## cr17280

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### Recent developments and short-term outlook
- Real GDP expanded by 3.7 percent in FY2015 and an estimated 3.0 percent in FY2016, driven by increased fishing and construction activity.
- Growth is expected to moderate to 2 percent in FY2017, supported by continued recovery in the construction sector.
- Consumer prices: broadly zero during FY2015–16; expected to converge back to the U.S. inflation rate of 2 percent with the resumption of Compact-funded infrastructure spending.
- Employment: FY2016 employment rose by 2.4 percent.
- Nominal GDP (FY2016): US$323 million.
- GDP per capita (FY2016): US$3,157.
- Population (FY2016): 102,249.

### Fiscal developments and trust funds
- Fiscal balance: recorded an estimated surplus of 9 percent of GDP in FY2016.
- Consolidated government finance (selected ratios, percent of GDP):
  - Revenue and grants: 70.2 (FY2016), projected 68.9 (FY2017), then 68.4 (FY2018).
  - Revenue: 36.9 (FY2016), 36.2 (FY2017).
  - Tax revenue: 13.2 (FY2016), 13.3 (FY2017).
  - Fishing license fees: 19.6 (FY2016), 19.0 (FY2017).
  - Grants: 33.3 (FY2016), 32.7 (FY2017).
  - Expenditure: 61.2 (FY2016), 60.2 (FY2017).
  - Current expenditure: 49.0 (FY2016), 47.8 (FY2017).
  - Capital expenditure: 12.1 (FY2016), 12.5 (FY2017).
  - Overall balance: 9.0 (FY2016), projected 8.7 (FY2017).
  - Overall balance (excl. grants): -24.3 (FY2016), projected -24.0 (FY2017).
- Fishing license fees increased from 6 percent of GDP in FY2010 to about 20 percent of GDP (on average) during FY2015–17; fishing license fee receipts in FY2015–16 estimated in the range of US$60–65 million.
- Balance of trust funds (CTF and FSMTF): 126.8 (FY2014), 145.5 (FY2015), 170.0 (FY2016), 188.5 (FY2017), with projections rising through FY2022 (e.g., 294.4 in FY2022).
- External debt outstanding stock (end period, US$ millions): 81.6 (FY2016), 80.1 (FY2017); in percent of GDP: 25.3 (FY2016), 24.3 (FY2017).

### Medium-term outlook, Compact transition, and risks
- Major medium-term challenge: scheduled expiration of U.S. Compact grants after FY2023 (Compact grants averaged US$80 million annually over FY2004–23).
- Projected combined balance of the two trust funds: $1.2 billion in FY2023; projected investment earnings will not be sufficient to replace expiring Compact grants nor preserve the real value of the trust funds.
- Without fiscal reforms, the fiscal surplus is expected to turn into a deficit beyond 2023; under the baseline the fiscal balance is projected to turn into a deficit of 4 percent of GDP in FY2024.
- Key downside risks:
  - Possible extreme weather events resulting from climate change.
  - Delays in infrastructure projects.
  - Declining external grants.
  - Uncertainties surrounding the global economy could pose risks to trust fund returns.
- Upside potential: a decisive push for structural reforms could boost potential growth.

### Executive Board and staff policy recommendations
- Fiscal consolidation and buffers:
  - A gradual medium-term fiscal adjustment of 4 percent of GDP ahead of FY2024 is needed to build adequate buffers.
  - Measures to achieve adjustment: domestic revenue mobilization, expenditure reforms, and higher trust fund savings.
  - Authorities urged to work toward implementing the adjustment efforts envisioned in the 2023 Action Plan.
  - Further increase budget contributions to trust funds.
  - Accelerate public financial management reforms to support fiscal adjustment and address weaknesses in budget planning and execution.
- Climate and disaster resilience:
  - Continue efforts to adapt to climate change, including explicit recognition of fiscal costs in the budget.
  - Develop contingent financing plans for natural disasters from diverse sources.
  - Build resilience through explicit budget provisions for adaptation costs.
- Structural and private sector reforms:
  - Reduce transportation costs, strengthen regulatory frameworks, and improve access to finance to facilitate private sector development.
  - Streamline the investment application process to attract foreign direct investment.
- Financial sector and inclusion:
  - Promote safe financial inclusion and ensure the financial system supports growth.
  - Extend the oversight authority of the Banking Board to credit unions.
  - Facilitate more secured lending by developing the long-term lease market and the online secured transactions registry.
  - Continue to raise financial literacy and address skills gaps.
- Data and statistics:
  - Further improvements in the compilation of national accounts and external sector statistics to support economic analysis and policymaking.
- Specific operational notes:
  - Public investment set to increase gradually with the Infrastructure Development Plan (IDP for FY2016–25).
  - Fishing revenues projected to stabilize in nominal terms given Vessel Day Scheme (VDS) dynamics.

