COVID-19 Response, Recent Developments and Outlook

The FSM declared a public health emergency from March 2020, extending through the end of January 2022, with the national and state governments enacting strict containment measures including the international border closure. The pandemic response focused on strengthening the health system, and assistance to affected firms and vulnerable groups. The effectiveness of the pandemic containment measures resulted in no COVID-19 cases in FSM so far and had commenced the repatriation flights successfully from abroad since May 2021. The authorities aim for achieving at least 70 percent vaccination coverage this year, mandating the vaccination for all 18 years and older citizens, achieving about 66 percent vaccination rate of the eligible population as of September 30, 2021.

The economic contraction of-3.2 percent is projected for FY2021, due to the international border closure, with slow recovery expected in FY2022 with the gradual border reopening. Staff projected the return to pre-pandemic real growth levels in FY2024.

The authorities noted the downside risks associated with the containment measures and longer border closure for the pandemic, and agreed with the economic contraction in FY2021, followed by a slow recovery in FY2022 on the premise of an expedited vaccination rate. The authorities are very cautious in the gradual reopening of the international border considering the capacity of the local health system. The policy support will continue for businesses and low-income households, to help counter the downside risks to the economy. The authorities will audit and publish the COVID-19 related spending reports.

Fiscal Policy

The FSM acknowledged staff analysis on the fiscal risks, rising debt levels under the current policies, over the medium term. The authorities will utilize the existing study of the taxation system conducted by the National Tax Reform Commission, at the national and state levels, to determine areas for improvements and adjustments, with the report recommendations to be submitted to the President by January 1st, 2022, and related proposed legislative developments and amendments to be considered by the FSM Congress and State Legislatures. The authorities also agree with staff on the introduction of VAT in a revenue neutral manner, though the revenue boostis expected through improved tax efficiency. The revised legislation to increase the excise taxes on cigarettes and tobacco has been submitted to the FSM Congress for consideration. These tax reforms are estimated to collectively raise the tax revenue-to-GDP to about 16 percent, from the current level of around 12 percent. There is also consideration of the changes to non-tax revenues, including to reassess the concessional domestic fishing license fees. The FSM would welcome the Fund TAs on these tax reform efforts.

The authorities also agreed, despite the need to provide support to the economy in the near-term, expenditure rationalization would be necessary going forward. The FSM established the Project Management Unit at the national level and the Project Management Offices at the state level to strengthen the project coordination and provide technical support. This should help accelerate the project implementation and grant disbursement. A medium-term fiscal framework would be beneficial, and the authorities are receiving EU support in this area.

Financial Sector

The banking system has remained sound and well contained financial stability risks. The authorities concurred with the need to extend near-term financial sector support and enhance monitoring. The interest payment relief and loan deferrals may need to be extended for the targeted groups if the border closure continues, with very close monitoring, and gradual phasing out of these support measures.

There is a need to upgrade banking laws, adopt prudential banking regulations, and strengthen the supervisory capacity. The authorities underscored that the banking regulation and supervision should be strengthened to cope with the possible expiration of FDIC oversight. The proposed amendments to the Banking Act will carefully consider extending the FSMBB’s supervision to the non-deposit taking entities such as the FSMDB and credit unions. The strengthened risk-based supervision will monitor the CBRs, as well as compliance under the AML/CFT framework.

Structural Reforms

The FSM 2023 Action Plan continues to guide the implementation of the long-term structural reforms and sustainable growth strategies, with the emphasis on private sector led growth, and prepare the economy from FY2024 onwards. Some key actions for boosting investments include the amendments in the foreign investment bill, to simplify the FDI application process. The authorities aim to establish a one-stop shop to handle foreign investment.

The impacts of the pandemic have underscored the need for improved ICT infrastructure and digital connectivity in the FSM. The authorities acknowledged the importance of enhancing digital connectivity, given the constraint of available transportation among the islands. The development of a digitalization strategy and a roadmap to expand e-government is welcome. The ongoing digitalization project in partnership with the World Bank would improve connectivity and affordability, as well as promoting online business transactions and enhance financial inclusion.

Climate change

The FSM remain committed to strengthening resilience to climate change. The higher frequency and severity of natural disasters is experienced in the small island, damaging existing infrastructure and productive activities, particularly in agriculture and fishing. The authorities acknowledged the medium-term policy recommendations covering the development of an overarching National Adaptation Plan, speed up implementation of adaptation investment projects, strengthen capacity for public investment management, and mobilize external grant financing.

Efforts are ongoing to address gaps identified in the recent Climate Change Policy Assessment, including development of National Adaptation Plan and a Building Code Policy. The authorities have received two new grant approvals from the Green Climate Fund in calendar year 2021, a significant achievement for FSM by being the only Pacific country to have two projects approved this year by GCF, as well as the first Enhancing Direct Access project for the Pacific region. The authorities also launched this month, a $40million project financed by the World Bank to enhance climate resilience of the road transport infrastructure throughout the nation. Together, these programs would help with climate-smart agriculture, climate resilience infrastructures and further advance the enabling environment agenda. A new public law was passed by Congress in April 2021, mandating that the Investment portfolios in FSM’s sovereign wealth funds shall seek investment opportunities associated with a global transition to a lower carbon economy, and banning investments in assets associated with high carbon emitting companies. The authorities call on all Small Island States with Sovereign Wealth Funds to follow the same path, to shift investment capital towards innovative firms aiming to protect the planet.

Capacity Development

The authorities appreciated the IMF and PFTAC TAs and requests the continuation of these technical support, preferably in-person TAs when international travel resumes. The authorities specifically request for longer term TAs on Statistics / National Accounts, Tax reforms and Economic Planning. Other TAs should continue for revenue management, public financial management and banking supervision.