IMF Executive Board Concludes 2008 Article IV Consultation with Republic of Palau

Public Information Notice (PIN) No. 08/54
May 16, 2008

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. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2008 Article IV Consultation with the Republic of Croatia is also available.

On April 30, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Republic of Palau.1

Background

Over the past two years, economic activity in Palau has slowed, as the winding down of two major infrastructure projects, slowing private sector investment and weakening consumer demand have all led growth lower. However, inflation remains moderate—albeit somewhat higher than that of the United States, whose currency Palau uses as legal tender—with upticks owing to the impact of rising fuel costs on transportation.

Fiscal performance has weakened, with deteriorating revenue performance undermining the authorities' expenditure cutting efforts. The current deficit deteriorated by some 4 percentage points of GDP since FY2005 (October-September), and led to a breach of the budget target in FY2007. External debt is low, standing at 14 percent of GDP. Despite returns on the Compact Trust Fund that are in line with its benchmark, deficit financing has led the government's net financial assets to stagnate at about the level of GDP.

Deposits have partly recovered following the failure of Pacific Savings Bank in late 2006. However, credit growth has virtually halted as banks have become more cautious in extending credit, and credit quality is low as households are already highly leveraged.

In February 2008 the long delayed amendments to the Financial Institutions Act (FIA) were signed into law, paving the way for more effective bank supervision. These amendments allow the Financial Institutions Commission (FIC) to issue prudential regulations without legislative approval; require all banks to have an annual audit; and grant the FIC's staff legal immunity in carrying out official acts. They also empower the FIC to examine for anti-money laundering (AML) issues. Amendments strengthening the AML legislation were put in place in late December.

The near-term outlook is broadly favorable, with risks tilted to the downside. Growth is projected to moderate further to about 2 percent as prospects for large private investment projects continue to be clouded by uncertainties surrounding the expiry of Compact grants in late 2009. Downside risks include higher oil prices and the global economic slowdown which may affect tourism. On the upside, a possible expansion of scheduled flights could lead to increased arrivals of high-end tourists.

Executive Board Assessment

Executive Directors welcomed the authorities' disciplined policies over the past two years, and commended the recent strengthening of financial sector legislation and the continued prudent management of foreign grants, which has preserved the effectiveness of these funds and contributed to an improved quality of life. However, they expressed concern about the impending challenges facing the economy, and encouraged the authorities to build a strong consensus in favor of ambitious fiscal consolidation and an improvement in the business environment to spur private sector led growth.

Directors stressed that sustainability depended critically on fiscal consolidation. They observed that a sizable fiscal adjustment would be required even if Compact grants—which are scheduled for cessation in 2009—are renewed. Directors cautioned against postponing consolidation, as this would only serve to increase future adjustment and raise the likelihood of depleting the trust fund. They encouraged the authorities to implement a front-loaded adjustment followed by a medium term pace of consolidation aimed at safeguarding the trust fund.

Directors applauded the authorities' strong efforts to reduce expenditure, and encouraged them to build on their progress on expenditure compression, especially in light of new spending pressures related to the maintenance of the Compact road and the new capital. At the same time, Directors regretted that these efforts had been undermined by revenue weakness. They called for continued strengthening of tax administration, including the removal of exemptions, stressing the need to increase revenue generation. Over the medium term, the authorities should consider a comprehensive overhaul of the tax system, including measures aimed at decreasing distortions and improving efficiency. Commercialization and eventual privatization of public utilities should also be considered to strengthen public finances.

Directors underscored that establishing a foundation for private sector led growth was key to achieving self-reliance. They noted that high value added tourism and export diversification could help sustain growth and living standards. Directors welcomed efforts that have been made in land titling, but noted that a lack of consensus on the role of foreign investment and labor exacerbate investor uncertainty. Regardless of the foreign investment model ultimately adopted, Directors underscored that policies will need to be underpinned by a strong legal framework that facilitates contract enforcement and secures property rights.