### Key quantitative projections and indicators (selected)
- Real GDP growth (annual percent change): -1.7 (FY2012), -3.0 (FY2013), -2.4 (FY2014), 3.7 (FY2015), 3.0 (FY2016), 2.0 (FY2017), 1.4 (FY2018), 0.9 (FY2019), 0.7 (FY2020), 0.7 (FY2021), 0.6 (FY2022).
- Consumer prices (annual percent change): 6.3 (FY2012), 2.2 (FY2013), 0.7 (FY2014), -0.2 (FY2015), 0.5 (FY2016), 0.9 (FY2017), 2.0 (FY2018–FY2022 projected).
- Current account (in percent of GDP): -13.4 (FY2012), -10.1 (FY2013), 1.2 (FY2014), 4.2 (FY2015), 3.2 (FY2016), 3.4 (FY2017), ~3.0 (FY2018–FY2020 range).
- Trade balance (millions of U.S. dollars): -125.4 (FY2012), -128.8 (FY2013), -117.5 (FY2014), -127.9 (FY2015), -142.8 (FY2016), -141.6 (FY2017).
- Private and official transfers (millions of U.S. dollars): 109.1 (FY2012), 108.6 (FY2013), 129.1 (FY2014), 111.6 (FY2015), 119.4 (FY2016), 119.3 (FY2017).
- Commercial banks (loans as percent of GDP, end period): 11.6 (FY2012), 11.0 (FY2013), 11.7 (FY2014), 13.2 (FY2015), 15.1 (FY2016), 15.5 (FY2017).
- Commercial banks (deposits as percent of GDP, end period): 62.6 (FY2013), 67.4 (FY2014), 74.6 (FY2015), 80.3 (FY2016), 80.0 (FY2017), 82.0 (FY2018 projected).

### Current account, trade, and banking system
- The current account improved from a deficit of 10.1 percent of GDP in FY2013 to a surplus of 3.2 percent of GDP in FY2016, as the large trade deficit was offset by official transfers and fishing license fees.
- Banking system capitalization (Tier 1 capital) is 25 percent of risk-weighted assets.
- Private sector credit has remained stagnant at around 20 percent of GDP in recent years.
- Loan-to-deposit ratio of the banking system is around 20 percent (loan/deposit ratio FY2016: 18.9 percent).
- Corporate loans represent one-quarter of bank loans.
- Posting property as collateral is hindered by complex land ownership issues.
- Interest rate spreads between lending and deposit rates are high, keeping banks profitable (around 7 percent for corporate loans and 15 percent for consumer loans).

### Debt sustainability and DSA findings
- The DSA indicates the FSM remains at a high risk of debt distress under the baseline scenario without major fiscal or structural reforms.
- Under baseline:
  - PV of external debt-to-GDP ratio expected to exceed the threshold of 30 percent in FY2035.
  - PV of external debt-to-exports ratio expected to exceed the threshold of 100 percent in FY2034.
- Public debt trajectory:
  - PV of public debt-to-GDP ratio projected to increase from 21 percent of GDP in FY2016 to 35 percent of GDP in FY2037 (remains below benchmark of 38 percent).
- Stress tests and sensitivities:
  - Vulnerability concentrated on natural disaster shocks modelled via the standard contingent liability shock scenario; contingent liability shock would cause thresholds to be breached earlier (e.g., PV of external debt-to-GDP would exceed the threshold in FY2032 under the shock).
  - A 0.5 percentage point decline in long-term returns, compared to the baseline, would raise the deficit by 2 percentage points of GDP.
- Mitigating factors:
  - Most external debt is concessional with long maturities; debt service ratios are low.
  - Income flows from Compact grants are stable until FY2023 and trust funds are being accumulated.

