Federated States of Micronesia: 2019 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for the Federated States of Micronesia

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Federated States of Micronesia

Abstract

2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Federated States of Micronesia

Background

1. The Federated States of Micronesia (FSM) is a Pacific island state, dependent on foreign grants and vulnerable to climate change. The country comprises 607 islands spread over the world’s 14th large st geo graphic Exclusive Eco nomic Zone (EEZ). The Compact Agreement with the United States provides for grants and various assistance. The FSM is highly vulner able to climate change, facing frequent weather-related disasters and rising sea levels. Its fede ral structure, comprising fo ur states with diverse cultures, has challenged national-level consensus building. While extreme poverty remains high compared with Pacific Island peers, significant improvements have been made over the last decade in maternal and child health, access to electricity, and improved sanitation.

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Source: iStock.com/PeterHermesFurian

2. The FSM faces significant medium-term uncertainty related to the post-2023 relationship with the United States. Unless arrangements under the Compact Agreement are renewed, the government is expected to lose access to the Compact grants and various macro-critical services in 2023 (Box 1). While the U.S. government has been contributing into a trust fund (known as the Compact Trust Fund; CTF) with an aim to replace these grants from 2024, distributions from the fund are unlikely to be enough to offset the loss of the grants, giving rise to a fiscal cliff.”

3. Now is the time for action to reduce the post-2023 uncertainty. There has been some progress in implementing the reforms recommended during the 2017 Article IV consultation, including saving revenue windfalls into the FSM Trust Fund (FSMTF)—a fund established by the FSM government with the aim to provide an additional revenue source to ensure long-term fiscal sustainability (Appendix I). Nonetheless, little progress has been made on revenue mobilization and expenditure rationalization to cope with the potential fiscal cliff. In addition, the 2019 Article IV consultation also covered actions to address the potential reduction of banking sector oversight and post-disaster rehabilitation under the Compact Agreement, as well as structural reforms to promote private sector development. To help the authorities strengthen climate change resiliency, a Climate Change Policy Assessment (CCPA) was conducted as an integral part of the consultation.

Recent Developments

4. The FSM economy has performed well in recent years. GDP growth has been higher than the historical average since FY2015 (ending September 2015). While GDP growth is estimated to have slowed down from 2.4 percent in FY2017 to 1.2 percent in FY2018 due to a contraction in construction, employment growth has remained higher than the historical average. Inflation has been low due to the use of the U.S. dollar as legal tender and is estimated at 1.5 percent in FY2018.

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FSM: GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: FSM authorities; and IMF staff calculations.

5. Revenue windfalls strengthened the fiscal position. The general government (comprising national and state governments) has recorded budget surpluses since 2012, with revenues from foreign grants and fishing license fees (reflecting the FSM’s large EEZ) accounting for around a half of GDP. The surplus increased to 15 percent of GDP in FY2017 and 27 percent of GDP in FY2018, owing to large-scale corporate tax payments from investment companies domiciled in the FSM,1 while a pickup in capital grants from the United States and the World Bank boosted public investment. The decision to save most of the revenue windfalls allowed the government to build up the FSMTF to 57 percent of GDP in FY2018. Meanwhile, the value of the CTF rose to 168 percent of GDP.

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FSM: Fiscal Developments

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: FSM authorities; and IMF staff calculations.

6. The external position also improved. The FSM’s large trade deficit has been financed by surpluses in the income balances, generated mostly by grants and fishing license fees. The current account (CA) balance turned to a surplus in FY2015 due to rising fish exports and fishing license fees, while the trade deficit has narrowed in FY2016–17, consistent with real depreciation driven by low inflation in the FSM relative to trading partners. The CA surplus surged to 24.5 percent of GDP in FY2018 owing to the large corporate tax payments. The FSM has a positive net international investment position (NIIP) amounting to 130 percent of GDP at end-FY2017, mainly reflecting a large share of bank deposits invested abroad and the buildup of the FSMTF.2

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FSM: Current Account and Components

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Source: FSM authorities; and IMF staff calculations.
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FSM: Effective Exchange Rate (EER)

(Index, 2010= 100)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: IMF staff estimates.

