2014 Article IV Consultation with the Republic of Palau- Concluding Statement of the IMF Mission

February 27, 2014

Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

February 27, 2014

After two years of strong performance, growth slowed down in FY2013 due to a decline in construction and tourism, while inflation moderated thanks to stable food and fuel prices. The outlook points to a modest recovery, but Palau’s heavy reliance on tourism, grants, and food and fuel imports carries downside risks. A gradual fiscal adjustment over the medium term remains critical in order to ensure fiscal and debt sustainability. Promoting private sector development and preserving financial stability are essential to sustaining growth.

I. Recent Developments and Outlook

Growth. After two years of strong expansion, growth is estimated to have been around zero in FY2013 as a result of a decline in construction associated with lower capital grants and spending, and a drop in tourist arrivals. Contributing factors to the 7 percent (y/y) decline in tourism include the cessation of some flights from Asia, the recent increase in tourism-related fees, and the U.S. dollar appreciation. The impact of typhoon Haiyan appears to be small in terms of growth but creates spending pressures. Growth is projected to increase to 1¾ percent in FY2014 (fiscal year, ending September) and to 2-2½ percent over the medium term, along with a recovery in tourism due to new hotel projects, resumption of flights, and increasing tourists from China; and infrastructure developments financed by foreign loans and grants.

Inflation and credit growth. Inflation is expected to stay around 3 percent in FY2014, but is projected to increase slightly during FY2015–16 due to the implementation of the value-added tax (VAT). Bank credit increased 11½ percent in 2013, while the nonperforming loan ratio remained broadly flat at 3¾ percent.

External stability. The current account deficit deteriorated to 6½ percent of GDP in FY2013 mainly due to the decline in tourist arrivals and reconstruction-related imports, while the real effective exchange rate increased 4½ percent (y/y average) owing to the U.S. dollar appreciation. The recovery of tourism and moderating international food and fuel prices would improve the current account balance in FY2014–15 before deteriorating again during FY2016–18 due to imports related to infrastructure projects. Over the medium term, the deficit would decline to 5½ percent of GDP and remain fully funded by stable grants and foreign direct investment. However, heavy reliance on tourist arrivals from only a few Asian economies would remain a vulnerability, and weaknesses in the investment regime could hinder the development of tourist-related businesses. Against this backdrop, strengthening fiscal consolidation and improving competitiveness through structural reforms are critical to maintaining external stability going forward.

Risks and policy responses. Palau’s modest outlook is subject to downside risks. Financial market volatility and growth slowdown in Asia, U.S. dollar appreciation, and natural disasters, including those related to climate change, could hurt tourism and growth and weaken external and fiscal positions. The country’s heavy reliance on food and fuel imports also makes it susceptible to commodity price volatility. Given the absence of monetary and exchange rate policies, Palau will continue to rely on fiscal measures and structural reforms to address these risks. Therefore, successful fiscal consolidation over the medium term is needed to build adequate fiscal buffers to ensure long-term fiscal sustainability and external stability. Improving the investment and business climate would help diversify the economy, support growth, and at the same time, reduce economic vulnerability.

II. Ensuring Fiscal and Debt Sustainability

Developments. After three years of improvements driven by robust tourism and economic buoyancy, the pace of fiscal consolidation slowed in FY2013. The current fiscal deficit excluding grants (fiscal anchor) improved by 4¼ percentage points (ppt) of GDP during FY2010–12, and is estimated to have remained unchanged at 12¼ ppt of GDP in FY2013. Despite the slowdown in tourism, tax revenue continued to increase in FY2013 thanks to increases in the hotel room and departure tax rates, higher prices in the tourism industry, as well as improvements in tax compliance. Meanwhile, fiscal current spending was also larger-than-originally budgeted mainly due to reconstruction expenses caused by typhoon Bopha in December 2012. The government cash buffers, excluding the Compact Trust Fund (CTF), increased to about US$12½ million (5 percent of GDP) by end-FY2013.