### Policies for building resilience and growth — priority areas and fiscal strategy
- Four macro-critical and high priority areas: (i) securing fiscal and external sustainability, (ii) adapting to climate change, (iii) facilitating private sector growth, and (iv) promoting safe financial inclusion.
- Securing fiscal sustainability:
  - A gradual medium-term fiscal adjustment of 4 percent of GDP is needed.
  - A cumulative fiscal adjustment of US$15 million (4 percentage points of GDP) over the next six years would be needed to finance the shortfall and preserve the projected value of trust funds in real terms.
  - Adjustment package (examples):
    - Revenue mobilization (2 percent of GDP): implement Compliance Improvement Strategy; strengthen on-time filing and payment; management of tax arrears and outstanding returns; consider reforming the personal income tax; introducing a net profits and value-added tax; replacing import duties on alcohol, tobacco, motor vehicles and fuels with excise taxes.
    - Expenditure reforms (1 percent of GDP): rationalize current expenditures, including efficiency gains in health and education (a 4 percent reduction in health and education spending could generate 1 percent of GDP).
    - Increased Trust Fund contributions (1 percent of GDP): raise annual budget contributions to the FSM Trust Fund by US$10 million (3 percent of GDP) from existing fiscal surpluses; saving surpluses in trust funds could generate additional investment income of 1 percent of GDP after FY2023.
- Timely action emphasized to avoid delays that could worsen growth outcomes; additional adjustment would help build buffers against fishing revenue volatility and climate change costs.
- Example sensitivity: a 10 percent change in fishing license fees set by the PNA would swing the fiscal balance by 2 percentage points of GDP.

### Adapting to climate change and disaster resilience
- FSM vulnerability: adaptation costs could be around 1–3 percent of GDP every year and are built into the fiscal baseline.
- Contingent costs: could be around 10 percent of GDP every 20 years (losses and damages), to be recognized as a fiscal risk and included in public debt management considerations.
- Recommended actions:
  - Explicit recognition of adaptation and contingent fiscal costs in the budget.
  - Prioritization of climate-related spending in the Infrastructure Development Plan and finalization of Joint State Action Plans (JSAPs) for all states.
  - Develop diverse sources for contingent financing for natural disasters; consider participation in the Pacific Catastrophe Risk Insurance (PCRAFI) Facility.
- Box highlights:
  - Typhoon Maysak (March 2015): 5 deaths; FEMA/USAID provided US$13 million (4 percent of GDP) in relief and recovery assistance; national government allocated US$6.4 million (2 percent of GDP) for relief.
  - FSM Infrastructure Development Plan (IDP) includes US$31 million of climate adaptation public investment over ten years.
  - Contingent cost estimate: 10 percent of GDP every 20 years (PCRAFI, 2011) — incorporated in the DSA as a contingent liability shock.

### Private sector development and constraints
- Public sector absorbs about half of total employment and remains the main source of economic activity.
- Over the past two decades the economy has stagnated: FY2015 real GDP is about the same level as in FY1995; private sector output is lower by more than 25 percent relative to two decades earlier.
- Main constraints:
  - High transportation costs due to smallness and remoteness.
  - Regulatory burdens from complex decision-making processes across a loose political federation and geographically dispersed states.
  - Limited access to finance, including land tenure and property right issues that hinder use of land as collateral.
- Recommended reforms:
  - Enact the amended Foreign Direct Investment (FDI) Act and establish a national Investment Promotion Agency.
  - Invest to upgrade ports and port services and build new transit routes.
  - Advance renewable energy investments to reduce energy costs.
  - Promote sustainable tourism (Nan Madol World Heritage Site designation in 2016) and create links with target markets in Asia.
  - Improve access to finance via secured transactions, long-term land leases, and support to SMEs.

