of the Marshall Islands

Abstract

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Republic of the Marshall Islands

Background

1. The Republic of the Marshall Islands (RMI) is a small and remote country in the Northern Pacific with a dispersed population. RMI is vulnerable to climate change because of its low elevation, and it has experienced droughts and floods repeatedly. The economy is highly dependent on external aid, with annual grants averaging about 35 percent of GDP over the past decade. RMI’s policy priorities have been to prepare for a reduction in the U.S. Compact grant after FY2023 (about 10 percent of GDP), to adapt to climate change, and to promote sustainable growth.

uA01fig01

Grants and remittances, 2016

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Sources: IMF, latest Article IV Staff Reports; and staff calculations.

2. RMI’s connections to the global financial system are at risk. The country has one domestic commercial bank, Bank of Marshall Islands (BOMI), which is at risk of losing its last U.S. dollar correspondent banking relationship (CBR) with a U.S.-based bank as a result of heightened due diligence by banks in the United States. The CBR is currently renewed every year, conditional on progress in improving the anti-money laundering and combatting the financing of terrorism (AML/CFT) framework (Selected Issues Paper 1). In addition, RMI plans to issue a decentralized digital currency as a second legal tender in addition to the U.S. dollar and the relevant law was enacted in February 2018 (Selected Issues Paper 2).

Developments, Outlook and Risks

A. Recent Developments and Outlook

3. The economy rebounded in FY2016 and momentum accelerated in FY2017, driven by public investment. Real GDP growth is estimated to have accelerated to about 3½ percent in FY2017, with a fall in copra production more than offset by the strong pick-up in fisheries and infrastructure projects, with the latter due to the resumption of U.S. capital grants. Growth is expected to remain robust relative to the historical norms in the near term, at about 2½ percent in FY2018 and about 1½ percent over the medium term, underpinned by gradual increases in infrastructure spending. Consumer prices started to rise again in mid-2017, with annual CPI inflation at 1.0 percent in 2018Q2. Inflation is expected to rise gradually to around 2 percent over the medium term.

4. The overall fiscal surplus narrowed despite large fishing license fees (Box 1). Government revenue from fishing licenses (including a one-off transfer of reserves from the Marine Resources Authority) increased significantly, from 6¼ percent of GDP in FY2014 to 18 percent in FY2017. But the overall fiscal surplus is estimated to have narrowed by ¼ percentage point to 3 percent of GDP during this period, given strong increases in recurrent spending, in particular purchase of goods and services and subsidies. The fiscal surplus is projected to narrow further to 1¾ percent of GDP in FY2018 and turn into a deficit of 1½ percent by FY2023, as government spending is expected to continue growing strongly, particularly on goods and services, while fishing license revenues remain stable in nominal terms.

5. The current account has shown large swings in recent years. Surging fishing license fees and the temporary hold on Compact grant-funded infrastructure projects saw the current account surplus widen to 15 percent of GDP in FY2015, before narrowing to 7½ percent in FY2016 because of the resumption of infrastructure-related imports. The current account balance is estimated to have turned into a small deficit in FY2017 and is projected to widen to about 3½ percent of GDP in the medium term, as infrastructure-related imports should continue to rise while fishing license fee income should remain stable in nominal terms. Such a deficit in the medium-term projection can reasonably be expected to be financed by concessional financing from donors and investment earnings from the Compact Trust Fund (Appendix I). On this basis, the external sector position is assessed to be broadly in line with underlying fundamentals and desirable policy settings, but it remains vulnerable to risks arising from possible problems with the fiscal adjustment to lower Compact grants, unresolved AML/CFT issues, and the planned issuance of digital currency (Appendix II). However, the possible margin of error in this assessment is large, given data limitations and special circumstances, especially the large expected structural change in external financing in FY2024 due to substantially lower U.S. Compact grant flows.

B. Risks and Spillovers

6. Overall risks remain tilted to the downside (Appendix III). In the absence of adequate risk- mitigating measures, the issuance of a decentralized digital currency as a second legal tender would not only increase macroeconomic and financial integrity risks but elevate the risk of losing the last U.S. dollar CBR. If RMI’s only domestic bank lost its last U.S. dollar CBR, external aid and other flows could be disrupted, which would result in a significant drag on the economy. Insufficient fiscal consolidation is the main medium- to long-term risk to growth. Government spending would need to be curtailed to maintain fiscal sustainability after FY2023. Alternatively, if the government resorted to additional external financing, external debt distress risks, which is already high as indicated by DSA analysis, would rise further, putting growth at risks because of repercussions on external financing.1 Extreme weather-related events also remain a downside risk to the economy. On the upside, decisive SOE reforms, if combined with well-managed large infrastructure projects, could raise potential growth. Because of its limited international linkages other than those to the U.S. via the Compact agreement, RMI remains insulated from spillovers from external developments.

The Authorities’ View

7. The authorities broadly agreed with staff’s assessment of the economic outlook. A strong pick up in fisheries activity also contributed to strong growth in FY2017. The pickup is expected to be temporary, and growth is expected to moderate to robust levels in FY2018, supported by continued strength in the construction sector. The authorities also expect that, over the medium term, infrastructure projects funded by the U.S. and other development partners will be the main driver of growth. They agreed that foreign grants would continue to provide stable funding for large current account deficits (excluding grants).

