Public Information Notice No. 07/30

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with the Federated States of Micronesia

March 8, 2007

On February, 28 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Federated States of Micronesia.¹

Background

The Federated States of Micronesia (FSM) has relied heavily on U.S. grants under the Compact of Free Association since gaining independence in 1986. Sharp reductions in Compact-related capital spending, higher oil prices, and the closure of textile mills in Yap have weighed on economic activity. Real GDP grew by only 1½ percent in FY2005 and declined by nearly 1 percent in FY2006. Employment rose slightly, as government hiring largely offset job losses in the private sector. Despite higher oil prices, inflation remains low.

The current account deficit remained wide at 13 percent of GDP, with aid covering half of the import bill, down from two-thirds a decade ago. Goods exports are around 10 percent lower than the average for the decade, due mainly to the loss of textile trade preferences. With the U.S. dollar the official currency, the real effective exchange rate remains depreciated relative to other Pacific island currencies since 2000.

The underlying fiscal situation has deteriorated, despite a decline in the overall deficit. The general government deficit is estimated to have fallen to 1½ percent of GDP in FY2006, from 5½ percent of GDP the previous year, largely due to a sharp fall in capital spending. Although the national government ran a slight surplus, the four states ran deficits with Pohnpei drawing down its cash reserves while Chuuk and Kosrae incurred arrears.

Executive Board Assessment

Executive Directors noted that since the last Article IV consultation, economic growth in the Federated States of Micronesia has been weak, partly reflecting delays in Compact aid disbursement. While Directors expected economic activity to pick up with the release of these funds, they stressed that fiscal consolidation and private sector development will be essential to sustain economic growth in the medium term as Compact aid declines.

Directors expressed concern that continued budget deficits have raised the size of the adjustment that will be needed to achieve fiscal sustainability when the Compact expires in 2023. They urged the authorities to begin targeting surpluses that would help generate sufficient income to offset the loss of Compact grants and serve as a cushion against unforeseen shocks. Directors underscored that, to ensure this outcome, fiscal policy at the state level will need to be tightened, coordinated, and harmonized with that at the national level.

Directors recommended that spending cuts and comprehensive tax reforms be phased in to secure fiscal sustainability. Priority should be given to reducing the public sector wage bill, which is large by regional standards, possibly in the context of a broad reform of the public sector. This would help to preserve essential spending on health care, infrastructure, and education. Directors attached high priority to the early introduction of the planned value added tax, and to measures to broaden the tax base and to strengthen tax administration. They welcomed the measures to address the projected social security administration shortfalls.

Directors highlighted the importance of the Trust Fund as a source of revenue after Compact grants expire, and urged the authorities to strengthen the Fund's operations and boost its returns by improving its governance and transparency. At the same time, they stressed that the Trust Fund is not designed to provide resources similar to the current levels of grant support or to supplant other revenue sources, but to assist in the transition to a more self-sufficient economy.

Directors underscored the urgency of improving the business environment to increase the size and efficiency of the private sector. They encouraged the authorities to vigorously implement reforms to ease the high cost of doing business in order to spur private investment. These should include steps to privatize public enterprises and close unprofitable ones, improve the enforcement of contracts, facilitate land use, and ease restrictions on foreign investment.

Directors encouraged the authorities to step up the pace of financial sector reform to support private sector development. In this regard, they welcomed the new secured transaction law, which will help to expand lending. Other important measures would be to privatize the Bank of the Federated States of Micronesia and to place the Development Bank under the supervision of the Banking Board. Directors commended the authorities for taking steps to combat money laundering and terrorism financing.

Directors emphasized the need to build institutional capacity with technical assistance from the IMF and the Pacific Financial Technical Assistance Centre. In particular, they encouraged the authorities to improve the quality and timeliness of economic statistics, especially the national and fiscal accounts.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.