### Financial inclusion, credit, and credit unions
- Financial sector features:
  - Banking system co-supervised by the Banking Board and the FDIC.
  - Tier 1 capital 25 percent of risk-weighted assets; regulatory capital to risk-weighted assets FY2016: 24.4.
  - Interest rate spreads: around 7 percent for corporate loans and 15 percent for consumer loans.
  - Loan-to-deposit ratio around 20 percent (loan/deposit ratio FY2016: 18.9).
  - Deposit accounts: only about half of the population has deposit accounts; number of deposit accounts dropped after a US$100 minimum balance requirement.
- Credit unions:
  - Currently small, with assets less than 1 percent of GDP.
  - Recommendation: enact the draft Credit Union Act to bring credit unions under Banking Board oversight.
- Measures to facilitate lending:
  - Promote contracting of secure long-term land leases to generate collateral.
  - Expand use of the online secured transactions registry (Secured Transactions Act of 2006).
  - Strengthen small business development training and FSM Development Bank’s DFI.
  - Address skills gaps in business plan and financial statement preparation; enable outsourcing of bookkeeping/accounting via ICT.
  - FSM Development Bank should refocus lending to SMEs while remaining profitable and independent without interest rate caps or budget transfers.

### Data, statistics, and technical assistance
- Data issues:
  - Coverage of key macroeconomic data broadly sufficient (except external sector statistics), but not compiled in a timely manner.
  - GDP estimates not rebased for more than 10 years (current base year FY2004); authorities plan a business survey to help with rebasing.
  - CPI rebasing in progress (expected in 2018).
  - External sector statistics have persistent large errors and omissions.
- Recent actions:
  - FSM implemented the enhanced General Data Dissemination System (e-GDDS); National Summary Data Page launched in July 2017.
  - PFTAC support focused on PFM, revenue reforms, government finance statistics, national accounts, and financial supervision training.
  - PFTAC TA planned for FY2018 to marginally increase from FY2017; support includes PEFA roadmap implementation and tax compliance measures.

### Trust funds specifics and governance
- Compact Trust Fund (CTF):
  - Objective: provide ongoing revenue after Compact grants (about US$80 million, 20 percent of GDP) expire after FY2023.
  - Value as of end-FY2016: US$467 million.
  - CTF investment strategy at review: 51 percent equities, 19 percent fixed income, 30 percent alternative investments.
  - CTF compound average annual return between FY06 and FY16: 5.4 percent, net of fees.
  - C account held US$94 million as of end-FY2016.
  - Independent external evaluation (FY2015) recommended a more conservative portfolio and a glide path toward that goal.
- FSM Trust Fund (FSMTF):
  - Value as of end-FY2016: US$82 million.
  - Contributions since FY2004 to end-FY2016: US$68 million (US$66 million from FSM government; US$2 million from China).
  - Fund performance between FY2010 and FY2016: average compound annual return 5.9 percent.
  - Amendments in FY2016 specify no withdrawals before FY2024; from FY2024 the Board determines maximum distributable investment income.
  - Staff encourages an external review of FSMTF, preparation for drawdown phase, and appointment of a Board for FSMTF; consider adopting the Santiago Principles.
- Audit findings (2015 audit of FSMTF by National Public Auditor):
  - Shortcomings: lack of a Board of Trustees; lack of annual reports and audits; instances of improper maintenance of the books of accounts; a transfer from the budget to the fund without an allotment, as required by law.
  - Authorities’ response: broad agreement with findings and established a procedure to ensure all budget transfers have an allotment.

### Key baseline macro assumptions and sensitivity
- Baseline macro assumptions:
  - Long-run real GDP growth rate: 0.6 percent.
  - Long-run growth adjusted down by 0.5 percentage points from a non-disaster potential growth rate of 1.1 percent.
  - GDP deflator: expected to remain 1 percentage points below CPI inflation.
  - CPI inflation: projected to follow the U.S. rate of inflation.
  - Tax-to-GDP ratio: assumed to remain unchanged in baseline.
  - Fishing license fees: assumed to remain stable in nominal terms (noted range US$60-65 million over FY2015-17).
  - Compact Trust Fund and FSM Trust Fund: projected average nominal return of 5 percent in staff baseline assumptions; combined assets projected to reach US$1.2 billion at end-FY2023.
- Drawdown policy and fiscal effects:
  - Drawdowns from trust funds for FY2024 and beyond assumed at 3 percent of fund balances to maintain their value in real terms, with a 2 percent inflation adjustment.
  - This would generate US$35 million of revenues in FY2024; shortfall relative to expiring Compact grants (US$80 million): US$45 million.
  - Fiscal position change: projected surplus of about US$30 million in FY2023; estimated deficit of US$15 million (4 percent of GDP) in FY2024.
- Sensitivity:
  - A 0.5 percentage point decline in long-term returns would raise the deficit by 2 percentage points of GDP.
  - The CTF’s C Account buffer could mitigate shortfalls for several years but not permanently.