8. The authorities saw the grant revenue loss after FY2023, the potential U.S. dollar CBR loss, and climate change as the main risks to the outlook. They noted that the planned reduction of the U.S. Compact grant after FY2023 created significant economic uncertainty, leading them to explore new revenue sources, including the issuance of a digital currency as a second legal tender. The authorities agreed that the potential loss of the remaining U.S. dollar CBR would have a strong negative economic impact although RMI could still be connected to global financial system through a branch of a foreign bank and an Australian dollar CBR. The frequency of extreme weather episodes due to climate change has increased in recent years with adverse effects on the economy.

Protecting Finanical Stability

A. Avoiding Risks from Issuing a Digital Currency as Legal Tender

9. RMI has recognized a decentralized digital currency (“SOVEREIGN” or “SOV”) to be issued by a third party as a second legal tender in addition to the U.S. dollar. A foreign private company—an Israel-based start-up with limited financial sector experience—will be in charge of the issuance and receive half of the initial SOV issuance. The authorities expect sizeable revenue gains from the other half of the SOV issuance, which would help prepare for the reduction of U.S. Compact grant after FY2023: 20 percent of the initial coins accruing to RMI will be distributed to the resident RMI citizens to jump-start the use of the SOV, while the rest of initial coins will be allocated to trust funds to supplement the current Compact Trust Fund, support citizens who were affected by the previous U.S. nuclear tests, and finance infrastructure projects. As a first step, a law was passed in February 2018 to recognize the SOV as second legal tender, signal the RMI’s strong commitment, and help the foreign private company secure the financing needed for the development of the technology for the new digital currency.

10. The issuance raises serious economic, reputational, AML/CFT, and governance risks.

  • Unless strong AML/CFT measures are implemented, the issuance of the SOV, as contemplated, will elevate the already high risks of losing the last U.S. dollar CBR. The law requires that all users of the SOV undergo standard “Know Your Customer (KYC)” procedures and that their identity be recorded on the blockchain. However, neither the content of the “standard KYC procedures,” nor the modalities of their implementation have been established. In addition, other key measures such as transaction monitoring, reporting of suspicious transactions, compliance monitoring, and sanctioning of compliance failures are not addressed. In light of the potential for digital currencies to be misused for money laundering and terrorist financing (ML/FT) purposes, the issuance of the SOV without effective implementation of comprehensive AML/CFT measures could offset recent progress in strengthening the AML/CFT framework, leading to increased scrutiny from the AML/CFT standard setter and potential countermeasures, including, possibly, the immediate loss of the CBR.

  • SOV issuance in the currently planned form and in the absence of a monetary policy framework could also result in monetary instability and pose significant challenges to macroeconomic management. The SOV will, by design, be an international currency and subject to large volatility in its exchange rates.2 The challenges would be amplified by the planned distribution of SOVs to citizens, which would be equivalent to a monetary expansion through “helicopter money.” Depending on the exchange rate of the SOV against the U.S. dollar at the time of distribution, the implied transfer of purchasing power could be significant and require a sizable reduction in other government spending to prevent an unsustainable increase in aggregate demand.3 And as the SOV can be used to settle debts and taxes, the government and banks could experience adverse balance sheet effects and face U.S. dollar liquidity risks under currency convertibility.4

  • The SOV also raises cybersecurity and other operational risks. In the case of the SOV, these risks are compounded by the fact that the development and management of the SOV protocol are outside of the authorities’ control and in the hands of a foreign private company. In addition, the dual role of issuer and private investor bestowed to that company creates a significant conflict of interest. The limited telecommunication infrastructure in RMI will likely be an obstacle to the SOV becoming a widely used medium of exchange for some time.

uA01fig02

Mobile cellular subscriptions

(per 100 people)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Notes: 2015 data for Palau and Marshall Islands; 2016 for remaining countries.Sources: World Bank, World Development Indicators.

11. Considering the significant risks, staff recommends that the authorities seriously reconsider the issuance of the digital currency as legal tender. The potential benefits from revenue gains appear considerably smaller than the potential costs arising from economic, reputational, AML/CFT, and governance risks. While technology may help to address some of these risks, others would need to be mitigated through institutional changes. Furthermore, the use of the SOV as a means of exchange in transactions would require significant additional costs to upgrade the RMI’s telecommunication infrastructure.

The Authorities’ View

12. While acknowledging the risk from issuing the SOV, the authorities were confident that advanced technology would provide for sufficient risk mitigation. They anticipated that the risks of the SOV being misused for ML/TF purposes will be sufficiently mitigated by the fact that the identity of the SOV users will be recorded on the blockchain and that the SOV could only be traded through global cryptocurrency exchanges approved by the RMI government. They also added that the risks of monetary instability would be limited by a mechanism which will automatically adjust the SOV supply to prevent excessive price volatilities. The authorities noted that the SOV would only be issued once the planned issuance and use of the SOV are deemed to comply with Financial Action Task Force (FATF) standard and U.S. regulations and its use in transactions in the U.S. financial system has been approved by the U.S. government (as in the case of other countries’ fiat currencies). The authorities also added that they would shift their focus to addressing challenges to macroeconomic management at later stage. Considering all of these preparations, they expected it would take few years to issue the SOV. They noted that there would be no financial costs for the RMI because the Act explicitly provides that the costs related to the issuance of the SOV are to be borne by the foreign private company.

