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Republic of Palau and the IMF

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Public Information Notice (PIN) No. 04/14
March 2, 2004
International Monetary Fund
700 19th Street, NW
Washington, D.C. 20431 USA

IMF Concludes 2003 Article IV Consultation with the Republic of Palau

Public Information Notices (PINs) are issued, (i) at the request of a member country, following the conclusion of the Article IV consultation for countries seeking to make known the views of the IMF to the public. This action is intended to strengthen IMF surveillance over the economic policies of member countries by increasing the transparency of the IMF's assessment of these policies; and (ii) following policy discussions in the Executive Board at the decision of the Board.

On February 27, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Palau.1

Background

The Republic of Palau is a small island economy, heavily dependent on tourism and external assistance. With a population just under 20,000, Palau faces many development constraints common among other Pacific Island economies including a small domestic market and vulnerability to external shocks. The public sector is large and accounts for over one-third of total employment.

The Compact of Free Association provided front-loaded grants from the United States over the fifteen-year period to 2009. Large disbursements have been made since mid-1990s to build infrastructure and create a Compact Trust Fund (CTF) to enable Palau to become self-sustainable. The CTF stood at US$136 million at end-September 2003. In recent years, grants from the U.S. have averaged about US$24 million or 20 percent of GDP per annum, financing primarily government operations. Palau has also received large in-kind (off budget) and cash grants from Japan and Taiwan Province of China for infrastructure projects. External debt (all of which is on concessional terms) remains low at 16 percent of GDP.

Economic growth has been modest in the last few years and inflation is low. Following a recovery of 4.5 percent in FY2001, real GDP growth is estimated to have been only 1 percent annually in FY2002-03 (years ending September), reflecting the adverse impact of various external shocks that affected tourism, a major source of income for the country. The effect of shocks on growth has been only partially offset by project-related construction.

Palau has recorded large fiscal imbalances in recent years. The overall fiscal deficit (including grants) swung from over 20 percent of GDP in FY2001-02 to 2 percent of GDP in FY2003, due primarily to the time lags involved in the receipt and use of project-related external assistance. Excluding capital grants and spending, the balance between domestic revenue plus current grants and current expenditure declined from about 10 percent of GDP in FY2001 to 5 percent of GDP in FY2003. However, this adjustment was inadequate to prevent the virtual depletion of the government's usable reserves. To finance the deficits, the government also made withdrawals from the CTF in the last two years and accumulated domestic arrears in FY2003.

The external current account deficit deteriorated in FY2002 owing largely to the decline in tourist receipts in the aftermath of September 11, but improved in the following year. Tourist receipts rebounded in the second half of FY2003, helped by the depreciation of the real effective exchange rate, which remains significantly above the levels before the Asian crisis. Palau's tourism competitiveness was adversely affected by the large appreciation of the U.S. dollar vis-à-vis the Japanese yen in 2000-early 2002. Limited air flights and high airfares also make Palau's tourism less competitive. However, efforts have been made recently to introduce competition in air flights and diversify the tourist base. Imports fell in FY2003 reflecting lower grant-financed capital expenditure. The overall deficit since FY2001 has been financed by a drawdown in government financial assets.

The authorities launched a wide range of reform initiatives since 2001 but several important ones have stalled in the legislative process. Passage of the Financial Institutions Act and anti-money laundering legislation paved the way for establishing banking supervision and regulation in Palau. While the banking regulatory framework still needs improvements for effective implementation, a tax reform package, a new foreign investment law, a statistics law, and proposals related to streamlining the executive and legislative branch have not yet been enacted.

In the near-term, growth will be sustained, but medium-term prospects are clouded by fiscal uncertainties. The recovery of tourism and continuing large donor-financed infrastructure projects should support growth. Over the medium term, the big construction projects will likely wind down. The economy faces a large down side risk stemming from the scheduled sharp decline in grant assistance from the United States after 2009, which would affect government expenditure, domestic consumption, and economic activity.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They noted that Palau's economic growth performance over the past few years has been affected by various external shocks and vulnerabilities typical for a small economy. But they noted also the economy's heavy reliance on government activity, which, in turn, is driven to a significant extent by external grants that are expected to decline from 2009. Against this background, Directors stressed that Palau needs to vigorously pursue a medium-term program of fiscal consolidation and private sector development, in order to achieve sustained economic growth and reduce the dependence on foreign assistance. They were encouraged that the authorities have a realistic and comprehensive policy agenda to achieve these objectives, and pressed for timely implementation of reforms.