### External sector assessment and buffers
- External sector position:
  - Current account balance improved from -10.1 percent of GDP (FY2013) to 3.2 percent of GDP (FY2016).
  - External position assessed as weaker than fundamentals and desirable policies given structural break in FY2024; current account norm (including official transfers): 2.3 percent of GDP; underlying current account at end-FY2016: deficit of 1 percent of GDP; current account gap: -3.3 percent of GDP.
- Reserves and fiscal liquidity:
  - No central bank or foreign exchange reserves; government deposits serve to absorb short-term liquidity shocks.
  - Central government deposits around 20 percent of GDP in 2016, corresponding to 4 months of imports and 5 months of general government current spending.
- External financing:
  - Under baseline without major reforms, concessional external loans from FY2024 onward would be needed to safeguard priority development spending, potentially leading to breaches of some DSA thresholds.
  - Use of the U.S. dollar as official currency considered appropriate.

### Appendix and operational notes
- Public investment: IDP for FY2016–25 includes public projects at ~1 percent of GDP per year; IDP includes US$31 million of climate adaptation public investment over ten years.
- Social security fund reserves: US$50 million (16 percent of GDP) as of end-2016; fund runs a small deficit of around 0.5 percent of GDP financed by US$1 million annual budget transfers; staff recommends eliminating the deficit and budget transfer.
- PFTAC and AsDB support:
  - AsDB: Pacific Approach 2016–20 supports developing key growth drivers, providing efficient and sustainable infrastructure, and establishing better public sector management; Yap Renewable Energy Development project US$9 million approved 2013.
  - PFTAC: TA focused on PFM, tax administration, government finance statistics, national accounts, financial supervision, and training; FSM implemented e-GDDS in July 2017.

*Source: Federated States of Micronesia—Staff Report for the 2017 Article IV Consultation (IMF, cr17280).*

### 3.0 percent in 2016 (after 3.7 percent in 2015), driven by increased construction activity related to

### cr17280 - 3.0 percent in 2016 (after 3.7 percent in 2015), driven by increased construction activity related to

### Recent developments and short-term outlook
- Real GDP expanded by 3.7 percent in FY2015 and an estimated 3.0 percent in FY2016, driven by increased fishing and construction activity.
- Growth is expected to moderate to 2 percent in FY2017, supported by continued recovery in the construction sector.
- Consumer prices: broadly zero during FY2015–16; expected to converge back to the U.S. inflation rate of 2 percent with the resumption of Compact-funded infrastructure spending.
- Employment: FY2016 employment rose by 2.4 percent (Table 1 series).
- Nominal GDP (FY2016): US$323 million.
- GDP per capita (FY2016): US$3,157.
- Population (FY2016): 102,249.

### Fiscal developments and trust funds
- Fiscal balance: recorded an estimated surplus of 9 percent of GDP in FY2016.
- Consolidated government finance (selected ratios, percent of GDP):
  - Revenue and grants: 70.2 (FY2016), projected 68.9 (FY2017), then 68.4 (FY2018).
  - Revenue: 36.9 (FY2016), 36.2 (FY2017).
  - Tax revenue: 13.2 (FY2016), 13.3 (FY2017).
  - Fishing license fees: 19.6 (FY2016), 19.0 (FY2017).
  - Grants: 33.3 (FY2016), 32.7 (FY2017).
  - Expenditure: 61.2 (FY2016), 60.2 (FY2017).
  - Current expenditure: 49.0 (FY2016), 47.8 (FY2017).
  - Capital expenditure: 12.1 (FY2016), 12.5 (FY2017).
  - Overall balance: 9.0 (FY2016), projected 8.7 (FY2017).
  - Overall balance (excl. grants): -24.3 (FY2016), projected -24.0 (FY2017).
- Fishing license fees increased from 6 percent of GDP in FY2010 to about 20 percent of GDP (on average) during FY2015–17; fishing license fee receipts in FY2015–16 estimated in the range of US$60–65 million.
- Balance of trust funds (CTF and FSMTF): 126.8 (FY2014), 145.5 (FY2015), 170.0 (FY2016), 188.5 (FY2017), with projections rising through FY2022 (e.g., 294.4 in FY2022).
- External debt outstanding stock (end period, US$ millions): 81.6 (FY2016), 80.1 (FY2017); in percent of GDP: 25.3 (FY2016), 24.3 (FY2017).