B. Enhancing Financial Sector Supervision to Address CBR Risks

13. Good progress has been made in address CBR risks. The authorities have amended the Banking Act, with a view to align the AML/CFT provisions with the FATF 40 recommendations and have started the first national risk assessment with World Bank support. The Banking Commission is re-establishing a framework for prudential banking supervision in line with international standards. The Commission is also undertaking a regulatory reform project for banking legislation and prudential standards, with assistance from PFTAC. The BOMI (only domestic commercial bank) also continues to strengthen its own AML/CFT framework by instituting additional controls, including through an AML/CFT software upgrade, and is undertaking an independent audit of its AML/CFT system. As an alternative arrangement to CBR, the authorities also support the domestic bank’s effort to obtain U.S. Federal Reserve’s approval for establishing a clearing house in Hawaii to gain direct access to check-clearing and wire transfer services in the U.S.

14. Maintaining the U.S. dollar CBR is very important for the RMI because the country uses the U.S. dollar as its legal tender and is highly dependent on receiving and spending U.S. grants. To address the country’s ML/TF risks arising from the presence of offshore and maritime registries, the authorities amended the Association Law in November 2017, which notably require that reasonable measures be taken to identify the beneficial owners of legal persons established in the RMI and to register bearer shares. However, despite these efforts, the country’s reputational risks remain elevated, notably due to ongoing concerns related to the offshore and maritime registries and the implementation of the amendments to the Association Law, as well as to tax transparency.

15. Staff recommends that the authorities take additional steps to lower further the risk of losing the last U.S. dollar CBR, irrespective of the issuance of the SOV.

  • AML/CFT. Once the national risk assessment is completed, an action plan should be developed to address the main risks identified. Domestic capacity in the AML/CFT area should be strengthened, building on the technical assistance of international organizations. Since the offshore and maritime sectors still present ML/TF risks, staff recommends imposing AML/CFT obligations on both relevant registries, as well as ensuring that requirements aimed at increasing transparency of beneficial ownership of legal persons are duly implemented (including with respect to existing legal persons and bearer shares issued prior to November 2017) and that competent authorities have timely access to up-to-date beneficial ownership information of non-resident companies.

  • Banking supervision. Staff recommends enhancing the prudential banking supervision framework further, including by complying with the relevant international standards and introducing prudential requirements covering key banking risk areas, and strengthen its implementation. Regularizing offsite supervision and the banking sector report production are needed to monitor banking sector developments and take timely actions if needed. The introduction of a ceiling on the debt service ratio would help control the already high and rising household debt, which is mostly consumer credit and amounts to about 40 percent of GDP.

  • Cooperation. The communication with the last U.S. dollar correspondent bank as well as U.S. regulators should be further enhanced, as the potential issuance of the digital currency could increase the ML/FT risk profile of the country.

The Authorities’ View

16. The authorities agreed on the need to further strengthen financial supervision and regulation. They noted that the framework for onsite and offsite AML/CFT supervision of financial institutions was strengthened with the assistance of technical assistance providers. The BOMI was recently inspected and found to have put in place the main pillars for effective AML/CFT controls. These developments, as well as the progress made in other areas (such as the strengthening of the financial intelligence unit’s technical expertise and the new requirements to identify the beneficial owners of offshore companies) helped eased the short-term risk of losing the last U.S. dollar CBR. However, the authorities noted that the enactment of the law on the digital currency in February 2018 had unexpectedly increased the country’s risk profile and acknowledged the risk of the CBR not being renewed if the digital currency is issued without adequate AML/CFT measures in place.

Securing Long-Term Fiscal Sustainability

17. The Compact Trust Fund (CTF) was set up in FY2004 to compensate for the expiring portion of the U.S. Compact grant after FY2023 (Appendix I). The CTF assets amounted to US$357 million (203 percent of GDP) as of the end of FY2017, with contributions mostly from donors (U.S. and Taiwan Province of China), and they are projected to reach US$615 million (230 percent of GDP) by the end of FY2023. The design of the Fund is such that the expected investment earnings will replace the expiring portion of the U.S. Compact grant after FY2023, although it does not provide for real value preservation.

uA01fig03

US Annual Compact Grants and Contribution to CTF

(In USD million)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Note: All the grants are based on original agreement and adjusted for inflation.Sources: Country authorities and IMF staff estimates.

18. With fiscal adjustment of 4 percentage points of GDP relative to the baseline by FY2023, real value preservation for the CTF could be achieved and risks to long-term fiscal sustainability be reduced. Reinvesting a portion of the investment earnings rather than using them for revenue purposes would be sufficient to achieve real value presentation. But drawing on 3 percent of the CTF assets annually rather than the full investment return of 5 percent would require a fiscal surplus of 2½ percent of GDP (US$7 million) by FY2023 to absorb the revenue loss implied by the expiring U.S. Compact grant (US$27 million, 10 percent of GDP). Without this adjustment, the government would have to count on additional external financing to maintain government spending on the baseline path, putting long-term fiscal sustainability at risk.

uA01fig04

Fiscal Balance Path

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Sources: Authorities and IMF staff calculations

19. Staff recommends multi-pronged efforts to achieve the needed medium-term fiscal adjustment. In particular, in the order of priority, the authorities should reverse the recent increase in recurrent spending (3½ ppt) while improving revenue administration and implementing tax reform (½ ppt).

  • Expenditure compression. Staff strongly supports the government’s initiative to lower recurrent spending, including costs of travel, supplies and personnel while preserving spending on health and education. The recently proposed ceilings for ministries’ recurrent spending (yet to be approved by the Cabinet) should play a key role to discipline the total expenditure throughout the budgeting process.

  • Revenue administration. Staff welcomes recent progress in improving registration, filing, and payment voluntary compliance. Staff recommends further efforts to enhance tax administration, with PFTAC support, including (i) further improving the information exchange between Social Security Administration and the government to increase taxpayer registration, (ii) improving return and payment collection processes, and (iii) strengthening tax audits.

