Public Information Notice No. 06/26

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Republic of the Marshall Islands

March 8, 2006

On February 15, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of the Marshall Islands.¹

Background

The Republic of the Marshall Islands (RMI), a small Pacific island country, is heavily dependent on external assistance. Government expenditure accounts for more than 70 percent of GDP, and about 50 percent of government revenue consists of external grants, mainly from the United States. Consequently, overall economic activity is highly correlated with government expenditure and external grant flows. The private economy remains underdeveloped, primarily providing services to the government, with small contributions from agriculture, fishery, and tourism.

After nearly a decade of growth following independence in 1986, economic activity declined markedly in the mid-1990s. Real GDP per capita is estimated to have fallen around 30 percent since FY1994. This was a result of declining grant flows and the need to retire external public debt incurred through external commercial borrowing by the government against future Compact revenues. The weak economy reportedly fostered emigration to the United States, as citizens need only a valid passport to work there, and forced large expenditure cuts in part through the implementation of the Asian Development Bank Public Sector Reform Program. Following a period of fiscal consolidation in the late 1990s, economic growth picked up. Over the past five years, however, the reduction in civil service employment has been reversed. Also, Public debt and government loan guarantees, while currently manageable, are approaching their 1990s levels when loan repayments exerted strain on revenues.

The amended Compact agreement extends U.S. financial support until 2023 with grants declining steadily. The new agreement reflects a major change from the way past funding has been delivered, mainly through the establishment of a trust fund, grants more focused on key sectors, and enhanced accountability and monitoring. It also includes provisions for the United States to retain access to Kwajalein Atoll, where there is a large U.S. military base.

Based on limited data, real output growth appears to have slowed sharply in FY2003 and again in FY2004. Economic activity has been hampered by delays in implementing an upgraded public works program and the closure of a large privately owned tuna processing plant because of financial difficulties, leading to an estimated loss of 500 jobs. Civil service employment appears to have increased, primarily as a result of increased spending on education and health in line with the amended Compact agreement. Nevertheless, overall growth in employment continues to fall short of labor supply, and unemployment, especially for school-leavers, has increased above 30 percent. Real growth is expected to have picked up in 2005, reflecting an expansionary fiscal stance and, to a lesser extent, improvements in agriculture.

The current account surplus narrowed in FY2004, largely reflecting delays in official transfers. The trade balance improved slightly as export growth continued at trend, driven mainly by increases in the re-export of diesel fuel associated with the fishing transshipment base in Majuro, while imports were moderately lower reflecting lower spending on capital project-related imports. In FY2005, the current account surplus is estimated to have narrowed further, in part as a result of higher imports relating to capital projects and the closure of the tuna processing plant. There are no reliable statistics on remittances; however staff estimate the net outflow to be large, owing to the Kwajalein landowners investing their rental receipts abroad.

The fiscal position deteriorated in FY2004. This deterioration reflects, on the revenue side, a decline in grants aimed at infrastructure projects owing in part to delays in initiating projects, lower income tax collection, and volatility in non-tax revenue. At the same time, total expenditure increased with some shift in its composition from capital to current expenditure. Spending on wages and goods and services continued to rise contributing to the worsening of the fiscal position, and has reached 22½ percent of GDP in FY2004, up from 15½ percent of GDP in FY2000. The rise in wages and salaries stemmed from increases in the number of civil servants and the harmonization of wage levels in the Ministry of Education. Over the two years FY2003-04, the government met its mandatory contributions to the Compact Trust Fund, amounting to US$25 million. In FY2005, the government's overall deficit is estimated at 2 percent of GDP, mainly stemming from an underperformance of revenue collection.

Executive Board Assessment

Executive Directors welcomed the steps taken by the authorities to move the Marshall Islands toward lasting growth, including steps to improve fiscal sustainability through the retirement of high-cost commercial debt, and by building reserves to meet its mandatory contribution requirement to the Compact Trust Fund. While commending progress made in strengthening the government's institutional capacity, Directors underscored that, given the anticipated declines in Compact grants and prospective increases in debt-service payments, further fiscal and structural reforms are needed to advance to economic self-reliance.

With growth projected to pick up in the near term, it was emphasized that actions to achieve a larger fiscal surplus than budgeted in FY2006, consistent with medium-term fiscal sustainability, should be given priority. Directors stressed the importance of restraining current expenditures, especially on wages, and goods and services not linked to specific Compact funds, and further measures to enhance the revenue base. Some Directors, while recognizing the magnitude of the medium-term fiscal challenge, considered that an abrupt fiscal contraction could weigh on economic growth, and proposed that, with the support of the Fund's staff, the authorities could develop a program for the medium term that would avoid high upfront impact on employment.

Directors underscored the need to maintain substantial fiscal surpluses over the medium term in order to ensure fiscal sustainability and to avoid the further accumulation of external debt. In this regard, most Directors welcomed the tax measures proposed in the FY2006 budget speech, and observed that additionally broadening the tax base and simplifying the tax structure will be needed to revive revenue growth. On the expenditure side, while calling on the authorities to reduce outlays, Directors stressed the importance of protecting core expenditure.

Directors underlined the need to improve fiscal management and governance. They encouraged the authorities to strengthen the budgetary process by linking the current year budget to the medium-term framework. In addition, Directors called on the authorities to decisively improve governance and administration by implementing a new customs management system and managing the Compact Trust Fund in line with international best practices. They urged the authorities to avoid nontransparent quasi-fiscal operations.

Directors observed that the exchange regime, with the U.S. dollar as the sole legal tender, has imparted monetary stability, with domestic inflation largely mirroring that of the United States. Directors commended the authorities' commitment to an open trade regime, and welcomed the prospective participation of the Marshall Islands in regional trade arrangements.

Looking ahead, Directors underscored the critical importance of structural reforms to promote lasting private sector-led growth. In this regard, they noted that further efforts are needed to expand participation in land registration and to clarify the legal framework for secured lending, in order to help lower intermediation costs and facilitate the reorientation of commercial bank lending activities toward the private commercial sector. In addition, Directors encouraged steps to foster greater wage differentiation across skill levels, especially in the public sector.

Directors urged the authorities to step up efforts to address current constraints on bank lending, allowing the banking system to play a full role in the development of the economy. In this connection, they encouraged the Banking Commission to address the consequences of the loss of the correspondent banking relationship for one of the major banks, which currently inhibits the processing of foreign transactions and could dampen future bank lending.

Directors called for further efforts to strengthen financial supervision. They welcomed recent progress made by the Banking Commission in on-site and off-site bank examination, while noting that additional steps are needed to improve data and information collection, including loan quality and remittances. Directors called for the development bank to be placed under the supervision of the Banking Commission, with tighter controls and with activities limited to those traditional for a development bank. Directors urged further strengthening of the AML/CFT regime, including through tighter controls and reporting requirements for the shipping trust company.

Directors encouraged the authorities to improve the reliability, coverage, and timeliness of statistics to enhance monitoring and policy evaluation. They supported the authorities' request for additional technical assistance.

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.