### Medium-term outlook and risks
- Major medium-term challenge: scheduled expiration of U.S. Compact grants after FY2023 (Compact grants averaged US$80 million annually over FY2004–23).
- Projected combined balance of the two trust funds: $1.2 billion in FY2023; projected investment earnings will not be sufficient to replace expiring Compact grants nor preserve the real value of the trust funds.
- Without fiscal reforms, the fiscal surplus is expected to turn into a deficit beyond 2023.
- Key downside risks:
  - Possible extreme weather events resulting from climate change.
  - Delays in infrastructure projects.
  - Declining external grants.
  - Uncertainties surrounding the global economy could pose risks to trust fund returns.
- Upside potential: a decisive push for structural reforms could boost potential growth.

### Executive Board and staff policy recommendations
- Fiscal consolidation and buffers:
  - A gradual medium-term fiscal adjustment of 4 percent of GDP ahead of FY2024 is needed to build adequate buffers.
  - Measures to achieve adjustment: domestic revenue mobilization, expenditure reforms, and higher trust fund savings.
  - Authorities urged to work toward implementing the adjustment efforts envisioned in the 2023 Action Plan.
  - Further increase budget contributions to trust funds.
  - Accelerate public financial management reforms to support fiscal adjustment and address weaknesses in budget planning and execution.
- Climate and disaster resilience:
  - Continue efforts to adapt to climate change, including explicit recognition of fiscal costs in the budget.
  - Develop contingent financing plans for natural disasters from diverse sources.
  - Build resilience through explicit budget provisions for adaptation costs.
- Structural and private sector reforms:
  - Reduce transportation costs, strengthen regulatory frameworks, and improve access to finance to facilitate private sector development.
  - Streamline the investment application process to attract foreign direct investment.
- Financial sector and inclusion:
  - Promote safe financial inclusion and ensure the financial system supports growth.
  - Extend the oversight authority of the Banking Board to credit unions.
  - Facilitate more secured lending by developing the long-term lease market and the online secured transactions registry.
  - Continue to raise financial literacy and address skills gaps.
- Data and statistics:
  - Further improvements in the compilation of national accounts and external sector statistics to support economic analysis and policymaking.
- Specific operational notes:
  - Public investment set to increase gradually with the Infrastructure Development Plan (IDP for FY2016–25).
  - Fishing revenues projected to stabilize in nominal terms given Vessel Day Scheme (VDS) dynamics.

### Key quantitative projections and indicators (selected)
- Real GDP growth (annual percent change): -1.7 (FY2012), -3.0 (FY2013), -2.4 (FY2014), 3.7 (FY2015), 3.0 (FY2016), 2.0 (FY2017), 1.4 (FY2018), 0.9 (FY2019), 0.7 (FY2020), 0.7 (FY2021), 0.6 (FY2022).
- Consumer prices (annual percent change): 6.3 (FY2012), 2.2 (FY2013), 0.7 (FY2014), -0.2 (FY2015), 0.5 (FY2016), 0.9 (FY2017), 2.0 (FY2018–FY2022 projected).
- Current account (in percent of GDP): -13.4 (FY2012), -10.1 (FY2013), 1.2 (FY2014), 4.2 (FY2015), 3.2 (FY2016), 3.4 (FY2017), ~3.0 (FY2018–FY2020 range).
- Trade balance (millions of U.S. dollars): -125.4 (FY2012), -128.8 (FY2013), -117.5 (FY2014), -127.9 (FY2015), -142.8 (FY2016), -141.6 (FY2017).
- Private and official transfers (millions of U.S. dollars): 109.1 (FY2012), 108.6 (FY2013), 129.1 (FY2014), 111.6 (FY2015), 119.4 (FY2016), 119.3 (FY2017).
- Commercial banks (loans as percent of GDP, end period): 11.6 (FY2012), 11.0 (FY2013), 11.7 (FY2014), 13.2 (FY2015), 15.1 (FY2016), 15.5 (FY2017).
- Commercial banks (deposits as percent of GDP, end period): 62.6 (FY2013), 67.4 (FY2014), 74.6 (FY2015), 80.3 (FY2016), 80.0 (FY2017), 82.0 (FY2018 projected).