  • Tax reform. The authorities should enact the tax reform bill, 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; and (iv) replacing the existing import duties with excise taxes. Although the reform package is expected to be revenue neutral, its less-distortionary and growth-friendly measures including the introduction of a consumption tax and a net profit tax could help promote inclusive growth and bring additional revenues from efficiency improvement. The authorities should continue increasing implementation capacity in this area in cooperation with international institutions, including PFTAC.

20. In addition, given that the needed adjustment entails multiple years, accelerating the pace of medium-term fiscal framework (MTFF) and public financial management (PFM) reforms will help implement the needed fiscal adjustment.

  • MTFF. Staff welcomes the government’s effort to prepare a multi-year budget framework and recommends further refinements to the framework (with PFTAC assistance), including improving estimates of baseline revenues and introducing a new template for ministries’ budget submissions that classifies expenditure by output and expenditure type.

  • PFM. Staff encourages continued efforts to improve PFM in priority areas: the legal and policy framework, the budgeting framework, the accounting system, fiscal reporting, and cash management. Debt management function also needs to be strengthened given the growing appetite for project loans.

  • Social security. Staff welcomes the recent reform, including the gradual increase of the retirement age to 65 and the increase of the contribution rate by 1 percent, which is expected to generate annual savings of more than US$4 million (2 percent of GDP). More ambitious reform, in particular further reduction in benefits, is needed as the remaining annual financing gap of about US$3 million will further widen over the medium to long term (Box 2).

The Authorities’ View

21. The authorities broadly agreed that fiscal adjustment of 4 percentage points of GDP by FY2023 was needed to be prepared for the reduction of the U.S. Compact grant. They acknowledged that the fiscal balance had not improved in recent years despite the large revenue gains from fishing license fees, and agreed that the fiscal balance would deteriorate over the medium term if recurrent spending was not contained. They also noted that even larger adjustment might be required if negative shocks were to materialize, including natural disasters. The authorities underscored, however, that important progress in fiscal reforms had been made, including a long- awaited social security reform. They stressed that more reforms would be undertaken, including improving revenue mobilization and PFM, and growth-friendly tax reforms, while they would also seek additional donor contributions to the CTF.

Adapting to Climate Change

22. RMI is one of the countries expected to be most affected by climate change. The vulnerability arises from the exposure to rising sea levels, given its low elevation, and to natural disaster such as droughts and floods. Historical data on natural disasters from the Emergency Events Database indicate that the average likelihood of a severe natural disaster is 5.4 percent per year, with about 25 percent of total population being affected by a severe disaster event. Staff estimates that expected annual GDP growth would be lower by about 0.1 percent if the baseline projection is adjusted for the expected impact of severe natural disasters.5 In the case of a one-time extreme disaster event, annual GDP growth could be lower by about 2 percentage points compared to the baseline (Box 3). For the latter, the LIC-DSA indicates that the debt-to-GDP ratio could rise further by about 5 percent.

uA01fig05

Probability of Severe Natural Disasters

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Note: The size of the circle represents the probability that each country is hit by a severe natural disaster (above 75th percentile)Sources: Lee, Zhang and Nguyen, 2018 (IMF working paper, No.18/108).

23. Staff encourages the authorities to proceed with climate resilience projects, with the assistance of the World Bank and the Green Climate Fund, to strengthen early disaster warning system, improve coastal protection and planning, and promote renewable energy. It will also help provide contingency funds for emergency response to medium-size hazards. The climate-change adaptation costs are estimated to be about 2½ percent of GDP per year,6 and staff recommends recognizing these costs explicitly in the budget and the medium-term fiscal framework to ensure continuity and efficiency on both spending and funding sides.

The Authorities’ View

24. The authorities agreed on the need for continued efforts in building resilience and mitigating disaster risk. Noting the increasing risks of natural disasters due to climate change, the authorities actively sought assistance in the international community for climate adaptation and mitigation projects. Climate resilience projects are on track and currently focus on strengthening early warning system, climate resilient investment in shoreline protection, and immediate response and assistance to emergencies. They agreed on the need to include climate-change adaptation costs in the budget but it was viewed to be challenging given the competing demands for other expenditures.

Promoting Sustainable Growth

25. The planned state-owned enterprise (SOE) reforms should be fully implemented. As the population is spread out over more than 20 coral atolls, the provision of community services— such as electricity, airline, and shipping—is costly. However, progress in SOE reforms has been limited since the enactment of the SOE Act in 2015. Subsidies to SOEs rose from 5¾ percent of GDP in FY2014 to 7½ percent in FY2017, suggesting that the budget discipline of SOEs is deteriorating. Staff welcomes the recent establishment of the SOE monitoring unit within the Ministry of Finance, which will oversee the implementation of the SOE Act and estimate the costs for community service obligation (CSO). Staff recommends reducing subsidies to SOEs that are not justified by such services. This would help the fiscal consolidation efforts and could free up resources for other purposes.

26. Improving the business environment for sustainable private sector development remains key to promote sustainable growth. Private sector development is handicapped by remoteness, small economic size, and geographical dispersion, as well as a poor regulatory framework and business environment. The World Bank’s ease of doing business survey indicates that RMI is lagging its peers in the areas of registering property and resolving insolvency. Staff recommends land registration reforms which can help collateralize properties—thereby improving access to credit—and lower hurdles for long-term land leases by nonresidents—thereby facilitating foreign direct investment.