7. The FSM’s external position is assessed to be broadly consistent with the level implied by fundamentals and desirable policies (Appendix II). The underlying CA balance in FY2018 is estimated at a surplus of 3.4 percent of GDP after adjusting for the windfall corporate tax payments. The EBA-lite methodology estimates the CA norm at 3.9 percent of GDP, resulting in a relatively small CA gap of -0.5 percent. The policy gap (about -3 percent of GDP) is mostly explained by medium-term fiscal adjustment needs of 4–5 percent of GDP to avoid the FY2024 fiscal cliff (1114). The results should be interpreted with caution, given the FSM’s heavy dependence on grants and fishing license fees, which can be volatile.

Outlook and Risks

8. Growth is projected to converge to potential over the medium term. It is projected to improve to 1.4 percent in FY2019 reflecting a recovery in construction, then converging to potential estimated at 0.6 percent by FY2022. The estimate is underpinned by labor productivity growth of 0.7 percent and a slight contraction in employment, in line with the FSM’s performance over the last two decades, also taking account of the likely impact of natural disasters (the FSM experienced five natural disasters during this period). Inflation is projected to converge to 2 percent over the medium term, in line with U.S. inflation. Owing to a further corporate tax windfall collected in 2019Q1, fiscal and CA surpluses are projected to reach 19 percent and 16 percent of GDP, respectively, in FY2019.

9. Risks to the outlook are tilted to the downside (Appendix III). The substantial uncertainty surrounding the post-2023 relationship with the United States, including the FSM’s capacity to cope with the fiscal cliff, disaster rehabilitation, and financial sector supervision, can discourage private investment and cause emigration, dampening growth. Weather-related natural disasters remain a major downside risk to the economy. A sharp tightening of global financial conditions may reduce the prices of risky financial assets held by the CTF and FSMTF, hindering the planned buildup of these funds. On the upside, decisive reforms on public investment management (¶16) and private sector development (¶34–36), as well as renewal of the Compact Agreement or new grants from development partners, can shore up potential growth.

Authorities’ Views

10. The authorities broadly agreed with staff’s assessment on the economic outlook and risks. They acknowledged the substantial uncertainty originating from the potential expiration of the Compact support in 2023 and noted that a government committee, Joint Committee on Compact Review and Planning, has been working on the economic and other implications for over a year now, including the critical areas identified by staff.

Policy Discussions

With the scheduled expiration of the Compact Agreement heightening medium-term uncertainty, the authorities should start implementing fiscal consolidation, improving climate change resilience, strengthening banking sector supervision, and accelerating efforts to develop a vibrant private sector.

A. Start Fiscal Consolidation to Avoid Fiscal Cliff

Background

11. The fiscal balance is projected to remain in surplus through FY2023. Under staff’s baseline projection assuming no fiscal consolidation, the surplus is projected at 4–7 percent of GDP during FY2020–23, as grants and fishing license fees remain abundant. The combined value of the CTF and FSMTF is projected to reach 322 percent of GDP by FY2023, reflecting scheduled contributions from the U.S. government into the CTF, continued transfers of budget surpluses to the FSMTF, and a nominal rate of return assumed at 5 percent.

FSM: General Government Operations, FY2017–2024

(Baseline scenario; in percent of GDP)

article image
Sources: FSM authorities and IMF staff estimates and calculations.

12. Nonetheless, the FSM is expected to face a fiscal cliff in FY2024, with greater revenue volatility afterwards. Unless the Compact Agreement or parts of it are renewed, Compact grants amounting to 20 percent of GDP will expire in FY2023 and be replaced by investment returns accruing to the CTF, projected at around 11 percent of GDP in FY2024. As a result, the overall balance is projected to turn from a surplus of around 4½ percent of GDP in FY2023 to a deficit of 4½ percent of GDP in FY2024. Moreover, the distribution will be limited to investment returns from the CTF, with no distribution allowed in case of negative returns. This will translate into significant revenue volatility, complicating fiscal management.

13. Due to the fiscal cliff, the FSM remains at high-risk of debt distress. Under the baseline scenario, the post-FY2023 fiscal deficits would put debt on an upward trajectory, with the external debt-to-GDP ratio rising from 12 percent in FY2023 to 57 percent in FY2039. The Debt Sustainability Analysis (DSA) suggests that DSA thresholds on the present value of external debt-to-GDP and public debt-to-GDP will be breached within a 20-year horizon, which is more appropriate for the FSM because the standard 10-year horizon would mask the consequence of the potential FY2024 fiscal cliff on debt dynamics.

