2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Federated States of Micronesia
The Federated States of Micronesia (FSM) is a small island country spread out over the western Pacific Ocean with more than 600 islands, covering an area roughly the width of Australia. It has a population of just over 100,000. Four autonomous states make up the FSM – Pohnpei, Kosrae, Chuuk and Yap – each with its own distinct language and ethnic identity.
A key challenge for the country is the forthcoming expiry of annual grants from the United States (US) – equivalent to more than 20 percent of GDP – made under the Compact of Free Association between the two countries. After 2023, most of these will be replaced by distributions from a Compact Trust Fund (CTF) being built up from US contributions. However, the current track for contributions, together with expected investment returns, means that these distributions are unlikely to compensate for the loss of grants while also maintaining the CTF’s real value over time. The FSM also has its own, separate trust fund, the FSM Trust Fund (FSMTF) as an additional revenue source to enhance fiscal self-reliance.
A government committee has been established to plan for the expiry of the grants and of some support services currently received from the US. The FSM has an Action Plan 2023 to help prepare for these events, that includes increasing revenue mobilization, building fiscal buffers and developing the private sector. President David W. Panuelo was elected in May 2019 and aims to continue driving a reform agenda.
Other challenges include mitigating climate change effects and building resilience to natural disasters. The FSM is the first Pacific island country to have an IMF-World Bank Climate Change Policy Assessment (CCPA), conducted alongside the Article IV consultation.
The FSM authorities broadly agree with staff’s recommendations and are grateful for the technical assistance and training they receive from the Fund.
The FSM will face a fiscal cliff after 2023, with the overall balance projected to turn from a surplus of around 5 percent of GDP in 2023 to a deficit of 4–5 percent of GDP in 2024. The authorities broadly agreed with staff’s recommendation for a gradual fiscal adjustment leading up to 2023 to preserve budget space for priority areas of spending such as education and health. They will continue to enhance tax compliance and consider growth-friendly tax policy reforms, such as introducing a value added tax and selected excises on tobacco, alcohol and fuel. The authorities are also rationalizing tax expenditures and strengthening tax administration through the roll-out of a new IT system. Ongoing PFM reforms with the World Bank and European Union will help streamline and rationalize nonessential expenditure, as well as ensuring space for spending on climate change resilience.
The authorities are committed to continue building up the FSMTF by saving revenue windfalls into it. Funds in the FSMTF have grown from about $13 million in 2014 to around $230 million in 2019. New laws were also enacted this year that earmark 50 percent of corporate tax receipts and 20 percent of fishing license fees as contributions to the FSMTF. As things currently stand, the FSM will only be able to take investment returns out of the CTF, meaning there could be large revenue volatility after 2023. The authorities do not agree with staff’s recommendation to use the FSMTF as a stabilizer, as they want to keep building up the FSMTF for the long term. Instead, the authorities are seeking a review of the rules around CTF distributions.
Fiscal deficits post-2023 would place external debt on an upward trajectory, leaving the FSM at a high risk of debt distress. The authorities support staff’s consideration of the debt trajectory over a 20-year horizon in the DSA, as this reflects the risks facing the country. They intend to continue maximizing grant financing and not take on any new loans up to 2023.
Supervision of the FSM’s financial sector would be significantly transformed by any reduction in US FDIC oversight after 2023. The authorities agree with staff’s recommendation to strengthen the FSM Banking Board’s capacity for banking supervision, update the banking laws, maintain correspondent banking relationships and develop prudential regulations. The authorities have been active in addressing international tax transparency issues given that a number of investment companies are based in the FSM. An assessment by the EU and OECD Global Forum on Transparency and Exchange of Information for Tax Purposes two years ago found the FSM to be largely compliant.
Private sector development
The authorities agreed that improving the business and investment climate, and facilitating access to credit, is critical for private sector development. The country’s remoteness, limited natural resources and sparse population present challenges to private-sector growth. However, efforts are underway to implement reforms in sectors such as fisheries, information and communication technologies, maritime transportation, energy and niche tourism. These include judicial reforms for business dispute resolution and coordinating with the four State governments on land registries. A bill to amend the Foreign Investment Act is currently before Congress, aimed at streamlining FDI laws and creating a single national window for FDI.
The FSM has many low-lying islands at risk from natural disasters, compounded by rising sea levels and temperature change. The CCPA found there is generally good planning in place, and there may be available financing to address climate change impacts from the $200 million backlog of unspent compact infrastructure funds. However, some infrastructure gaps remain, largely as a result of the need to find suitable projects for donors as well as a lack of absorptive capacity in the FSM.
The CCPA recommended developing an overarching National Adaptation Plan that is fully integrated with sectoral and subnational strategies, as well as a comprehensive strategy for building resilience to natural disasters, particularly for early warning, disaster response and risk financing. The latter is important given the expected loss of access to direct funding from US federal agencies for natural disaster response and reconstruction after 2023.
The authorities will reflect on the findings and recommendations of the CCPA. Full implementation of the FSM’s energy master plan should enable the country to meet its Naturally Determined Contributions under the Paris Agreement. The authorities agree that adaptation planning is lacking and will continue to seek sources of financing as well as technical assistance to support their planning. They would also like climate finance institutions to streamline their requirements for small states that have limited capacity to access funding.