The Authorities’ View

27. The authorities plan to accelerate SOE reforms, which is also key to promote private sector development. They noted that SOE losses in part reflected service provision to remote outer islands but agreed on the necessity of fully costed and approved CSOs. The establishment of the SOE monitoring unit was a milestone in the SOE reform. The unit will start focusing on four SOEs to develop their CSO frameworks and improve their performances. While acknowledging the potential conflict of interest, the authorities explained that the amendment of the SOE Act in 2016—allowing for increased representation of public officials on SOE Boards—was needed to tap expertise in the public sector. They acknowledged the need to consider novel approaches in land registration reform for private sector development. Skilled labor shortage arising from ongoing migration of workers to the U.S. remained an important hurdle for private sector development. The authorities also noted that they continued to make progress toward Sustainable Development Goals, building on the progress with core Millennium Development Goals, including reducing poverty, promoting gender equality and empowering women (Appendix IV).

Data

28. Staff welcomes the progress in improving domestic capacity for independent national account data compilation. National accounts statistics have long been compiled by US-supported external consultants, with limited attention to developing the capacity of the local statistics office. A series of PFTAC TAs and trainings have improved RMI’s capacity for data compilation in recent years. Staff encourages the authorities to continue working closely with PFTAC for a successful independent compilation of the national accounts statistics and moving to independent BOP compilation over the medium term. Staff also recommends the development of standard financial soundness indicators for the overall banking sector.

Staff Appraisal

29. Outlook. Economic activity rebounded in FY2016 and growth accelerated in FY2017 as a strong pick-up in fisheries and construction activity more than offset lower copra production. Growth is expected to remain robust in the near term driven by continued infrastructure investment. The external sector position is assessed to be broadly in line with underlying fundamentals and desirable policy settings, but it remains vulnerable to risks arising from possible problems with the fiscal adjustment to lower Compact grants, unresolved AML/CFT issues, and the planned issuance of digital currency.

30. Risks. Overall risks remain tilted to the downside. The issuance of a decentralized digital currency as a second legal tender in the absence of adequate risk-mitigating measures would increase macroeconomic and financial integrity risks as well as elevate the risks of losing the last U.S. dollar correspondent banking relationship. Inadequate fiscal consolidation before the reduction of the U.S. Compact grant in FY2023 is the main medium- to long-term risk as government spending including on public investment would need to be curtailed to maintain fiscal sustainability after FY2024.

31. Digital currency. Unless strong AML/CFT measures are implemented, the issuance of the SOV will elevate the already high risks of losing the last U.S. dollar CBR. SOV issuance in the absence of a monetary policy framework could also result in monetary instability and pose significant challenges to macroeconomic management. Thus, the potential benefits from revenue gains at this point appear considerably smaller than the potential costs arising from economic, reputational, AML/CFT, and governance risks. The authorities should, therefore, seriously reconsider the issuance of the digital currency as a second legal tender.

32. Financial sector policy. The authorities should take additional steps to strengthen AML/CFT framework, which would help address CBR risks. Following the completion of the national risk assessment, an action plan should be developed to address the main risks identified. Domestic capacity in the AML/CFT area should be strengthened and AML/CFT obligations should be imposed on both the offshore and maritime registries. The prudential banking supervision framework should be enhanced further, including by complying with the relevant international standards and introducing prudential requirements covering key banking areas.

33. Fiscal policy. The government needs fiscal adjustment of 4 percentage points of GDP relative to the baseline by FY2023 to reduce risks to long-term fiscal sustainability. Multi-pronged efforts are required to achieve the needed medium-term fiscal adjustment by reversing the recent increase in recurrent spending and improving revenue administration and implementing tax reform. Accelerating the pace of medium-term fiscal framework and public financial management reforms will be critical in implementing the needed fiscal adjustment.

34. Climate change. The authorities should continue the work needed to adapt to climate change, including by strengthening early disaster warning system and improving coastal protection and planning. Explicit budgeting of climate-change adaptation costs would help ensure continuity in project implementation.

35. SOE reform. The authorities should fully implement the planned SOE reforms. Staff welcomes the recent establishment of the SOE monitoring unit and recommends reducing subsidies to SOEs that are not justified by the provision of the essential community services as this would help the fiscal consolidation efforts and could free up resources for other purposes.

36. Data. Staff welcomes the progress in improving domestic capacity for independent national account data compilation. Staff encourages the continued efforts for a successful independent compilation of the national accounts statistics and moving to independent BOP compilation over the medium term.

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

Fishing License Revenues1

Collective efforts have been made to secure long-term sustainability of tuna in the region. The Party to Nauru Agreement (PNA) is a regional initiative by 8 countries2 in Western Central Pacific Ocean (WPCO)3 which discusses terms and conditions for tuna purse seine fishing licenses to secure long-term sustainability of tuna in the region. In 2008, the PNA introduced the Vessel Day Scheme (VDS), which sets a maximum number of annual fishing vessel days in the region as well as a minimum benchmark daily price per vessel.4 The PNA allocates annual fishing vessel days to each member country based on tuna availability and scientific advices to maintain currently spawning biomass levels. Member countries usually charge vessel days at a higher price above the benchmark through negotiations in advance, and are flexible to trade vessel days with other members in necessary situations (e.g. extreme weather events or El Nino) based on mutual agreements. With such regional corporation, PNA member country’s fishing license revenue is partially shielded from tuna price volatility and short-term weather variability.

