Box 1. Possible Implications of the Global Slowdown and Financial Turmoil for the FSM
Although so far largely insulated from the immediate fallout of the global credit turmoil, the FSM faces risks from a protracted global slowdown and deepening financial crisis. In addition to the direct impact of declining equity prices on the FSM's sizable overseas investments, the FSM is exposed through other possible spillover channels:
Weaker export revenue. FSM's exports are estimated at around $23 million (9½ percent of GDP) in FY2008, compared to $166 million in imports. In terms of export destination, the United States and Asia, mainly China and Japan, account for the largest share. A sharp slowdown in advanced economies with spillovers to Asia would reduce demand for FSM's exports, mainly in fish and foodstuffs, while further declines in primary commodity prices would depress export values. The strengthening of the U.S. dollar (FSM's official currency) could also lead to a loss of export competitiveness.
Declining tourism. The number of visitors has risen by 8 percent since 2004 to around 14,000 per year. The global slowdown is likely to dampen prospects for tourism, while the stronger U.S. dollar may deter visitors from Australia and Europe whose numbers have increased significantly in recent years.
Lower remittances. Overseas worker remittances are estimated to have nearly tripled over the past five years, reaching around $9 million annually. Many workers are reported to be in lower-skilled jobs in the United States that may be at risk in a softening U.S. labor market.
Potential impact of higher shipping costs. The global credit crisis has spread to curtail trade financing, raising the risk of a sharp fall in international trade. Although importers in the FSM do not rely on trade credits, their overseas suppliers could be affected by tighter credit conditions, forcing them to raise shipping charges and delivery prices. These higher charges may partially offset the expected declines in global commodity prices. Higher transport costs and weaker global demand could also scale back fishing activities, resulting in lower fishing fees to the budget.
Declining value of overseas investment. The FSM has sizable overseas investment through the Compact Trust Fund and other reserves held by the states and large public enterprises. In addition, the banking system has exposure through its foreign asset holdings which make up nearly ⅔ of their assets. Much of this comprises of U.S. Treasuries and bonds issued by U.S. government sponsored entities, and to a lesser extent, loans in Guam and Saipan. Although the FSM banking system is well capitalized, liquid, and under FDIC coverage, concerns over potential losses could cause banks to become conservative in their lending. Lower U.S. interest rates would generate capital gains on their bond holdings but over the longer-term would depress net interest margins.
Official aid flows and foreign direct investment. Although Compact assistance is largely independent from global financial developments, other aid flows and concessional financing could come under pressure as advanced countries face tighter budget constraints with slowing growth. Public enterprises that have borrowed from commercial banks may face higher interest payments when refinancing. External debt is low, and FDI flows remain small, but financing for future projects may be constrained by the difficult market conditions.
The authorities have limited macro tools to address a sharper-than-expected slowdown, given the absence of monetary policy and the pressing need for fiscal consolidation. The first line of defense should be to unlock the undisbursed Compact grants, particularly for infrastructure, and to pursue structural reforms to generate domestic sources of growth. Outside donor assistance is also an option.
5.II. Policies to Promote Sustainable Growth
A. Need for Fiscal Consolidation
6. The fiscal situation has improved significantly. On the basis of partial information, staff is forecasting a reduction in the consolidated fiscal deficit to about 3 percent of GDP in FY2008, down from over 5 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 were offset partly by stagnant tax revenue and an increase in fuel subsidies (mostly in Yap).1
7. However, this improvement still falls well short of the surpluses needed to achieve self-sufficiency after the Compact expires. The mission projects that national and state governments combined would need to save around 3¾ percent of GDP annually (corresponding roughly to a $11 million surplus in FY2011) in order to generate the income needed to offset the end of Compact grants in FY2023.2 The required budget surplus varies by state given the different starting level of savings (see table on page 4), but even states with relatively high savings will need to improve their fiscal position.
To achieve these surpluses, the national and state governments would need to undertake further adjustment of around $18 million (7 percent of GDP) compared to their FY2008 performance.
8. Fiscal adjustment will need to begin with further expenditure restraint and improvement in Compact performance. In the short term, the priority remains to cut further public spending and facilitate Compact disbursements, while protecting the investment gains from past savings. At the same time, critical spending on health care, infrastructure, and education should be preserved for fostering sustainable development.