Directors welcomed the improvement in Palau's fiscal situation in the last two years as a result of a reduction of non-wage current expenditure. Nevertheless, they suggested deeper fiscal adjustment to prepare for the scheduled sharp decline in grant assistance from the United States after 2009. Directors stressed that the immediate priority is to limit the budget deficit in fiscal year 2004 to available financing. Concrete measures to achieve this will include implementation of the government's cost reduction plan, especially the measures to reduce the public sector's personnel and operating costs and to cut capital outlays not funded by external assistance. Directors urged the authorities to prioritize and tighten control of expenditure commitments in order to clear domestic payment arrears and prevent their re-emergence.

For the medium term, Directors stressed the importance of prudent management of the Compact Trust Fund and the need to further strengthen the fiscal position in order to rebuild usable reserves in the run-up to 2009. In this regard, they underscored the critical importance of public sector reform to downsize the civil service and hence the wage bill. They urged the authorities to adopt the tax package proposed in 2001 to strengthen tax revenue, to embark on a comprehensive revenue reform to support fiscal consolidation, and to continue to resist tax proposals that may create loopholes in the tax system and undermine government revenue. Directors also cautioned that external borrowing, including on concessional terms, should be consistent with medium-term debt sustainability, and welcomed the authorities' intention to develop Palau's debt management capacity.

On private sector development, while recognizing the severe constraints facing Palau, Directors emphasized that every effort must be made to create the conditions for private sector-led growth, as it is vital for economic self-reliance and sustainable development and for absorbing displaced workers from the public sector. They supported the government's structural reform agenda set out in its economic development strategy and Management Action Plan, and urged timely and consistent implementation, particularly in the areas of privatization, foreign investment, land ownership, and banking.

Directors welcomed recent progress in enforcing the Financial Institutions Act and anti-money laundering legislation. They urged the authorities to adopt the amendments and regulations that are needed to further improve the legal framework for banking supervision and regulation that was adopted in 2001, and to strengthen implementation capacity. They advised the government to exercise caution in its involvement in commercial lending and risky investments.

Directors noted that with much remaining to be done in the area of structural reform, a strong public consensus in support of reform would need to be developed. They therefore welcomed the Fund staff's outreach efforts to engage in dialogue with the members of Congress, and encouraged further endeavors in the future.

Directors encouraged the authorities to take steps to improve the compilation and reporting of economic statistics. In this regard, they commended the authorities for placing the Statistics Law before the Congress, and emphasized that efforts need to be made to train and retain local professional staff.


Republic of Palau: Selected Economic and Financial Indicators, 1999/00-2003/04


 

1999/00

2000/01

2001/02

2002/03

2003/04

     

Est.

Est.

Proj.


Real Sector

         

Real GDP growth (percent change) 1/

0.3

4.5

1.1

1.5

2.0

Consumer prices (percent change, end-of-period) 2/

3.0

-1.3

0.4

0.3

0.5

Business and tourist arrivals

45,932

49,731

39,833

46,615

50,000

   

Public finance (in percent of GDP)

         

Revenue

52.6

44.3

42.1

52.7

56.4

Domestic revenue

25.0

26.5

23.6

24.1

26.4

Grants

27.6

17.8

18.4

28.7

30.0

           

Expenditure

72.8

66.7

65.8

58.6

66.3

Current

62.0

53.8

48.6

47.3

49.2

Capital

10.7

12.8

17.3

11.3

17.1

           

Overall fiscal balance (including grants)

-15.6

-20.9

-28.1

-2.3

-12.4

   

Compact Trust Fund (CTF) balance

         

(in millions of U.S. dollars)

161.8

135.0

124.5

136.6

...

Government non-CTF financial assets

         

(in millions of U.S. dollars)

77.7

43.7

13.7

16.4

...

Usable reserves (in millions of dollars) 3/

29.4

7.6

3.1

0.4

...

           

Balance of payments (in millions of U.S. dollars)

         

Exports (f.o.b.)

11.5

18.7

20.3

11.9

12.3

Imports (f.o.b.)

-127.1

-99.8

-100.7

-93.7

-108.8

Tourism receipts

53.2

58.5

47.4

57.9

62.2

Current account balance (including grants)

-35.5

-7.3

-17.1

-5.3

-22.6

(in percent of GDP)

-30.6

-5.6

-14.0

-4.3

-17.8

Overall balance

0.4

-25.1

-34.2

-3.4

-16.5

           

External public debt 4/

20.0

20.0

20.0

19.4

18.3

Debt service ratio 5/

2.2

0.9

1.0

1.8

3.0

           

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

1/ Based on limited available data.

2/ U.S. CPI is used for 1995 to 2000. Palau has compiled its own CPI since June 2000.

3/ The government's non-CTF assets excluding amounts reserved for capital projects and other specific uses.

4/ Does not include public enterprise debt not guaranteed by the government.

5/ In percent of exports of goods nonfactor services.


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.




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