Fishing license revenues in RMI have increased significantly since the introduction of the VDS minimum benchmark price. The VDS benchmark price per vessel was initially set at US$5,000 per day in 2011, and subsequently increased to US$6,000 in 2013 and to US$8,000 in 2015. Under the VDS scheme, RMI has been allocated about 3,000 annual fishing vessel days and has distributed them to foreign and domestic vessels at different prices. Aiming at promoting domestic fishing industry, RMI has sold about 40 percent of its annual fishing vessel days to domestic fleets at discounted prices (for example, US$6,000 in 2016). The remaining 60 percent of fishing vessel days have been sold to foreign vessels at negotiated prices which are usually higher than the benchmark price at over US$10,000 per day. More recently in 2015, five PNA countries5 launched the sub-regional pool scheme which allows foreign vessels to access multiple countries’ fishing zones by paying a premium price of about US$12,000 per day.6 Benefitting from the increase of VDS benchmark prices and increase value of vessel catch in its national water, fishing license revenues have increased significantly from US$3 million in FY2011 to US$25.6 million in FY2017 (excluding a one-off transfer of reserves from MIMRA7).

uA01fig06

Fishing License Revenue and Value per Catch

(In USD millions)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Sources: MIMRA Annual Report and Oceanic Fisheries Program
uA01fig07

RMI: Vessel Days Allocation and Fishing License Revenue

(In percent of the total)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Note: Chart is based on 2016 data.Sources: MIMRA and IMF staff estimates.

Going forward, fishing license revenues are expected to remain stable in nominal terms over the medium term. The benchmark prices and fishing vessel days are not expected to increase further given the difficulty to reach a consensus among PNA members. Short-term tuna price volatility and environmental variability are less likely to influence the fishing license revenues given the structure and flexibility of the VDS scheme.

1 Prepared by Mareta Kaiteie and Huan Zhang.2 Federated States of Micronesia, Kiribati, RMI, Nauru, Palau, Papua New Guinea, Solomon Islands and Tuvalu.3 WPCO represents 60 percent of the world tuna catch, of which PNA water accounts for about a half.4 VDS minimum benchmark price was officially implemented in 2011, three years after the introduction.5 Tuvalu, Nauru, RMI, Solomon Islands, and Tokelau6 Given that tuna is highly migratory and follows the Western Pacific Warm Pool, regional pool scheme effectively mitigates the risks of low tuna catch due to the El Nino Southern Oscillation variability. For example, during El Nino years (e.g. in 2015), tuna migrates to Kiribati and Samoa, therefore leaving RMI a low tuna catch rate. Being aware of this risk, RMI increased its contribution to regional pool from 9 days in 2015 to 352 days in 2017.7 The Marshall Islands Marine Resources Authority (MIMRA) administers fishing licenses on behalf of the government. The government secured US$15 million in FY2017 by tapping into MIMRA’s pooled deposits.

Social Security Reform1

The authorities adopted a long-awaited social security reform in FY2017. Without reforms, social security fund (SSF) was projected to deplete its reserves over the medium to long term, potentially adding a large fiscal drain. This reform includes (i) increase in the contribution rate by 1 percentage point (from 7 to 8 percent) for both employers and employees; (ii) gradual increases in retirement age from 60 to 65 years old (by 1 year every two years); (iii) increase in the maximum annual taxable income from US$20,000 to US$40,000; and (iv) reduction in benefit for those receiving US$300 or more per month among others. The reform is projected to substantially improve the prospect of SSF with annual fiscal savings of more than US$4 million (2 percent of GDP). Together with favorable investment returns and subsidies from the government, the SSF reserves improved from US$66 million in FY2016 to US$72 million in FY2017.

Nevertheless, more ambitious reforms are needed to put the social security system on a sustainable path. The remaining gap between benefits and contributions is still about US$3 million in FY2017, and would further increase over the medium to long term, posing additional fiscal burdens. If the government would not provide subsidies, SSF reserves would start declining from FY2021. To put the social security system on a sustainable path, more ambitious reforms will be needed. In particular, given that about 90 percent of current beneficiaries have received more than what they contributed, the authorities intend to focus on further reduction in benefits.

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Marshall islands – Social Security Fund

(In million USD)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Sources: MISSA; (MF staff calculations.
1 Prepared by Kazuaki Miyachi.

Implications from Natural Disaster and Climate Change1

RMI is one of the most vulnerable countries to climate change. The vulnerability arises from the exposure to rising sea levels due to very low elevation (average 2 meters), and RMI is highly dependent on rainfall for water supply. Droughts, floods, king tides, tropical cyclones, and erosion are the main threatening disasters for RMI. The disaster interval, defined as the years in between two disasters, was about 1.5 years during 2011–2016. According to the Emergency Events Database (EM-DAT)2, two severe droughts during the past five years (in 2013 and 2016) hit RMI and affected about 50 percent of the population in total.

The expected economic impact of severe natural disasters is expected to remain small as the probability of such event should remain small compared to other countries in the region. Based on the EM-DAT database and WEO data, Lee, Zhang and Nguyen (2018) find that the average likelihood of a severe natural disaster is 5.4 percent per year in RMI, a bit below the regional average, with about 25 percent of total population being affected on average by a disaster event. They estimate that expected annual GDP growth would be lower by about 0.1 percent, and the annual trade deficit higher by 0.3 percent of GDP, if the baseline projection were adjusted for the expected impact of severe natural disasters. In the case of a one-time extreme natural disaster event, real GDP growth could be lower by about 2 percentage points compared to the case of no disaster.

