Public Information Notice: IMF Concludes Article IV Consultation with Palau

November 24, 1999

Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case.

On November 10, 1999, the Executive Board concluded the Article IV consultation with Palau.1


Palau is an archipelago in the Western Pacific, with a population of about 18,000 and per capita GDP of about $7,000. It faces many development constraints which are common among Pacific island economies, including a narrow resource base, geographical isolation, a small domestic market, a lack of infrastructure and skilled labor, and vulnerability to external and natural shocks. Palau became independent in 1994, and at the same time entered the Compact of Free Association (the Compact) with the United States, under which Palau is to receive grants totaling more than US$500 million over a fifteen-year period to 2009. Under the Compact, US$70 million has been set aside in a Trust Fund (which has so far grown to about US$140 million) for use after Compact grants cease in 2009.

Real GDP grew rapidly in 1995-96, with the U.S. grants fueling consumption and investment, and tourist activity rising sharply. However, output growth stalled in 1997 and turned negative in 1998 and the first half of 1999 in the wake of the Asian crisis. With the U.S. dollar being legal tender, Palau suffered a 15 percent loss of competitiveness (measured by the nominal effective exchange rate, NEER) in the twelve months through June 1998 (or more than 20 percent, if NEER is based on shares in tourist arrivals), but about half that amount has since been recouped. Based on partial data, inflation appears to have been in the single-digit range in recent years, in line with inflation in the United States and Japan. While real activity has remained subdued in the second half of 1999, it is projected to pick up in 2000 reflecting a rebound in the regional economy and the initiation of large investment projects including a US$150 million road around the Babeldaob island.

Based on preliminary indications, the budget is expected to record a deficit of 12 percent of GDP in 1998/99, compared with a 6 percent of GDP surplus in 1997/98, and a balance in 1996/97. The abrupt worsening of the fiscal position reflected a number of factors, including the absence in this fiscal year of one-time gains that boosted revenues temporarily in the previous two years, as well as weak revenues resulting from the recession, a scheduled step down of U.S. grants, and a 5 percent of GDP rise in current expenditures. Though the government prudently avoided a foreign borrowing, there has been a significant drawdown of government financial assets to finance the budgetary shortfall.

After a large overall surplus in 1994/95 reflecting upfront grant disbursements under the Compact, the balance of payments has been in deficit in three of the last four years. Although the trade account has been in substantial deficit, owing to Palau's dependence on imports and its narrow export base, the external current account has been in surplus, on account of large tourist receipts, income from investing unspent Compact funds, and grants. However, there have also been substantial capital outflows, reflecting the pooling of deposits by U.S.-based banks at their headquarters for investment elsewhere. As a result, foreign reserves have declined to around US$65 million in mid-1999 (equivalent to about a year of imports) from about US$100 million at end-1994/95.

Executive Board Assessment

Executive Directors welcomed the opportunity to review economic developments and policies in Palau in the context of the first Article IV consultation with the country, with which they looked forward to long and fruitful cooperation. In light of the prospective phase-out of U.S. grants, Directors agreed that the main challenge confronting the authorities is to ensure the long-term viability of Palau's economy by reducing its reliance on foreign assistance. They welcomed the authorities' commitment to take the necessary comprehensive measures, notably fiscal consolidation and structural reform, in order to foster a dynamic private sector and expand the productive base of the economy.

As the U.S. dollar is used as legal tender, Directors noted that the burden of macroeconomic adjustment will fall mainly on fiscal policy. They observed that recent fiscal developments had benefited from some transitory factors, and that the Social Security and Civil Service Pension Funds were presently underfunded. Directors stressed the importance of protecting investment income from the Compact Trust Fund as a source of budgetary resources in the long term. Against this background, they agreed with the staff's recommendation to eliminate the budget deficit over the next three years. They also supported the authorities' target to lower the budget deficit (excluding grants) by 4 percent of GDP in FY 2000, notably through substantial reductions in the wage bill and expenditures on goods and services. By such measures, deficit reduction targets could be achieved while allowing the needed expansion of expenditures in priority areas, such as education, health, and infrastructure improvements. They also encouraged steps to improve public enterprises' financial performance and to outsource government services, and welcomed the introduction of a performance-based output budgeting system.

