Abstract
69Our Palauan authorities appreciate the constructive and frank dialogue with staff during the 2021 Article IV consultations. They agree that the staff report provides a fair assessment of the macroeconomic challenges posed by COVID-19 and the policy response to date. The policy recommendations are well received by the authorities and will be taken into consideration as they develop their inclusive and sustainable growth recovery strategy.
Our Palauan authorities appreciate the constructive and frank dialogue with staff during the 2021 Article IV consultations. They agree that the staff report provides a fair assessment of the macroeconomic challenges posed by COVID-19 and the policy response to date. The policy recommendations are well received by the authorities and will be taken into consideration as they develop their inclusive and sustainable growth recovery strategy.
The tropical archipelago of Palau is located in the western Pacific Ocean and is made up of 8 principal islands and about 445 uninhibited rock islands, with a combined land area of about 177 square miles. Palau’s Rock Islands were granted the prestigious status of UNESCO World Heritage in 2012 and are a major tourist attraction.
Palau’s economy is highly dependent on tourism. InFY2019, the sector contributed more than a third to GDP. The sudden stop to tourist arrivals at the onset of CO VID-19 severely affected economic activities.
Palau is designated a high-income country and will graduate from OECD Development Assessment Committee’s (DAC) list of countries eligible for development assistance in January 2022.
Despite its high-income per capita status, the inherent vulnerabilities and costs associated with a small, open, island state, are disproportionally high and they diminish the country’s purchasing power. These costs are further exacerbated by the country’s extreme exposure to climate change and natural disasters. Furthermore, logistical challenges in delivering services to the dispersed population in remote locations aggravate inequalities in access to basic services and economic opportunities.
COVID-19 Response and Recent Developments
Along with commercial flight cancellations, the authorities immediately strengthened the healthcare system by setting up domestic testing and quarantine facilities. Palau recorded its first CO VID cases in August 2021 at the border but has remained a CO VID-safe destination due to its strict and preemptive measures since the beginning of the pandemic. There has been no community transmission detected and no deaths recorded. With support from the US Operation Warp Speed, Palau’s vaccination program has been very successful. As of October, this year, full vaccination coverage was approaching 100 percent of the eligible population. This impressive inoculation rate was enabled by a strong public campaign that was met with minimal vaccine hesitancy. The focus is now on the third booster dose.
To support affected businesses and households, the authorities rolled out the Coronavirus One Stop Shop Relief Act (CROSS Act) in the tune of $20 million. This was complemented by the US Coronavirus Aid, Relief, and Economic Security Act (CARES Act), amounting to $19 million, bringing the combined relief packages to 15.2 percent of GDP.
The sudden stop in tourist arrivals triggered the economic contraction as restaurants, hotel services, tour guides, and other related services, were immediately affected. Consequently, the current account deficit rose to 48 percent of GDP in FY2020, although it was partially offset by the ADB loan that financed the CROSS Act. The loss of tourism revenues, economic contraction and counter-cyclical fiscal measures led to a large deficit of 10.9 percent of GDPinFY2020. Without the concessional loan and grants, the bottom line could have been much worse.
Economic Outlook and Risks
The authorities expect a gradual economic recovery from FY2022, but output will remain below pre-pandemic levels through FY2023. Tourism activities will be the major determinant of the macroeconomic situation in the near future. While the world’s COVID-19 inoculation rate is expected to rise, new variants and vaccine effectiveness continue to be the major risks that will dictate tourist arrivals. The authorities initiated a cautious opening of safe travel corridors with Guam and Taiwan that include stringent testing regime and proof of vaccination, with an aim to gradually include more tourism partnering countries.
Palau faces a host of other risks that could impede growth in the near to medium term. They include higher than expected inflation, extreme exposure to natural disaster and climate change, and the uncertain timing and terms of a new Compact Agreement with the US.