Yearly Impact From Natural Disasters in Pacific Island Countries

(In percentage point)

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*Lee, D., Zhang, H. and Nguyen, C., 2018. The Economic Impact of Natural Disasters in Pacific Island Countries: Adaptation and Preparedness (No. 18/108). International Monetary Fund.*Yearly impacts are calculated as the product of probability of severe natural disasters (above 75th percentile) and the coefficients of severe natural disaster dummy (above 75th percentile) from the fixed effects regressions.

The costs from climate change could rise further in the long run. Climate change is likely to result in higher global temperatures, which could increase risk of droughts and intensity of storms (NASA, 2005)3. While the estimated impact of severe natural disasters is low, the recent study by the ADB estimates that the broader climate change cost in Pacific region could be about 2.2 to 3.5 percent of the country’s annual GDP by 2050 when all the key factors that are affected by climate changes are considered such as agriculture, water, costal, energy, human health, and ecosystems (ADB, 2014)4.

1 Prepared by Huan Zhang.2 Established by the Center for Research on the Epidemiology of Disasters and the database is available at http://www.emdat.be/.3 Riebeek, H. The Rising Cost of Natural Hazards. 2005. Retrieved from NASA Earth Obsevatory.4The Economics of Climate Change in the Pacific. 2014. Asian Development Bank.
Figure 1.
Figure 1.

Marshall Islands: Real Sector Developments

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

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

Marshall Islands: Fiscal Sector Developments

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Sources: Country authorities, WEO, and IMF staff estimates.
Figure 3.
Figure 3.

Marshall Islands: External and Credit Developments

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

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

Marshall Islands: Selected Economic Indicators, FY2014–23 1/

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

Fiscal year ending September 30.

Includes current grants.

In this table, it is assumed that RMI will continue to benefit from its grant-only status. On the other hand, in the LIC-DSA, for World Bank (IDA) and other MDBs, regular credit terms on all lending is assumed for all years in the projection period for which grant finance has not already been committed. This is because the DSA serves to test a country’s capacity to take on WB and ADB financing on credit terms.

Table 2.

Marshall Islands: Statement of Government Operations, FY2014–23 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, FY2014–23 1/

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

Fiscal year ending September 30.

Table 4.

Marshall Islands: External Vulnerability Indicators, FY2014–17

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

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, FY2014–17

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Sources: RMI authorities; and IMF staff estimates.

Includes deposits of social security administration and other trust funds.

Yearly 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 Outlook1

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, medium-term fiscal adjustment of about 4 percentage of GDP is needed.

1. The Compact Trust Fund (CTF) was created in 2004 to contribute to the long-term budgetary self-reliance of the RMI. The CTF aims to provide the RMI with a stable source of revenue to compensate for the reduction of US Compact grants after FY2023. This reduction of US Compact grants will amount to US$27 million (about 10 percent of GDP) in FY2024.

2. 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.2 In years when investment earnings are not sufficiently high, the C account of the fund can be used to make up for the shortfall.3 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.

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Compact Trust Fund Oustanding Value

(In millions of US dollars

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Sources: RME authorities; staff estimates

3. Contributions to the fund. The value of the CTF (excluding the D account) was US$357 million as of end-FY2017. Of this amount, US$219 million came from contributions by the U.S. (US$161 million), the RMI (US$ 33 million), and Taiwan POC (US$26 million). The D account amounted to US$13 million as of end-FY2016.

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Marshall Islands CTF; Weighted Annual Investment Return

(Percent)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Sources: Fiscal Year 2016 Annual Report

4. Fund performance. The current investment strategy of the CTF (adjusted in 2014) stipulates that 30 percent of the fund is invested in the U.S. equities, another 30 percent in international equities, while the rest is split between fixed income (20 percent) and alternative investments (20 percent). As of end-FY2016, the fund’s average annual nominal return rate since inception was 6.7 percent, net of fees.

5. 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.

Scenarios

6. 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 reduction of Compact grants in FY2024, but not preserve the real value of the CTF. In the policy action scenario, the real value of the CTF is preserved.

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Compact Trust Fund Balance 1/

(In millions of FY2017 dollars)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

1/ Includes the market value of the CTF and accumulation of fiscal surpluses.2/ Assume 5 percent return from FY 2018, with no fiscal adjustment.3/ Assume 5 percent return from FY 2018, achieve fiscal surplus of 2.5 percent by FY2023.4/ Assume 4 percent return from FY 2018, achieve fiscal surplus of 2.5 percent by FY2023.Sources: Fund staff estimates.

7. Baseline scenario. If the CTF earns a 5 percent nominal return annually from FY2018 onwards, the distribution from the estimated assets for FY2024 would generate sufficient income to fully offset the revenue loss implied by the expiring Compact grants (US$27 million). Under this scenario, however, long-term self-sufficiency would not be secured because the real value of the CTF will likely decline over time.

8. Policy action scenario. Under this scenario, the government is assumed to undertake a fiscal adjustment of about 4 percentage of GDP over the medium term (from FY2018 to FY2023) to build an overall fiscal surplus of 2½ percent of GDP (about US$7 million) by FY2023. Under this course of action, drawdowns from the CTF can be contained at around 3 percent (about US$20 million) of fund balances. The remaining 2 percent of fund balances can be preserved in the CTF, which enables to maintain the real value of CTF (with about 2 percent inflation adjustment).

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Compact Trust Fund Investment Returns

Relative to the reduction in grants (=100, US deflator adjusted)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

1/ Assume 5 percent return from FY 2018, with no fiscal adjustment.2/ Assume 5 percent return from FY 2018, achieve fiscal surplus of 2.8 percent by FY 2023.3/ Assume 4 percent return from FY 2018, achieve fiscal surplus of 2.8 percent by FY 2023.Sources: Fund staff estimates.