Directors encouraged the authorities to press ahead with their efforts to broaden the tax base and improve tax administration through an early passage of the Tax Reform Act, prepared with Fund technical assistance. They also welcomed the prospective revision of the water rate structure. Directors viewed these revenue efforts as particularly important in light of Palau's relatively low level of tax revenues.

Directors stressed the need for substantial structural reforms to stimulate private sector activity, attract foreign investment, and promote tourism. The recent establishment of a presidential task force to review the country's current foreign investment laws by January 2000 was welcomed as an important step in simplifying regulations and procedures. Directors encouraged the authorities to step up efforts to resolve the large number of unsettled claims concerning land ownership and lease rights, which would allow more effective use of land as collateral for bank loans and would also improve the environment for foreign direct investment.

Directors stressed the importance of maintaining a healthy financial system. They recommended the introduction of banking regulation and supervision for locally chartered banks in line with international practices, and encouraged the authorities to seek technical assistance in this area.

Directors underscored the need for improved institutional capacity to compile core economic and financial data. They welcomed the authorities' efforts in this regard, as well as their intention to take advantage of technical assistance from the Fund and other sources.

Table 1. Palau: Selected Economic Indicators, 1994/95-1998/99 1/
(In US$ mn., unless otherwise indicated)

1994/95 1995/96 1996/97 1997/98 1998/99

Nominal GDP 2/
105.2 124.3 131.1 129.3 129.3
(Percent change) 24.3 18.1 5.5 -1.4 0.1
Visitor arrivals per year 2/ 47,023 60,719 66,441 59,008 ...
Public finance of national government
Revenues 166.2 66.0 72.3 73.4 56.4
Domestic 23.2 28.5 39.1 43.4 32.3
Grants 143.0 37.5 33.2 30.0 24.1
Expenditures 65.3 75.1 76.5 64.6 71.6
Current 56.7 58.1 58.3 54.8 61.0
Capital 8.5 17.0 18.3 9.9 10.7
Overall fiscal balance (incl. grants) 100.8 -9.2 0.3 7.7 -15.2
(As percentage of GDP) 95.8 -7.4 0.2 6.0 -11.8
Overall fiscal balance (excl. grants) -42.2 -46.7 -32.9 -22.3 -39.4
(As percentage of GDP) -40.1 -37.6 -25.1 -17.2 -30.4
Balance of payments
Exports (f.o.b.) 13.9 13.9 11.8 11.1 11.0
Imports (f.o.b.) 60.4 72.4 72.9 63.2 63.3
Balance of trade -46.6 -58.5 -61.1 -52.1 -52.3
(As percentage of GDP) -44.3 -47.1 -46.6 -40.3 -40.4
Current account balance
Including grants 68.3 12.6 21.7 17.2 8.0
(As percentage of GDP) 64.9 10.2 16.5 13.3 6.2
Excluding grants -16.3 -18.4 -7.9 -11.3 -14.0
(As percentage of GDP) -15.5 -14.8 -6.1 -8.7 -10.8
Overall balance 96.3 -12.2 -3.1 4.1 -19.3
Government financial assets 97.5 84.1 81.0 85.1 65.8
Compact Trust Fund balance 70.8 77.2 105.5 122.4 140.8
External debt service 4.5 3.0 3.4 3.6 4.1

Sources: Data provided by the Palauan authorities; and IMF staff estimates.

1/ Fiscal year begins on October 1; 1998/99 data are estimated.
2/ On a calendar-year basis. The column 1994/95 refers to 1995, and so forth.

1Under 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. In this PIN, the main features of the Board's discussion are described.


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