Staff’s Views

14. To cope with the fiscal cliff, a gradual fiscal adjustment of 4–5 percent of GDP through FY2023 is warranted. While there is uncertainty in staff’s baseline projection, this would likely enable balancing the budget in FY2024, minimizing fiscal financing needs and concerns over the fiscal cliff. Given the potential impact on growth—staff analysis suggests that the adjustment can shave off GDP growth by 0.1–0.3 percent annually over FY2020–24—the adjustment should be gradual, supported by efforts to raise grants-financed public investment3 and pro-growth structural reforms to vitalize the private sector.

FSM: Illustrative Fiscal Scenarios

(In percent of GDP)

article image
Sources: FSM authorities and IMF staff estimates and calculations.

15. The adjustment can be achieved by growth-friendly measures, preserving essential social spending.

  • Growth-friendly tax policy reforms, including introducing a VAT and selected excises on tobacco, alcohol, and fuel, and tightening eligibility on concessional fishing license fees for the domestic fishing industry, can contribute 2½–3 percent of GDP. These measures would be more efficient and less distortive than a tax rate increase for the gross receipts tax, which is levied on business turnover. These tax policy reforms should be supplemented by accelerating tax administration reforms, supported by technical assistance (TA) from the Pacific Financial Technical Assistance Center (PFTAC), and the planned roll-out of a new tax administration IT system.

  • To mitigate the negative impact on the poor, expenditure reforms should focus on rationalizing nonessential expenditure, while preserving spending on education, healthcare, and infrastructure, including on climate change resilience. Limiting wage bill growth at 1 percent annually over FY2020–23 would yield a saving of VA percent of GDP by FY2023, which can be achieved by slower salary increases rather than employment measures (e.g., hiring restraints), complemented by efforts to enhance public sector efficiency (Box 2). Rationalizing goods and services spending through public financial management (PFM) reforms (1116) can also generate savings and promote growth.

FSM: Menu of Fiscal Adjustment Measures

article image
Sources: IMF staff estimates and calculations.
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Pacific Islands: Tax Revenue, 2018

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: FSM authorities; and IMF staff calculations.
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Pacific Islands: Government Wage Bill, 2017

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: FSM authorities; IMF staff calculations.

16. PFM reforms are critical to underpin fiscal adjustment. Weaknesses in PFM include reliance on manual processing as well as inadequate procurement procedures and capital project screening. With support from the World Bank and PFTAC, the authorities adopted a reform roadmap for 2017–20 and are upgrading PFM regulations and the IT system. Stepping up these efforts can generate multi-faceted benefits from: (i) identifying expenditure savings without undermining the quality of spending; (ii) speeding up execution of projects financed by capital grants, which can cushion the negative growth impact of the fiscal adjustment; and (iii) laying the foundation for more efficient public investment management, which will help climate change adaptation.

17. Future revenue windfalls should be saved to build up the FSMTF. In this context, staff commends the authorities’ decisions to save the revenue windfalls during FY2017–18 and welcomes the newly adopted mechanism to save fixed proportions of corporate income tax collections and fishing license fees to the FSMTF.4 This effort can be further ensured by budget process reforms reducing the scope for undue and ad-hoc spending increases.

18. The current arrangement restricting post-2023 distributions from the CTF to investment returns will result in large revenue volatility. Reconfiguring the distribution arrangement aimed at lowering the volatility—which would require amending the Trust Fund Agreement under the U.S. Compact Agreement—would help reduce fiscal risks beyond FY2023. In the absence of such a reconfiguration, the volatility can be offset by drawdowns from the FSMTF as needed. In this case, distributions from both trust funds should be set at a level that can sustain their balances in the long run. According to staff simulations (Appendix IV), setting annual distributions at 11 percent of GDP from the two trust funds, as envisaged in the fiscal adjustment scenario (¶14), would lead to a decrease in the combined value of the two funds as a percent of GDP in the long run. Undertaking a gradual fiscal adjustment beyond FY2023 and reducing annual distributions to 6 percent of GDP by FY2034 would stabilize the expected value of the trust funds at about 270 percent of GDP through FY2050, ensuring long-run sustainability and intergenerational equity.

