Public Information Notice No. 12/24

Public Information Notice: IMF Executive Board Concludes 2012 Article IV Consultation with Palau

March 14, 2012

On March 12, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the 2012 Article IV consultation with the Republic of Palau.¹

Background

Palau depends on tourism and foreign aid for its livelihood. Annual tourism receipts amount to about 50 percent of GDP, while grants, in particular under the Compact Agreement with the United States, averaged 25 percent of GDP during the last decade. An overarching challenge for Palau is to achieve self-sufficiency when the renewed Compact grants wind down in FY2024.

The economy has recovered strongly from the 2008–09 downturn. Real GDP growth is estimated to have reached about 6 percent in FY2011, on the back of a 25 percent surge in tourist arrivals. Annual inflation increased from 1½ percent during 2009–10 to 3½ percent in 2011, due to a sharp rise in food and fuel prices during the first half of the year.

The fiscal position has improved markedly but the deficit remains sizable. Thanks to spending restraint and economic recovery, the current fiscal deficit (excluding grants) declined cumulatively by 3½ percent of GDP during the past two fiscal years. But the deficit remained high at 14 percent of GDP. At end-FY2011, government cash reserves stood at only US$7 million (about one and a half months of government spending), while arrears amounted to about US$15 million (7 percent of GDP).

The external position has improved alongside the rebound in tourist arrivals. The current account deficit (excluding grants) declined to 11 percent of GDP in FY2011, despite a rise in imports from higher commodity prices. The Compact Trust Fund balance has stabilized at around US$150 million, albeit still 15 percent below pre-crisis peaks.

The economy is likely to continue expanding, with growth projected at 3 percent in FY2012 and 2 percent over the medium term. Downside risks dominate. A severe downturn in Asia, the main tourist source region for Palau, could significantly affect the tourism sector, with large adverse knock-on effects on the economy. Although the renewed Compact grants are unlikely to be affected, other aid flows may be delayed as donors face tighter finances. A sharp rise in food and fuel prices could also depress domestic demand and weaken the fiscal and external positions, given Palau’s heavy dependence on imports. The sizable fiscal deficit and the absence of monetary and exchange rate policies suggest that Palau has limited policy space to counter these risks.

Executive Board Assessment

Executive Directors welcomed Palau’s strong economic recovery and positive near-term outlook. Directors observed, however, that risks are tilted to the downside and that Palau remains vulnerable to external headwinds. The key challenge is to build the domestic consensus for reforms that will achieve a sustainable fiscal position and strengthen growth prospects as Compact grants wind down.

Directors commended the recent improvement in the fiscal balance. They encouraged the authorities to take advantage of the current economic upturn to further advance fiscal consolidation and boost government cash reserves. Directors underscored that fiscal sustainability calls for gradual and substantial adjustment over the medium term, requiring comprehensive tax reform and sizable reductions in the public wage bill and subsidies. They also stressed the need to address the large unfunded liabilities of the Civil Service Pension Fund and the Social Security.

Directors welcomed recent efforts to strengthen the budget process and clear arrears. They supported the implementation of a medium-term budget framework in FY2013 to improve budget planning and enhance credibility. Directors welcomed ongoing efforts to reform government-owned utilities.

Directors noted that the banking system remains sound, and welcomed continued progress in strengthening bank oversight. To safeguard financial stability, they encouraged enhancement in the regulation and supervision of non-bank financial institutions, including the National Development Bank of Palau.

Directors welcomed recent progress in improving the business climate. They encouraged further efforts to promote private sector development, including creating a level playing field for domestic and foreign investors.

Directors welcomed the authorities’ commitment to improving the quality and timeliness of data. They encouraged adequate staffing and capacity building of the Office of Planning and Statistics.

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. An explanation of any qualifiers used in summings up can be found here: http://www.imf.org/external/np/sec/misc/qualifiers.htm