Public Information Notice No. 03/11

Public Information Notice: IMF Concludes 2002 Article IV Consultation with the Federated States of Micronesia

February 10, 2003

On January 24, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Federated States of Micronesia.¹

Background

The economy of the Federated States of Micronesia is largely supported by the United States financing provided under the Compact of Free Association. The first Compact (Compact I), covered the 15-year period FY1987-2001, with two stepdowns in funding; a second Compact (Compact II), covering the 20-year period FY2004-23, is nearly finalized. Compact II will entail declining levels of U.S. grant assistance, a Trust Fund to provide revenue after the cessation of such assistance, and strict procedures/audits/reporting requirements for the use of Compact funds. For FY2002 and FY2003, Compact I provided for funding to continue at the average level of the previous 15 years, resulting in a substantial increase in assistance-or "bump-up funds"-in these two years relative to FY2001.

Economic activity is dominated by the public sector; the private sector, while progressively increasing in importance, remains largely a provider of services to the public sector. Fiscal adjustment was postponed following the first stepdown in FY1992, as expenditure levels were sustained by external commercial borrowing secured against future Compact funding. However, following the second and larger stepdown in FY1997, and in the face of an already high external debt burden, significant fiscal retrenchment was undertaken with the help of an Asian Development Bank (AsDB)-supported Public Sector Reform Program. Real GDP declined by an average rate of 3.6 percent per annum during FY1996-98, but rebounded by FY2000 reflecting the implementation of a number of infrastructure projects and some pick-up in private sector activity.

More recently, economic activity is estimated to have slowed. Despite the use of the bump-up funds by some of the FSM's four state governments to boost spending during FY2002, GDP is estimated to have grown only by 0.8 percent. The fiscal stimulus appears to have been mostly offset by an emerging fiscal crisis in Chuuk and a "wait and see" attitude of the private sector in the face of uncertainty associated with the new Compact. Inflation declined to close to zero in FY2002.

After years of large deficits, the underlying consolidated fiscal position of the National and the state governments continued to deteriorate in FY2002, with little prospect for improvement in FY2003. The estimated small surpluses in these two years resulted entirely from the availability of the bump-up Compact grants. Excluding these funds, a consolidated fiscal deficit-of about US$11 million-US$12 million (5 percent of GDP)-is projected for these two years. Fiscal performance across the National and four state governments has varied considerably, with the National government and the Chuuk state accounting entirely for the deficits in recent years; the Chuuk state is estimated to have built up arrears of US$15 million.

The external current account position has remained weak in recent years as the trade deficit has widened and transfers have declined with the stepdowns in Compact funding. Export volumes have been stagnant and tourism receipts have remained subdued. Further, interest and dividend earnings from the sizable investment of government assets in U.S. equities have decreased significantly since FY2001 owing to the rundown of government assets to finance the deficits of recent years and the downturn in the U.S. equity market. On the other hand, since FY2000, imports have recovered in step with the increase in government expenditure and the rise in oil prices.

The external debt position has improved significantly with the full repayment of the earlier commercial borrowing. With the outstanding debt wholly on concessional terms, the debt service ratio fell sharply to 6 percent of exports of goods and services, and the external debt ratio to 23 percent of GDP, in FY2002.

Policy reforms-especially structural measures to promote private sector activity-have advanced little in the past few years, but some initial steps are now under way. In recent months, the requisite approval for an AsDB-supported Private Sector Development Program loan has been granted by all governments except Chuuk. In the area of tax reform, a high-level Revenue Symposium recommended the introduction of a VAT in October 2002, with support from the Pacific Financial Technical Assistance Center.

Executive Board Assessment

Directors welcomed the expected pick-up in economic activity and continued low inflation in the Federated States of Micronesia (FSM), as well as the recent improvement in the external debt position with the repayment of the earlier commercial borrowing. However, they expressed concern about the country's weakening fiscal position and the decline in usable government assets, as the significant fiscal retrenchment achieved earlier under the Public Sector Reform Program had been partly reversed in recent years. They also noted that significant progress is yet to be made in strengthening the legal and institutional framework for private sector development.

Directors agreed that the FSM faces major policy challenges, as it has to adjust to reduced external assistance under the second Compact of Free Association (Compact II) covering the fiscal years 2003-2023. In this regard, Directors noted that little headway had been made in preparing the economy for the required adjustment. They stressed that only with strong fiscal adjustment, structural reforms to stimulate private sector activity, and greater investment in human capital can the FSM look forward to macroeconomic stability and economic growth. Directors recognized, however, that, given the FSM's structure as a loose federation of autonomous states, difficulties might be faced-as in the past-in garnering the political consensus for needed policy actions. In the view of Directors, this made it all the more important that the authorities spare no effort in mobilizing broad support, by widely disseminating information on the likely consequences of Compact II and the imperative of corrective action.

Directors called for bold fiscal measures in the FY2004 budget. They agreed that fiscal adjustment in the initial years of Compact II will have to come mainly from cuts in government current expenditure, focused on the wage bill. Directors therefore welcomed the authorities' intention to keep nominal wages unchanged and to reverse the recent increase in working hours in several of the states. Directors underscored the need for a comprehensive review-with possible donor assistance-of the compensation levels and structure of the civil service to sustain public sector retrenchment and wage rationalization. They also emphasized the need to review non-wage outlays with a view to reducing the large travel budget and discretionary spending on constituency-based projects. In view of the need to enhance the country's productive and economic growth potential, Directors agreed that the FSM should safeguard spending on infrastructure and on health and education, while improving the efficiency of such expenditures.

As tax revenues remain very low, Directors highlighted the crucial need to mobilize additional revenues. They welcomed the proposed VAT and called for its early implementation. Directors attached considerable importance to minimizing differences in VAT laws among the four states and to administering the tax on a uniform basis. They also stressed the urgency of strengthening tax administration.

Directors underscored the need to improve transparency and accountability in the government's fiscal operations. These efforts will benefit from the stringent new reporting and auditing requirements and the strengthened oversight of U.S. assistance under Compact II.

Directors concurred that private sector development is essential to help sustain growth in the medium term and mitigate the likely declines in living standards resulting from fiscal adjustment. They recognized, however, that the FSM's narrow resource base and remote location and other structural constraints pose difficult challenges for developing the private sector. Nevertheless, Directors called for actions to harness the limited available potential in agriculture, fishing, and tourism, including through structural reforms in land tenure, the foreign investment regime, and the public enterprise sector. They urged the authorities to press ahead with the actions envisaged in these areas in the context of the Private Sector Development Program.

Directors noted that the banking system in the FSM is well regulated and supervised. They welcomed the recent passage of legislation that brings existing bank regulations into line with the Basle Core Principles to further strengthen prudential standards. Directors commended the authorities' intention to strengthen the anti-money-laundering law, and recommended that they submit a Self-Assessment Questionnaire on Terrorist Financing to the Financial Action Task Force.

Directors noted that statistical deficiencies continue to hamper meaningful economic assessment and management and called for further improvements in data compilation and coverage. They, therefore, supported the authorities' intention to strengthen the FSM's statistical capacity through better recruitment and training as well as sustained technical assistance. A few Directors saw a larger role for Fund technical assistance on a more general basis.