Authorities’ Views

19. The authorities broadly concurred with staff’s assessments and recommendations on fiscal policy. They supported staff’s judgement to use a 20-year forecast horizon in the DSA in consideration of the expected fiscal cliff. A gradual fiscal adjustment through FY2023 would be warranted, aimed at preserving the budget space for critical development spending, in particular on education and health. Efforts to enhance tax compliance will continue, while tax policy reforms including the introduction of a value added tax (VAT) will be considered as a policy option. Ongoing PFM reforms supported by the World Bank and the European Union would help improve the quality of government spending and assess potential for rationalization. Revenue windfalls will continue to be saved into the FSMTF, ensured by the recently enacted amendment to the FSMTF law, while limited use of the windfalls for high-quality government spending would also be warranted in case economic growth slows down more than envisaged.

20. The authorities agreed that potential revenue volatility inherent in the current arrangement of CTF distributions would imply substantial fiscal risks for post-2023. The CTF committee has been actively engaged with their fund managers for the last 18 months to review options to amend the distribution formula and CTF legislation. The authorities did not agree with the recommendation to draw from the FSMTF to offset the volatility. The recommendation essentially safeguards the CTF while shifting the risks of depletion to the FSMTF. It is the policy of the authorities to continue building the FSMTF beyond FY2023, building on the hard-won fiscal prudence of recent years, ensuring benefits for future populations, and progressing toward economic self-sufficiency and less dependence on foreign financial assistance.

B. Strengthen Climate Change Resilience

Background

21. The FSM economy is highly vulnerable to climate change. Rising sea levels and temperatures threaten livelihoods, particularly on low-lying islands, and are compounded by the rising frequency and intensity of natural disasters, resulting in significant macroeconomic costs.5

22. The U.S. Compact Agreement currently insures the FSM against natural disaster risks. Under the Compact Agreement, the USAID and FEMA fund post-disaster reconstruction for public and private property, following declarations of disasters by the presidents of the FSM and the United States. This assistance will no longer be available for post-2023, unless renewed.

23. In this context, a Climate Change Policy Assessment (CCPA) was conducted as an integral part of the 2019 Article IV Consultation.6 The CCPA reviewed the FSM’s macro-relevant climate change policies, including on mitigation, adaptation, and disaster risk financing, contributing to staff’s views and recommendations laid out below.

Staff’s Views

24. Good progress has been made on climate change preparedness, but gaps remain. The FSM has developed the Nationally Determined Contribution under the Paris Agreement, a national climate change policy, the Infrastructure Development Plan (IDP) that includes mitigation and adaptation projects, and state-level action plans for disaster risks. However, it has yet to develop an overarching National Adaptation Plan that is fully integrated with sectoral and state-level strategies, and a comprehensive disaster resilience strategy that covers early warning, disaster response, and risk financing.

25. Accelerating climate change adaptation requires strengthening public investment management and mobilizing further grant financing. Speeding up adaptation investment would generate multiple benefits, including boosting growth in the short run and lowering reconstruction costs and output losses in the event of natural disasters. While the FSM has an ambitious list of adaptation projects, finishing them over the next 10 years would require substantially increasing public investment. Since the country’s limited capacity to implement capital projects is the main bottleneck, staff recommends strengthening public investment management, particularly at the state level, to identify and smoothly execute high priority adaptation projects. This can be supported by establishing a standardized methodology for project appraisal and selection across states. The FSM’s high risk of debt distress and the fiscal adjustment need through FY2023 would also call for mobilizing grant financing and prioritizing projects.

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FSM: Public Sector Debt under a Natural Disaster Shock

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: IMF staff calculations.Notes: the figure shows an illustrative simulation on the impact of a natural disaster on public debt, comparing scenarios with and without adaptation investment ramp-up.Without adaptation: GDP growth remains at its potential under the baseline. When a disaster hits in 2030, real GDP declines by 5 percent and public debt rises by 10 percent of GDP.With adaptation: reflecting higher adaptation investment over 2020–30, GDP grows faster than potential during this period. When a disaster hits in 2030, real GDP declines by only 3 percent whereas public debt rises by only 4 percent of GDP, as higher adaptation investment would lower reconstruction costs and output losses.

