Public Information Notice No. 09/27

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with the Federated States of Micronesia

March 5, 2009

On February 25, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Federated States of Micronesia (FSM).¹

Background

Economic performance in the FSM has been weak in recent years. As a result of problems with disbursing grants under the Compact agreement with the United States, rising commodity prices, and difficult business environment, the economy has contracted for five years in a row—one of the worst outturns among the Pacific nations. Output declined by 3.6 percent in FY2007 (October-September) and by an estimated 1 percent in FY2008. The economy continues to be dominated by the public sector and poor job prospects have stimulated migration to the United States where FSM citizens can work without a visa.

Inflation has remained relatively muted recently at about 5 percent, despite higher oil and food prices. The use of the U.S. dollar as the official currency, high prevalence of subsistence farming, and switching to lower-quality imports have limited price increases. The current account is estimated to have widened by 8 percentage points to 21 percent of GDP in FY2008 as the rapidly increasing costs of fuel and food imports outsized higher fishing revenues.

The fiscal situation has improved. On the basis of preliminary information, staff is forecasting a reduction in the consolidated fiscal deficit to about 3 percent of GDP in FY2008, down from over 6 percent in FY2006. This improvement was achieved largely through a reduction in the public wage bill in Chuuk and Kosrae and grants from China, which helped offset stagnant tax revenue and an increase in fuel subsidies. However, despite the recent improvement, the fiscal deficit still falls well short of the surpluses needed to achieve self-sufficiency after the Compact expires. Staff projects that national and state governments combined would need to save around 3¾ percent of GDP annually to build sufficient savings which would generate—together with the Compact Trust Fund—the income needed to offset the end of Compact grants in FY2023.

The recent pick up in bank lending has been concentrated on state-owned enterprises and overseas firms (especially in Saipan), with limited impact on the local private sector. Obtaining financing for local businesses and consumers remains difficult. During FY2008, the share of nonperforming loans jumped from 3 percent to 6 percent at the Bank of FSM (the main commercial bank), mainly as a result of one large delinquent loan, but the bank remains well capitalized with a capital adequacy ratio of 35 percent.

In the near term, the FSM economy is likely to remain weak. Growth is projected to recover modestly to ½ percent in FY2009, as falling commodity prices boost real household incomes and states make progress on spending Compact infrastructure grants—about $100 million in grants have not been used. However, the risks to the outlook are on the downside. The unfolding global slowdown could reduce tourist arrivals, remittances, exports, and foreign investment. Falling global equity prices have reduced significantly the value of the Compact Trust Fund and state investments and could force governments to scale back their spending. In addition, slowing activity could lead commercial banks to tighten their lending standards.

Without stronger reform efforts, medium-term growth prospects are poor. According to the World Banks' Doing Business survey, FSM recently slipped to 126th place in terms of the ease of doing business. At the same time, with Compact support on a declining path, the authorities face the need to downsize the public sector, a task made more difficult without sustained private growth.

Executive Board Assessment

Executive Directors noted that economic growth in the Federated States of Micronesia (FSM) has remained weak, reflecting high food and fuel prices, delays in disbursements of Compact grants from the United States, and a difficult business environment. While the recent decline in commodity prices and a faster pace of infrastructure investment could boost real incomes and growth, downside risks arise from the global economic slowdown, in particular from smaller remittance inflows and reduced tourism revenues. Directors stressed that fiscal consolidation, an acceleration of structural reforms, and further efforts to develop the private sector will be essential to improve medium-term growth prospects.

Directors commended the authorities for reducing the budget deficit in FY2008. They noted that further sustained efforts are needed to build savings that will allow the FSM to achieve fiscal self-sufficiency when the Compact expires in FY2023, as well as to provide a cushion against external shocks. Fiscal balances will need to improve at both the national and state levels.

To secure fiscal sustainability, Directors recommended additional cuts in non-essential spending and implementing comprehensive tax reforms, including the VAT, on a timely basis. The income tax base should be broadened and revenue administration strengthened, including by hiring more auditors and promoting greater information sharing between the national and state governments on the self-employed. The Unified Revenue Authority should be established and made operational as soon as possible. Directors called for a further reduction in the public sector wage bill, which is still large by regional standards, to provide scope for preserving essential spending on health care, infrastructure, and education. The authorities should also take advantage of lower fuel prices to reduce fuel subsidies.

Directors considered that the FSM's financial sector has weathered well so far the global downturn. They welcomed the authorities' commitment to strengthen the supervisory framework. To support private sector development, Directors encouraged the authorities to improve access to credit by small firms and to refocus the FSM Development Bank on supporting new businesses and micro-credit institutions.

Directors encouraged the authorities to move ahead with structural reforms to improve the business environment and facilitate the development of a more dynamic private sector, which will be key to catalyzing growth and supporting fiscal consolidation. Priority should be given to expanding the capacity of the courts to enforce contracts; liberalizing land use and titling requirements; and easing restrictive foreign investment rules. Directors welcomed the decision to shut down a large loss-making public enterprise and the steps taken to incorporate the other state-owned enterprises in the tax net.

Directors encouraged the authorities to intensify their efforts to strengthen the statistical base, especially the fiscal and balance of payments data, in order to improve surveillance and policy analysis.