FY2014 outlook. The FY2014 budget reflects the authorities’ commitment to fiscal consolidation by maintaining prudent spending and creating a reserve fund to build fiscal buffers. After typhoon Haiyan hit the country in November 2013, the authorities had to reallocate the planned savings of US$1½ million (½ percent of GDP) for reconstruction expenses. The mission supported the authorities’ intention to replenish the reserve fund by containing spending and saving additional revenue gains that are expected with the adoption of a new IT system in Customs, the recent increase in the tobacco tax, and the recovery of tourism. In view of these, the current fiscal deficit (excluding grants) is projected to narrow by 1½ percent of GDP, putting the fiscal consolidation back on track.

Medium-term fiscal framework. Without further adjustment over the medium term, Palau’s fiscal position will be unsustainable when the Compact grants expire in FY2024. Continued fiscal consolidation is needed to rebuild government deposits and ensure fiscal self-sufficiency, as otherwise domestic revenue and withdrawals from the CTF will not be sufficient to finance a steady level of spending after FY2024. In line with past IMF recommendations, a gradual reduction in the current fiscal deficit excluding grants by about 1¼ ppt of GDP annually during FY2015–19 would raise the government’s net worth to a level that will provide a sustainable source of financing going forward, and offer an adequate fiscal buffer to address future shocks, including tourism volatility. This gradual approach until FY2019 is recommended because the needed total adjustment (around 8 percent of GDP) is too large to be implemented immediately in one year. On the other hand, a slower adjustment that spreads the reduction in the current fiscal deficit excluding grants until FY2023, just before the Compact grants expire, would be highly sensitive to risks of slippages and adverse shocks. The recommended gradual fiscal adjustment requires efforts to raise revenue and reduce spending in terms of GDP at the same time.

Comprehensive tax reform. The mission welcomed the authorities’ comprehensive plan to reform the tax system aimed at simplifying the tax framework, increasing its fairness, and raising revenue capacity over the medium term. The authorities’ intention to pass the tax reform bill in Congress by April 2014 and have it implemented over the subsequent year is commendable. In line with the IMF/PFTAC technical assistance (TA) recommendations, the mission emphasized that all components of the tax reforms such as replacing the gross revenue tax with a single rate VAT with no exemptions except for exports, moving to c.i.f. valuation for imports, raising net income tax (NIT) for financial institutions, and expanding it to all VAT registered business are critical. The wage and salary tax rates for low income household could be reduced to offset a potential adverse impact of price increases due to VAT adoption. In addition, improving revenue administration capacity is important to support this major reform. The mission welcomed the authorities’ public consultation efforts and noted the importance of communicating all aspects of the reform package to engage stakeholders. In view of the authorities’ strong commitment to implement tax reforms, domestic revenue is projected to increase by about 4 ppt of GDP during FY2014–19. These potential revenue gains are feasible based on cross-country experience, especially given the fact that Palau’s income tax and goods and services tax as percent of GDP are among the lowest in the region. If the intended tax reform is delayed, adopting c.i.f. (cost, insurance and freight) valuation, removing import tax exemptions, broadening excise taxes, and raising NIT for financial institutions should be implemented as intermediate actions.

Expenditure reform. The mission emphasized that tax reform alone would not be sufficient to ensure long-term fiscal sustainability, and therefore, expenditure reform that contains current spending and ensures adequate public services is needed. Since the wage bill represents about half of current spending, controlling its growth is the top priority. By maintaining the wage bill growth below inflation, current spending could be reduced by 4 ppt of GDP during FY2014–19, providing adequate resources for capital spending. Combined with the above-mentioned revenue reforms, this expenditure reform should help achieve long-term fiscal sustainability.

Public finance management. Strengthening public finance management is critical to support fiscal consolidation, improve fiscal discipline and transparency, and contain fiscal risks. The mission encouraged the authorities to implement the medium-term budget framework with the support of Asian Development Bank (AsDB) TA to continue improving budget execution and planning and strengthening cash management to prevent building up domestic accounts payables. Prudent management of the newly established reserve fund will help safeguard fiscal buffers. Given the disbursement of new infrastructure loans, sound management of public debt would help ensure debt sustainability and minimize fiscal risks. The debt sustainability analysis indicates that Palau’s debt risk remains low after the disbursement of AsDB water and sanitation loans. However, the debt risk could increase without fiscal reforms, calling for continued fiscal consolidation and prudent debt management. Strong governance of loan-funded infrastructure projects will also be critical to ensure an efficient allocation of resources and contain the risk of debt distress.