26. A disaster resilience strategy should be developed in view of the expected expiration of the U.S. post-disaster assistance. Making greater use of risk transfer mechanisms can reduce the burden on the budget when disasters hit for post-2023. The strategy should include increasing use of insurance, such as regional parametric schemes under the Pacific Catastrophe Risk Assessment and Financing Initiative (PCRAFI); broadening the range of disaster-contingent financing from the World Bank and AsDB; and further building up the FSM’s fiscal buffers that enable immediate post-disaster response.7 The FSMTF could also provide for an additional buffer in the event of a catastrophic disaster, but this should only be a last resort.

Authorities’ Views

27. The authorities appreciated the findings and recommendations of the CCPA. Disasters such as tropical storms, inundations, and droughts have become more intense and frequent in the FSM in recent years, causing severe damages in both main and outer islands. Policy planning is well advanced, as all four states have adopted Joint State Action Plans for climate change. The authorities acknowledged the need to identify disaster risk financing options in view of the expected expiration of the U.S. post-disaster assistance in 2023. To expedite climate resilience building, they stressed the need for climate finance institutions to streamline access requirements to be in line with capacity in small states, and emphasized the need for development partners to mobilize technical support to fill implementation capacity gaps.

C. Strengthen Banking Sector Supervision

Background

28. Two commercial banks and a government-owned development bank dominate the FSM’s financial sector. The Bank of FSM (BFSM), a domestic commercial bank, and a branch of the Bank of Guam have deposits totaling 90 percent of GDP. Private sector credit remains low, with the loan-to-deposit ratio at as low as 15 percent and the rest of deposits invested abroad. The FSM Development Bank (FSMDB), a non-deposit-taking and state-owned bank, accounts for 30 percent of total private sector credit. The FSMDB is funded mostly by capital contributed by the national government and retained earnings from the past.

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FSM: Deposits and Loans

(In millionsof U.S. dollars)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: Micronesian authorities; and IMF staff calculations.

29. The FSM has benefited from FDIC oversight on the banking sector. Deposits at the BFSM, accounting for about 40 percent of total deposits, are insured by the FDIC under the Compact Agreement, while the Bank of Guam is also FDIC insured. Regulated by the FDIC under the standards applicable for FDIC- insured banks, the BFSM is well capitalized, liquid, and profitable, and has avoided a loss of corresponding banking relationships.8 The FSM is expected to lose access to the FDIC oversight unless the service agreement under the Compact Agreement providing for FDIC insurance is renewed.

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Selected Pacific Island Economies: Credit to Private Sector

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: Micronesia authorities; and IMF staff calculations.

Staff’s Views

30. Strengthening banking sector supervision is important to cope with a possible reduction in the FDIC oversight. The FSM Banking Board should upgrade the legal and regulatory framework for prudential supervision, strengthen monitoring of commercial banks, and develop a reform roadmap with actions needed to maintain financial sector stability and corresponding banking relationships. The first critical step would be upgrading the Banking Act to address various legislative gaps, including on fit and proper requirements, licensing criteria, and corrective and sanctioning powers. This effort will be supported by the IMF and PFTAC TA.

31. Promoting private sector credit will need to follow a gradual process. The main bottleneck appears to be the lack of collateral due to the land tenure prohibiting non-FSM citizens from owning land.9 This can be potentially resolved by using land lease as collateral, which has not been put into practice yet. Strengthening the business climate and enhancing financial literacy can help to create bankable projects in the private sector. The FSMDB has contributed to expanding private sector credit, with its lending growing by 15 percent annually over the last three years. Credit unions can also play a role, although their contribution would likely remain small. To ensure prudent lending, the FSMDB and credit unions should be placed under the supervision of the Banking Board.

Authorities’ Views

32. The presence of the U.S. FDIC has served the authorities well in safeguarding the banking sector. They agreed that the FSM should strengthen its own capacity for banking supervision. Upgrading the Banking Act, with support from IMF TA, would be warranted to modernize the legal framework for prudential supervision and ensure the maintenance of corresponding banking relationships. This should be followed by developing prudential regulations and strengthening technical capacity of supervisors.

33. The FSMDB has played a key role in promoting private sector credit. Its recently developed scheme for loan guarantee will provide start-up businesses with access to finance. The authorities noted that expanding the oversight of the Banking Board to the FSMDB would be premature at this stage, as the FSMDB will remain profitable and fully funded by government capital and retained earnings. The Banking Board agreed that credit unions should be brought under its oversight.