•Reducing further current spending. Targeted payroll reductions are being gradually implemented-especially in states with urgent financing needs-but current spending at around 60 percent of GDP is still large by regional standards.3 A further reduction in public employment together with wage restraint and cuts in non-essential expenditures could save an additional $5 million (2 percent of GDP) to bring the consolidated FSM budget back in balance. Here, the mission welcomes plans by the national government to save about $3 million (1 percent of GDP) over the next few years by streamlining non-essential spending. In addition, general fuel subsidies and limits on surcharges should be replaced with more targeted assistance to vulnerable households.
• Accelerating disbursements of Compact infrastructure grants. At least $100 million allocated for infrastructure and other sectoral programs during FY2004-08 remains undisbursed. Given the second-round positive effects of infrastructure spending on the economy and budget revenue, priority should be given to a timely assessment of bidding proposals, prompt execution of contracts, and budget allocation of co-financing funds.
• Ending the use of investment gains to fund current spending. Yap and the national government have recently used gains from their investment funds to finance subsidies and other current spending.
These gains amounted to $15.7 million (7 percent of GDP) in FY2007, creating the impression of abundant resources at a time when market returns have since fallen. Governments should not rely on these investment gains for spending and instead, begin targeting a surplus for transfer to their reserve funds. Yap's decision to pass legislation protecting their investment funds is a welcome step.
9. Medium-term sustainability will require significant tax revenue measures. Compared with other Pacific Island countries, the FSM collects comparatively little from its income and sales taxes.4 Priority should be given to passing quickly the government's tax reform package comprising the VAT, the net profits tax, and the Unified Revenue Authority (URA) which could over time generate an additional 3 percent of GDP of tax revenue. These tax reforms would also benefit the private sector by facilitating investment, streamlining tax payments, and improving efficiency.
10. States' concerns over handing tax administration to the URA can be addressed while preserving the benefits of a centralized tax agency and uniform tax system across the FSM. Building in safeguards, such as through memoranda of understanding with the URA or greater transparency, could help address states' concerns without compromising the URA's centralized administration and goal of a uniform tax system. The economic costs of further delays are significant for both the governments and the private sector-the lost tax revenue could amount to as much as $8 million for each year of delay, while businesses would continue to face higher costs of investment and inputs, with a negative impact on employment and growth.5 The mission supports the authorities' plan to expand communication of the reforms, including by providing information on expected price changes and wage tax reductions. To build ownership for the reforms, states could make better use of their tax reform units to lead the communication efforts. Including public enterprises under the net profit tax could strengthen support among private businesses, as all public enterprises except for one is exempt from paying the gross revenue tax.
11. Preparations for the tax reform and formation of Unified Revenue Authority should not delay efforts to improve current tax collections. The limited capacity of the national and state governments to conduct tax audits has undermined compliance. Hiring additional tax auditors could more than pay for itself through higher revenue, particularly if performance incentives were introduced, and would help strengthen compliance during the transition to the URA. Greater information sharing, facilitated by a formal memorandum of understanding between the national and state governments, on self-employed state contractors would help strengthen monitoring of the self-employed, many of whom pay little or no income tax.
12. At the same time, reforms of the public enterprise will reduce their burden on the budget. In FY2008, public enterprises (based on partial information) received around $4 million in loans and subsidies from the national and state budgets, while likely exceeding their combined $8 million in operating losses in FY2007. To reduce the drain on the budget and support private sector development, the following could be considered:
• Reducing the scope of public enterprises. Governments should continue efforts to privatize or shut down loss-making state-owned enterprises. In some cases, such as in fisheries, public enterprises with subsidies and cheap financing have expanded their operations and are competing directly with private businesses. These entities should either be privatized or scaled back to focus on assisting private sector development.
• Strengthening commercial orientation. To level the competitive playing field, remaining state-owned enterprises should be brought into the tax system (as done with the National Petroleum Corporation) and be encouraged to seek out market financing, instead of subsidized government loans. This would help strengthen their commercial orientation by raising the cost of capital to a market-determined rate (from the current zero level). Meanwhile, public enterprises continue to pay wages that are significantly higher than in the private and government sector, and despite their poor performance, have increased the average wage by 11 percent since FY2005. Governments as shareholder should link compensation to performance and set a target for paying dividends to the budget.