Reforming public entities. The mission welcomed recent progress in reforming the pension and social security systems in order to address longstanding unfunded future liabilities. The recent passages of legislations to make the Civil Service Pension Fund and Social Security Fund more sustainable, including by replacing the 30-year mandatory retirement with a mandatory retirement age, increasing social security entitlement age, and adjusting benefit structures, are important milestones. The authorities’ efforts to clear arrears to these funds and to improve compliance are also commendable. The upcoming actuarial valuations should assess the impact of the recent measures on the financial positions of the funds. The mission noted the authorities’ plan to further strengthen the pension system by switching it from a defined-benefit to a defined-contribution framework, and expand it to include the private sector. The mission encouraged the authorities to continue reforming the public utility company to achieve full cost recovery and reduce government subsidies.

III. Raising Growth Potential

Growth challenges. Palau faces a number of constraints common to small islands: a narrow economic base, remote location, small population, insufficient infrastructure, and restrictive investment regime, which all hamper economic growth and contribute to economic volatility and vulnerability. Infrastructure projects financed by AsDB and Compact capital grants are expected to remove some infrastructure bottlenecks and support private sector development, but more efforts are needed. Although Palau’s ranking in the 2014 World Bank’s doing business indicators improved, the country has ample room to strengthen investor protection, contract enforcement, and starting a business. The recent establishment of the Economic Advisory Group comprising representatives of the government, Congress, and the private sector would help address these challenges by facilitating better coordination between the private and public sectors.

Private sector development. Fiscal adjustment to preserve macroeconomic stability should work jointly with structural reforms to raise competitiveness, promote private sector development, and sustain growth. In this context, improving the investment climate and diversifying the economy remain key policy priorities. Since connectivity is essential to lifting growth, leveraging opportunities in growing Asian markets and promoting tourism from new countries would reduce tourism volatility. Developing domestic business activities that are part of the supply chain of the tourism industry and promoting investment outside the tourism sector will also help diversify the sources of growth. The mission reiterated that adopting a new foreign investment regime to simplify investment approval including establishing a one-stop window for new investment, and open all business activities to foreign investment through joint ventures remains critical. Labor reforms aimed at guaranteeing fair compensations, safer working conditions, and steadfast resolution of labor disputes, among others, are expected to be passed this year. In addition, the initiative to improve foreign workers’ flexibility to switch jobs would improve productivity and support inclusive growth.

Strengthening financial stability. The financial soundness indicators suggest that the banking system remains sound. The Financial Institution Commission has made good progress in completing on-site bank examination of all banks, publishing quarterly and annual reports, and strengthening data collection and reporting. The mission reiterated the importance of broadening financial supervision to include the National Development Bank of Palau (NDBP) and other non-bank financial institutions in order to minimize potential risks, particularly in view of the plan to allow NDBP become a deposit-taker institution. The impact of the secured transaction registry in promoting collateralized lending has been less than expected, but the authorities plan to continue working to improve its effectiveness. The mission urged passages of the amendments to the legislation on Anti-Money Laundering and Countering the Financing of Terrorism (AML/CFT), which is expected to address most of the deficiencies identified by the Asia/Pacific Group on Money Laundering. The Financial Intelligent Unit has continued developing capacity to investigate AML/CFT issues but more training and staffing are needed.

Statistics. Better data statistics would facilitate policy formulation and decision making by the private sector. The mission welcomed substantial improvement in data statistics over the past two years as a result of effective TA provided by IMF/PFTAC and other donors as well as hiring of new staff in the Office of Planning and Statistics (OPS). However, continued efforts to strengthen OPS remain critical in order to continue implementing TA recommendations going forward and reduce reliance on external assistance.

The mission would like to thank the authorities for their warm hospitality and constructive discussions.


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