D. Vitalize the Private Sector

Background

34. Vitalizing the FSM’s weak private sector would require targeted structural reforms. The FSM’s long-term economic growth has been the lowest among Pacific Island countries, reflecting the stagnant private sector accounting for only a quarter of economic activity. Private sector development has been constrained by the FSM’s remoteness, small size, and geographical dispersion. Given capacity constraints, reforms should be targeted to those with maximum gains. Against this background, the Article IV consultation focused on how to improve the business and investment climate, streamline the foreign direct investment (FDI) regime, and promote private sector credit. These efforts should support ongoing and prospective sectoral reforms, targeted for information and communication technologies, fishery, maritime, energy, and sustainable niche tourism, with support from the World Bank and AsDB (Appendix V).

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FSM: Private Sector Share in GDP and Employment

(In percent of total)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: FSM authorities; and IMF staff calculations.
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FSM: Doing Business Indicators, 2019

(Distance to frontier score 1/)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Source:World Bank.1/ On a scale of 0 to 100; 100 is the frontier and 0 is the furthest from the frontier.

Staff’s Views

35. Improving the business and investment climate is critical for private sector development and stronger governance. The World Bank’s Doing Business Indicators highlight the FSM’s weaknesses in starting business, enforcing contracts, protecting investors, and registering property.10 To address these obstacles, staff recommends lowering business license fees; reducing the time and cost for settling a commercial dispute; improving the quality of the judicial process; and making the land tenure management business-friendly through digitalizing the land registry.

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Selected Pacific Island Economies: FDI

(In percent of GDP)

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: Micronesian authorities; and IMF staff calculations.

36. Upgrading the FDI regime can foster private sector development. While FDI can generate employment and business opportunities domestically, it has been very low in the FSM compared with Pacific Island countries, likely reflecting the FSM’s weak business and investment climate and complex state-specific FDI regimes. In addition to the efforts to make the FSM more business friendly, FDI should be promoted by clarifying the regime and reducing undue regulatory burdens. The Foreign Investment Act can be upgraded to harmonize FDI laws and regulations across states, expand the list of national priority sectors, streamline licensing processes, and establish a national single window.

Authorities’ Views

37. Efforts to promote the private sector are underway. Improving the FSM’s business and investment climate would require coordination with state governments—land registries are managed at state levels, for example. A bill to amend the Foreign Investment Act, aimed at establishing a one stop shop for FDI applications and fast-track processing for priority sectors, is being prepared in consultation with state governments. Similarly, some state governments are embarking on judicial reforms for faster business dispute resolution.

E. Data Adequacy and Capacity Development

38. Data shortcomings continue to hamper macroeconomic surveillance. Staff welcomes that the FSM continues to implement the enhanced General Data Dissemination System. While the coverage of key macroeconomic data is broadly sufficient, they are not compiled in a timely manner. Resolving issues with tax data sharing between the Department of Finance and the Statistics Office, with support from the PFTAC, will be critical for improving the accuracy of national accounts.

39. Staff welcomes the authorities’ interest in capacity building. Further capacity building on revenue administration, PFM, financial sector supervision, and macroeconomic are critical for addressing the FSM’s challenges. While the modality of such TA should reflect the FSM’s capacity constraints, strong ownership by the authorities would be key for advancing reforms.

Authorities’ Views

40. The authorities looked forward to further assistance from the IMF and PFTAC on improving tax administration, bank supervision, and macro statistics. They would prefer hands-on TA tailored to the need of the FSM, with TA missions leaving tangible outputs that can be referenced by technical staff (e.g., manuals for tax administrators). Discussions are underway to resume tax data sharing between the Department of Finance and the Statistics Office, with due consideration on confidentiality for taxpayers.

Staff Appraisal

41. The economy of the FSM has performed well in recent years. The FSM enjoyed output and employment growth higher than the historical average and low inflation owing to the use of the U.S. dollar as legal tender. The fiscal balance has recorded large surpluses since FY2017, with the external position assessed to be broadly consistent with fundamentals and desirable policies. Nonetheless, the FSM remains highly vulnerable to climate change and natural disasters, while private sector activity remains anemic. Looking forward, growth is projected to converge to a potential rate of 0.6 percent, in line with the performance over the last two decades.