9. Sensitivity to investment returns. It should be noted that preserving the real value does not eliminate the risk of future shocks to fiscal income from the CTF. CTF investment returns are highly volatile, and the outcome of scenario analysis is sensitive to the assumption used for these returns. Staff estimates suggest that a permanent decrease in expected returns of 1 percentage point (from 5 to 4 percent) would increase the fiscal adjustment need by 2¼ percentage point of GDP from the recommended policy action scenario. The U.S. Government Accountability Office (GAO) projected that, with a 15 percent probability, the CTF would not be able to disburse any funds in 1 or more years during the first decade due to return volatility,4 underscoring the importance of further building assets in the CTF.

Appendix II. External Sector Assessment1

External balance assessment. The external sector position is assessed to be broadly in line with underlying fundamentals and desirable policy settings, but it remains vulnerable to risks arising from possible problems with the fiscal adjustment to lower Compact grants, unresolved AML/CFT issues, and the planned issuance of digital currency.2 The assessment is also complicated and subject to a large margin of error, given serious data limitations, the vulnerabilities of a small island economy in general, and the anticipated large structural change in external financing in FY2024 from substantially lower U.S. Compact grant flows.

  • The External Sustainability approach estimates the current account norm to be a deficit of 3.0 percent of GDP, compared to the projected medium-term current account deficit of 3.1 percent. Hence, with a gap of 0.1 percent of GDP, the projected current account balance is assessed to be broadly in line with the level that would stabilize the net international investment position and also allow to maintain the real value of the Compact Trust Fund after FY2023.

  • The Current Account and REER approaches are less applicable due to data limitations that result in large margins of statistical variation around the estimates. These backward-looking approaches cannot take into account the structural break in FY2024 arising from the reduction of U.S. Compact grant.

Reserves. RMI’s government U.S. dollar deposits effectively serve as reserves and are the main instrument to absorb short-term liquidity shocks, given that the country has no central bank and uses U.S. dollar as its official currency. Compared with other Pacific island countries, RMI has relatively low level of reserves, at about 0.6 months of imports as of FY2017, but the stable foreign grants inflow shields the country from liquidity squeezes.

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Reserve Levels

(In current months of imports)

Citation: IMF Staff Country Reports 2018, 270; 10.5089/9781484375723.002.A001

Competitiveness. RMI’s external competitiveness is hampered by domestic labor shortage, especially skilled labor. Under the U.S. Compact Agreement, people from RMI can work in the U.S. without separate permit, resulting in an increasing number of skilled workers migrating to the U.S. motivated by higher wages, better health care and education systems. However, this negative impact is partly offset by higher remittances to RMI. The capital projects in the pipeline supported by ADB/WB could potentially raise the country’s competitiveness by improving infrastructure capacity.

External Financing. The long-standing trade deficit is offset by fishing license fee income and official transfers. Fishing license fee income is expected to stabilize around US$25 million in nominal terms, and grants from other donors are expected to continue after the Compact grant agreement with the U.S. expires in FY2023. Most of public investment would continue to be financed by capital grants.

Appendix III. Risk Assessment Matrix 1/

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Appendix IV. MDG and Strategic Surveillance Matrix

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Appendix V. Main Recommendations of the 2016 Article IV Consultation

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1

RMI remains at a high risk of debt distress as new disbursements from WB and ADB are assumed to be in credit terms despite its grant-only status. To a large extent the high risk of debt distress, therefore, is by design, as the DSA serves to test a country’s capacity to take on WB and ADB financing on credit terms.

2

The SOV is not equivalent to a central bank digital currency, which is a digital form of the central bank’s liability (cash and reserves) because RMI uses the U.S. dollar as a legal tender and the SOV’s exchange rates would be determined on global cryptocurrency exchanges.

3

For example, if the SOV was issued at the price of about $50 as targeted at the Initial Coin Offering and distributed to resident RMI citizens as planned, it would be equivalent to a transfer to households of about 11 percent of GDP per year over the next five years.

4

The liquidity backstop to guard against potential liquidity problems is limited in the absence of deposit insurance and small government deposits. However, with a loan-to-deposit ratio of less than 60 percent, the Bank of Marshall Islands holds a substantial share of its asset abroad, which could help boost liquidity should such pressures arise.

5

The baseline projections after FY2023 take into account the expected impact of natural disasters in the LIC-DSA analysis, while assuming no natural disasters for FY2018–2023 to avoid complication in near-term policy discussions.

6

The ADB estimated that the climate-change adaptation costs would be 1½–2½ percent of GDP annually for the Pacific region (ADB, 2013) and the Intergovernmental Panel on Climate Change (2014) suggested that the costs of sea level rise impacts in the Pacific would be highest for Micronesia, Palau, RMI, and Nauru.

1

Prepared by Kazuaki Miyachi.

2

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.

3

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-FY2016, it held US$59.8 million (about 2.2 times of the projected amount).

4

U.S. Government Accountability Office, “Compacts of Free Association, Actions Needed to Prepare for the Transition of Micronesia and the Marshall Islands to Trust Fund Income.” 2018.

1

Prepared by Huan Zhang.

2

The recommended fiscal adjustment of 4 ppt of GDP over the medium term is to preserve the real value of the CTF and would lower the risks that the external position will not be consistent with underlying fundamentals.

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. “Short term” and “medium term” are meant to indicate that the risk could materialize within 1 year and 3 years, respectively.