More concerning to the authorities is the country’ s graduation from OECD DAC list of countries eligible for grants and concessional loans. There is a high risk of knock-on effect of this graduation which could affect existing relationships with other development partners. The authorities are of the view that for a small island state with a population of about 18,000, the high-income categorization ignores the fixed public administration and social services costs, let alone efforts to facilitate a diversified and sustainable economy while building resilience against external shocks including climate change. Nominal income per capita is generally not an appropriate measure of wealth and purchasing power in microstates.
Fiscal Policy
The authorities are committed to fast tracking the roll out of targeted benefits under the CROSS Act, and to extend them until recovery is firmly entrenched. An additional $ 100 per month supplementary benefit is planned in light of the prolonged impact of the pandemic and increased cost of living. To address the widening deficit, a 10 percent across the board cut to recurrent expenditures in the FY2022 budget, save for crucial public services, was planned.
With the help of the ADB, the authorities engaged in a review of public expenditures which will enhance the efficiency and impact of CO VID-19 related spending. They are also planning to carry out ex-post audits of spending and publish the results.
Over the medium term, the authorities recognize the increased likelihood of breaching debt sustainability benchmarks and are committed to a gradual fiscal adjustment as soon as conditions permit. On the revenue mobilization side, a Comprehensive Tax Reform Legislation was signed by the President last month, which will contribute about a fifth of the required adjustment from FY2024. On the expenditure side, the planned Fiscal Responsibility and Debt Management Act would lay the foundation for enhanced budget processes, debt management and fiscal risk management. Moreover, reforms to improve the efficiency and financial stability of the public pension system, the social security, and the public utilities company will be needed to preserve medium and long-term fiscal sustainability.
Financial Sector Policies
The authorities agree that increased credit provision to the private sector could support growth, especially given the low level of lending and the banks’ strong capital and liquidity provisions during the pandemic. The introduction of the Palau Goods and Services Tax (PGST) will require businesses to prepare financial reports. Complying to this requirement will help address information asymmetry which has hindered lending to small and medium enterprises. Capacity building will also be needed in areas such as business plan preparation for bankable projects.
In recognition of the increased role of the National Development Bank of Palau’s (NDBP) in the economy, there are plans to allow it to take deposits through a license of the Financial Institutions Commission (FIC). This will also support financial stability in general.
The authorities continue to make good progress on enhancing AML/CFT compliance. In particular, the moratorium on crypto assets and crypto currency activities will be maintained until adequate regulation are put in place. Technical support from the Fund in this area will be critical. Notable improvements were made to the Know-Your-Customer initiative and to the transparency of financial transaction reporting.
On Correspondent Banking Relationships (CBR) we remain very concerned that the Pacific region has been under severe pressure from de-risking (according to BIS, Swift data). Existing relationships have proven to be fickle and are sometimes terminated with only several months’ notice. We therefore wish to express our appreciation and strong support for the ongoing work on this issue by Fund staff.
Climate Change
Climate change is adding new layers of economic and environmental challenges Palau is already facing. Higher temperatures and stronger typhoons are causing coastal flooding and destroy marine ecosystems which impose social and economic costs. Rebuilding after every natural disaster is becoming more and more expensive for the authorities. Hence, they are committed to building resilient infrastructure to address Palau’s fragility to climate change.
The authorities emphasized the need to access climate finance (concessional loans and grants) to support their ambitious climate change adaptation and mitigation efforts. Notwithstanding the authorities’ efforts to estimate the climate financing gap through the Palau Climate Change Policy, we encourage staff to assess how Palau could benefit from the Fund’s climate technical assistance toolkits of CMAP and/or DRS.
Tourism
The pandemic risks leaving long-term scarring on Palau’s tourism industry. The authorities are already considering a major adjustment to its tourism strategy, building on the 2016 Palau Responsible Tourism Policy Framework. A major feature of the policy is moving away from mass-tourism and focus on niche markets. In adjusting to COVID-19 social distancing requirements, the authorities aim to take advantage of opportunities offered by high-value and eco-tourism that promote culture while safeguarding its biodiversity. Furthermore, there is great potential benefits from including in the strategy a domestic agri-food supply chain and value-added industries, as well as the preservation of historical sites.
The authorities are also working to diversify source markets to include Oceania, Europe and the US.