Directors commended recent actions by the bank supervisory authority and passage of financial sector legislation, which demonstrated the authorities' commitment to a well regulated financial sector. Prompt issuance of implementing regulations will be key to improving supervision and enforcement. Directors supported the authorities' continued efforts at capacity building, including through additional technical assistance, but emphasized the need for adequate funding. Implementing industry charges, as provided under the law, would also serve to strengthen autonomy by decreasing the risk of legislative underfunding.

Directors supported the continued use of the U.S. dollar as legal tender and the maintenance of an open trade regime. They noted that, over the near term, external stability did not appear to be at risk given current levels of net financial assets, but going forward fiscal consolidation would be required to preserve competitiveness.

Directors encouraged the authorities to improve the coverage, reliability, and timeliness of key economic statistics, through designating adequate human and financial resources while stepping up capacity building efforts through technical assistance.


Table 1. Republic of Palau: Selected Economic Indicators, 2001/02-2007/08 1/
 
  2001/02 2002/03 2003/04 2004/05 2005/06 2006/07 2007/08
            Est. Proj.
 

Real sector

             

Real GDP growth (percent change)

-3.5 -1.3 4.9 5.5 3.0 2.5 2.0

Consumer prices (percent change; period ave.)

-1.2 -0.6 5.8 3.2 4.8 3.0 4.2

Business and Tourist arrivals

48,157 60,734 83,452 85,004 79,720 87,142 88,885
  (In percent of GDP)

Public finance

             

Cenral government

             

Revenue

43.1 42.4 54.0 54.3 53.6 61.3 61.3
  • Domestic revenue

25.7 23.8 26.0 26.8 27.6 26.7 26.7
  • Grants

17.3 18.6 28.1 27.6 26.0 34.5 34.5

Expenditures

64.6 66.3 62.6 61.7 54.2 61.7 61.7
  • Current

52.2 48.9 50.0 46.4 45.1 42.9 42.9
  • Capital

12.4 17.4 12.6 15.3 9.1 18.8 18.8

Current balance 2/

-26.4 -25.1 -24.0 -19.7 -18.9 -16.2 -16.2

Overall balance (excluding grants) 3/

-20.3 -28.3 -2.4 -6.9 -3.9 -0.4 -0.4

Overall balance (including grants) 3/

             
  (In millions of U.S. dollars; unless otherwise indicated)

Compact Trust Fund (CTF) balance

124.5 136.3 141.6 152.5 157.0 174.0 174.0

Interest income and capital gains/losses

-4.7 19.5 11.3 16.8 10.4 23.0 23.0

Interest fees and withdrawals

5.8 7.7 6.0 5.9 5.9 6.0 6.0

Government non-CTF financial assets

13.7 16.4 9.5 9.8 11.8 9.9 ...

Balance of payments

             

Trade balance

-76.4 -79.8 -101.4 -91.8 -101.7 -81.2 ...

Exports (f.o.b.)

20.3 8.4 5.9 13.4 13.6 10.1 ...

Imports (f.o.b.)

-96.7 -88.2 -107.3 -105.2 -115.3 -91.3 ...

Tourism receipts

57.4 75.6 96.9 97.2 92.9 99.4 ...

Current account balance

             
  • Including grants

-21.2 -6.0 -6.8 -4.7 -20.8 9.8 ...

Excluding grants

-41.8 -27.0 -30.2 -25.4 -42.5 -13.6 ...

Overall balance

-34.0 -4.9 -8.6 -4.8 -5.3 -5.3 ...

External public debt 4/

20.0 19.4 20.3 18.6 17.5 22.9 21.5

Debt service ratio 5/

0.9 1.5 1.8 2.1 1.7 1.6 ...
  (In percent of GDP)

Current account balance

             

Including grants

-17.6 -4.9 -5.2 -3.3 -13.5 6.0 ...

Excluding grants

-34.6 -22.1 -23.1 -17.8 -27.6 -8.4 ...
               

External public debt 4/

16.6 15.9 15.5 13.1 11.4 14.1 12.5
 

Sources: Data provided by the Palauan authorities; and Fund staff estimates.
1/ Fiscal year ending September 30.
2/ Defined as domestic revenue minus current expenditure.
3/ Including errors and omissions.
4/ Does not include public enterprisse debt which is not guaranteed by the government.
5/ In percent of exports of goods and 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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