42. Risks to the outlook are tilted to the downside. Unless the arrangements under the Compact Agreement providing for economic supports are renewed, the government is expected to lose access to the Compact grants and various services by 2023, resulting in substantial macroeconomic uncertainty. Now is the time for policy actions to reduce this uncertainty.

43. A gradual fiscal adjustment is warranted to cope with the expected fiscal cliff. The FSM remains at high-risk of debt distress, with the Compact grants set to expire under the current arrangement, putting debt on a rising path. A gradual fiscal adjustment of 4–5 percent of GDP through FY2023 would be needed to balance the budget in FY2024. Growth-friendly tax measures and tax administration reforms, as well as rationalization of the wage bill and nonessential expenditures, would help protect spending on education, healthcare, and infrastructure. Continuing the prudent policy to save revenue windfalls will enable a further buildup of the FSMTF, strengthening fiscal resiliency.

44. The FSM’s resilience to climate change can be strengthened by closing gaps in preparedness, speeding up adaptation, and developing a disaster resilience strategy. Developing an overarching adaptation plan that is fully integrated with sectoral and state-level strategies would help reduce the gaps in preparedness. Swift implementation of adaptation projects would require stronger public investment implementation capacity as well as further mobilization of grant financing and prioritization of projects. Making greater use of disaster risk transfer mechanisms including disaster insurance can help strengthen the government’s ability to respond to natural disasters for post-2023.

45. The FSM’s own capacity for banking sector supervision should be strengthened in view of the possible reduction in FDIC oversight in 2023. Efforts should be stepped up to update banking laws, adopt prudential banking regulations, and develop a reform roadmap to strengthen the Banking Board’s supervision of commercial banks. The FSMDB and credit unions should be placed under the supervision of the Banking Board to ensure prudent lending.

46. Vitalizing the private sector is critical to shore up potential growth and navigate the FSM through the post-2023 uncertainty. The business and investment climate can be improved by lowering business startup costs, reducing time for settling disputes, digitalizing the land registry, and reducing undue regulatory burdens on FDI.

47. Further capacity building on revenue administration, PFM, financial sector supervision, and macroeconomic statistics are critical for addressing the FSM’s challenges. The authorities’ interest in TA in these areas is welcome. While the modality of TA should reflect capacity constraints, strong ownership by the authorities would be key for advancing reforms.

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

Compact of Free Association Between the United States and the FSM

The original Compact of Free Association (Compact Agreement) between the United States and the FSM was signed in 1986.1 The current Compact, amended in 2004, provides for the United States’ responsibility for the security and defense of the FSM as well as the right of eligible FSM citizens to enter, study, and freely seek employment in the United States without visas. The Compact will remain effective unless it is terminated in accordance with the agreement. Under the Compact, the United States also provides the FSM with various economic supports until FY2023, including:

• Annual grants during FY2004–23 to support specific public services, including education, health, and infrastructure development (the so-called Compact sector grants).

• Annual contributions into the Compact Trust Fund during FY2004–23, aimed at building up revenue sources for post-FY2023 and supporting the FSM’s budgetary self-reliance.

• Assistance for various public services, including special education; post-disaster relief and reconstruction by the Federal Emergency Management Agency (FEMA) and USAID; deposit insurance and supervisory oversight for the Bank of FSM by the Federal Deposit Insurance Corporation (FDIC); postal services; civil aviation safety; and weather monitoring and forecasting. These supports are set to expire in FY2023.2

1 The FSM became an independent nation after its constitution was ratified in 1978. Prior to this, the country was part of the U.N. Trust Territory of the Pacific Islands under the administrative control of the United States.2 For more detail, see the May 2018 report by U.S. Government Accountability Office (GAO-18–415).

Improving the Efficiency of the Public Service in the FSM1

The public sector wage bill tends to be elevated in Pacific Island countries. The median ratio of the wage bill to GDP in the Pacific is about 13 percent, more than twice as large as the average for emerging market and developing economies. Possible reasons include: the minimum staffing requirements for a fully functioning government in small states can be disproportionately high; state-owned enterprises are prevalent due to structural impediments to private sector activity; and hiring in the public sector is used as a de facto social safety net.

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Pacific Island Countries: Public Sector Wage Bill, Latest Year Available

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: AsDB staff calculations.