13. The increased volatility in financial markets and creation of new trust funds highlight the need for careful management of these public funds. Although trust funds in the FSM have recorded losses over the past year, they can recover these losses over time given their long investment horizons. Yap and the national government have established their own trust funds to protect their savings from being tapped to finance budget shortfalls, and other states are considering similar moves. It would be important to note that establishing separate trust funds with their own staffing can be costly and difficult to manage given the limited resources.6 Instead, consideration could be given to consolidating the various trust accounts under a single investment arrangement to minimize fees while preserving autonomy over the fund. For the Compact Trust Fund, the auditor should publish his report annually, as the last report was completed in FY2006. For the Social Security Fund, the administrator should update regularly their medium-term projections to identify any need for corrective action to secure its long-term solvency.
B. External Stability and Exchange Rate
14. Over the medium term, external stability is not at significant risk given the relatively low level of external debt (about 30 percent of GDP), its long-term nature, Compact funding, and current level of net financial assets. However, over the longer term, insufficient fiscal adjustment to declining Compact grants or adverse market conditions could deplete the FSM Trust Fund and other savings and lead to an unsustainable buildup in external debt, although, at this stage, this scenario appears unlikely.
15. The use of the U.S. dollar as the FSM's official currency remains appropriate given FSM's close macroeconomic and financial linkages with the United States (including under the Compact) and limited administrative capacity to conduct its own monetary policy.
C. Real and Financial Sector Reforms
16. The business environment remains difficult, holding back private sector development. According to the most recent Doing Business report from the World Bank, the FSM slipped to 126th place in the world, the lowest among Pacific Island countries, in terms of the ease of doing business. In particular, the FSM fared poorly in terms of the time needed to enforce contracts and the low recovery rates in bankruptcy compared to other island countries. The problems in accessing secure land titles have also made registering property difficult, deterring new investment.
Source: World Bank, Doing Business, 2009.
17. Reforms to improve the business environment can help promote private sector growth, create new jobs, and generate higher revenue.
Such reforms could include:
• Strengthening the judiciary. The court's limited capacity has led to considerable delays in enforcing contracts and resolving bankruptcy claims. This in turn has contributed to the low rates of recovery in bankruptcy and reluctance by banks to secure collateral for new lending. For example, the national government has one judge in each state, while Yap and Chuuk have only three, covering a wide range of cases from criminal to corporate. Expanding the court's capacity and introducing a separate commercial court with its own standing judge and fast-track procedures for resolving contract disputes and bankruptcies would help expedite the legal process.
• Developing a market for land. Expanding land titling and allowing land to be traded in special designated commercial areas would facilitate new investment. Opening up the land market would also support the development of commercial agriculture and a private market for mortgage lending.
• Liberalizing further the foreign investment regime. Relaxing state restrictions on investing in certain sectors, such as in retail, and requirements on exports and minimum capital would allow foreign investment to play a larger role in creating jobs and bringing in new skills. Over the longer-term, harmonizing the permit system across the four states would help attract larger scale investment.
18. One of the biggest obstacles to starting a new business is access to credit. Commercial banks in the FSM continue to primarily invest in safe U.S. Treasuries or other overseas securities (almost ⅔ of their assets), rather than lend to new businesses. Part of the reason is the inherent risk of start-up lending, the high fixed costs associated with small business loans, and the difficulties in collecting on collateral. At the same time, the FSM Development Bank continues to lend to well-established firms (in direct competition with commercial banks), rather than supporting start-ups. To improve access to credit, particularly for new businesses, consideration could be given to:
• Redirecting the focus of the FSM Development Bank to support start-ups. Requiring established firms to graduate after a fixed time to commercial bank borrowing would support the growth of commercial banks and free up resources for the Development Bank to engage in new lending. To do so, the FSM Development Bank would need flexibility in adjusting rates to match the risk of the borrower. The Development Bank should also scale back its sizable securities portfolio (around $12 million of which 40 percent are in overseas equities) to reduce its exposure to market risk.
• Expanding micro-credit for small businesses. Because of the high fixed costs of small commercial loans and the interest rate limit under the usury law, commercial banks are constrained from lending to small businesses. Credit unions and micro-credit agencies, such as in Yap, are filling in this gap, but their size remains very small. To support these specialized lenders, the FSM Development and commercial banks could provide seed money or equity capital, as well as technical training. Over time, as these businesses grow, they can graduate to borrowing from the commercial banks.
• Improve the functioning of the secured transaction law. Banks have actively used the new law to register their security interest over a range of collateral. It would be important that any early disputes under the law by handled in a fair and prompt manner in order to build confidence in the law as a tool for banks to expand their lending. The functioning of the law could also be supported by having the filing office automatically notify lenders of any subsequent liens on property to avoid duplication and requiring more specific information on the underlying collateral, particularly on inventory.
• Expanding the availability of trade financing. Trading companies typically pay upfront with retained earnings to complete their international transactions, but this exposes them to default risk and limits their ability to seek out new suppliers or customers. Encouraging banks to seek out international banking partners, including outside the United States, would allow them to offer a wider range of credit and trade services, such as letters of credits, helping exporters and importers to better manage their risk and tap new markets.
19. Micronesian banks remains relatively insulated from the global financial crisis, but risks remain. The direct impact of the financial turmoil is likely to be limited, given banks' large stable deposit base, FDIC insurance coverage, and large holdings of U.S. government bonds. However, credit has grown rapidly (by nearly 24 percent annually in June, mainly commercial loans overseas), while nonperforming loans (NPLs) have risen. Looking ahead, the key risks for banks stem from the weak domestic economy, spillovers from the global slowdown (including on overseas loans), and lower interest income which could push banks to tighten lending standards. Against this backdrop, the supervisors will need to monitor carefully banks' exposure to market risk and rising NPLs and ensure adequate provisioning. In light of their recent growth, credit unions should be regulated by the Banking Commissioner and subject to appropriate licensing requirements.
20. Efforts to transform the FSM into an offshore financial center and a tax haven for foreign corporations run the risk of damaging financial relations with other countries. The Banking Commissioner's limited resources in insurance supervision and the national tax administrator's difficulties in auditing foreign corporations with tax haven status hinder their ability to safeguard against such risks. Moreover, the prospects for limited investment and tax payments suggest little benefit for the local economy.7
21. The authorities recognize the various challenges and are taking the appropriate steps to address them. The government's efforts to implement the Compact, reform the tax system, and improve the lending framework will help promote growth and strengthen the fiscal position. Further reforms to improve the business environment and the financial sector will stimulate private sector-led growth. Building consensus for action through outreach and dialogue with the public, legislative bodies, and the private sector will help promote these reforms. We wish the authorities every success in their endeavors.
The mission would like to thank our counterparts for their excellent cooperation, kind hospitality, and frank discussions. We are grateful for the opportunity to contribute to the policy discussion in the FSM, including during our visit to Yap, and look forward to continuing our close dialogue in the future.
Kenneth Kang, Raynold Moveni, Martin Sommer, and Anthony Gill (ADB)
1 The share of tax revenue in GDP in the FSM fell by about 1 percentage point between FY2006-08.
2 The accumulated budget surpluses (projected at $320 million) would complement assets of the Trust Fund ($1,010 million), so that returns from these combined assets would replace the real value of expiring Compact grants in FY2023. Relative to the 2006 Article IV consultation, the estimated target surplus has slightly increased as a result of the greater-than-expected FY2006 deficit, higher fuel subsidies in Yap, and the likely delay in tax reforms. These factors, however, have to some degree been offset by strong investment returns, fiscal consolidation in Chuuk and Kosrae, grants from China, and the partial write-off of arrears in Chuuk.
3 In the Marshall Islands, current spending amounts to about 50 percent of GDP, while in other Pacific Island countries, such as Fiji, Samoa, Solomon Islands, Tonga, and Vanuatu, it is only 20-35 percent of GDP.
4 Tax revenue in the FSM is only 12 percent of GDP, compared with more than 20 percent of GDP in many other Pacific Island countries, such as Kiribati, Palau, Samoa, and Tonga.
5 For example, there is anecdotal evidence that companies are delaying investment over uncertainty regarding the introduction of the net profit tax.
6 For example, a state investing $30 million with management fees that are higher by 50 basis points (0.5 percent) could under plausible assumptions pay $4.3 million in additional fees by FY2023.
7 To date, only a handful of companies have filed their tax returns, bringing in only a trivial amount of tax revenue.