The FSM’s wage bill is high relative to its regional peers. Latest available estimates show that the ratio of public sector employment to total population in the FSM (7.5 percent) is slightly above the Pacific average (7.2 percent). However, public employment in the health and education sectors is low compared with the peers: the density of physicians is 0.6 per 1,000 population in the FSM, lower than the regional average of 0.8; and the student-to-teacher ratio is 39.3 in the FSM, while the regional average is 21.7.

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FSM: Public Sector Wage Bill Dynamics

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: AsDB staff calculations.

Since 2004, the number of public sector employees (including state-owned enterprises) in the FSM has declined by about 0.9 percent annually but average wage rates per employee increased nearly 2.0 percent. Benchmarking against private sector counterparts reveals substantial wage premia for public sector employees and ample scope to raise productivity in the public service.

Therefore, a combination of slower wage increases and reforms to enhance public sector efficiency can help promote longer-term fiscal sustainability.

uA01fig16

Ratio of Output per Worker to Wage Rates, FY2004–17 Average

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: AsDB staff calculations.

Recent public administration reviews in the FSM, supported by Asian Development Bank (AsDB), have helped identify critical reforms to encourage better performance in national and state governments. Key recommendations include:

  • Simplifying job grading and pay structures. Overlaps in job grading and pay structures have undermined incentives for good performance. A draft bill effectively simplifying the pay scale and levels for national government employees has been prepared by the national government.

  • Consolidating the public service system. Special service contracts have been increasingly used to attract skilled personnel. Clear compensation advantages for contract personnel seem to have reduced incentives to perform among regular staff. Contract positions performing core civil service functions should be integrated into the regular public service under a reformed and unified compensation structure, while noncore positions can remain contracted out for limited durations.

  • Strengthening performance-based contracts for education and health. The FSM Strategic Development Plan 2004–24 highlights the need for performance-based contracting (PBC) for teaching and health services personnel, but current arrangements are missing several critical components. A well-designed PBC framework requires a clear set of objectives and performance indicators, systems for collecting and validating data on these indicators, and appropriate incentives to motivate achievement of agreed upon goals and targets.

1 Prepared by Rommel Rabanal (AsDB), based on AsDB reports and data on public sector reform in the FSM and the Pacific.
Figure 1.
Figure 1.

Federated States of Micronesia: Real Sector Developments

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: FSM authorities; IMF WEO database; and IMF staff estimates and calculations.
Figure 2.
Figure 2.

Federated States of Micronesia: Fiscal Developments

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: FSM authorities; World BankWDI database; and IMF staff estimates and calculations.
Figure 3.
Figure 3.

Federated States of Micronesia: External and Credit Developments

Citation: IMF Staff Country Reports 2019, 288; 10.5089/9781513513263.002.A001

Sources: FSM authorities; IMF WEO database; and IMF staff estimates and calculations.
Table 1.

Federated States of Micronesia: Selected Economic Indicators, FY2015–24 1/

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Sources: FSM authorities and IMF staff estimates and calculations.

Fiscal year ends on September 30.

Excludes contributions to the Compact Trust Fund.

Compact Trust Fund and FSM Trust Fund.

Calendar year. 2010=100.

Table 2a.

Federated States of Micronesia: General Government Operations, FY2015–24 1/

(In millions of U.S. dollars)

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Sources: FSM authorities and IMF staff estimates and calculations.

Fiscal year ending September. The consolidated fiscal accounts cover the national and four state governments.

Excludes contributions to the Compact Trust Fund.

Table 2b.

Federated States of Micronesia: General Government Operations, FY2015–24 1/

(In percent of GDP)

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Sources: FSM authorities and IMF staff estimates and calculations.

Fiscal year ending September. The consolidated fiscal accounts cover the national and four state governments.

Excludes contributions to the Compact Trust Fund.

Table 3.

Federated States of Micronesia: Balance of Payments, FY2015–24

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Sources: FSM authorities and IMF staff estimates and calculations.

Refers to passenger services transportation.

Includes household remittance and corporate tax on income from abroad.

Table 4.

Federated States of Micronesia: Deposit Money Banks, FY2013–17

(In millions of U.S. dollars, unless otherwise noted)

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Sources: FSM authorities and IMF staff estimates and calculations.

Includes loans to abroad.

Calendar year average.

Average rates offered by the deposit money banks.

Average rates charged by the deposit money banks.