*Source: Federated States of Micronesia—Staff Report for the 2017 Article IV Consultation (IMF).*

### 6. The current account balance has improved substantially since FY2013 and turned into a

### 6. The current account balance has improved substantially since FY2013 and turned into a

### Current account and trade
- The current account improved from a deficit of 10.1 percent of GDP in FY2013 to a surplus of 3.2 percent of GDP in FY2016, as the large trade deficit was offset by official transfers and fishing license fees.

### Banking system and credit
- Banking system capitalization (Tier 1 capital) is 25 percent of risk-weighted assets.
- Private sector credit has remained stagnant at around 20 percent of GDP in recent years.
- The loan-to-deposit ratio of the banking system is around 20 percent.
- Corporate loans represent one-quarter of bank loans.
- Posting property as collateral is hindered by complex land ownership issues.
- Interest rate spreads between lending and deposit rates are high, keeping banks profitable.

### Medium-term outlook
- Without major reforms, growth is projected to converge to the historical average of 0.6 percent.
- Long-term growth reflects labor productivity growth estimated at around 0.6 percent since FY2000.
- Inflation is expected to rise to 2.0 percent, in line with U.S. inflation.
- Under the baseline scenario, the fiscal balance is projected to turn into a deficit of 4 percent of GDP in FY2024, after the expiration of Compact grants.
- Current account surpluses are likely to decline over the medium-term.

### Projections and selected indicators (baseline and policy scenarios)
- Real GDP growth (%) baseline: 2.0, 1.4, 0.9, 0.7, 0.7, 0.6, 0.6 (FY2017–FY2023 row as presented).
- Fiscal balance (percent of GDP) baseline: 8.7, 8.6, 8.5, 8.3, 8.1, 8.0, 8.0 (FY2017–FY2023 row as presented).
- Current account balance (percent of GDP) baseline: 3.4, 3.0, 2.9, 2.8, 2.8, 2.9, 3.0 (FY2017–FY2023 row as presented).
- External debt (percent of GDP) baseline: 24.3, 22.3, 20.4, 18.6, 16.9, 15.3, 13.8 (FY2017–FY2023 row as presented).
- Policy scenario Real GDP growth (%) row: 2.0, 1.1, 0.7, 0.5, 0.6, 0.7, 1.0 (FY2017–FY2023).
- Policy scenario Fiscal balance: 8.7, 9.1, 9.5, 9.8, 10.2, 10.6, 11.0 (FY2017–FY2023).
- Policy scenario Current account balance: 3.4, 3.4, 3.8, 4.4, 5.0, 5.5, 6.0 (FY2017–FY2023).
- Policy scenario External debt: 24.3, 22.4, 20.5, 18.8, 17.1, 15.5, 13.8 (FY2017–FY2023).

### Debt sustainability
- The DSA indicates the FSM remains at a high risk of debt distress under the baseline scenario without major fiscal or structural reforms.
- Concessional external loans from FY2024 onward will be needed to safeguard priority infrastructure spending under the baseline, leading to the breach of external debt thresholds (external debt-to-GDP, external debt-to-exports).
- With fiscal and structural reforms, the risk of debt distress could be greatly reduced.
- Debt service ratios are low (below the DSA thresholds) due to concessional borrowing with long maturities.
- Income flows are positive with stable flow of funds from Compact grants until FY2023, projected to be replaced partly by investment income from the Trust Funds after FY2023.

### Risks and spillovers
- External risks: extreme weather-related events and persistently low rates of return on financial assets in the Trust Funds.
- Upside external risk: lower-than-expected energy prices could improve the current account and stimulate growth moderately.
- Domestic risks: delays in infrastructure projects.
- Upside domestic potential: decisive fiscal and structural reforms could boost potential growth.
- Near-term contingency: authorities could accelerate infrastructure spending financed by unspent Compact infrastructure grants (US$160 million or 50 percent of GDP at end-FY2016).
- DSA note: despite high risk of debt distress, debt service ratios remain low and income flows from Compact grants are stable until FY2023.

### Authorities’ views (summarized)
- Authorities broadly agreed with the assessment on the economic outlook and risks.
- They endorsed the need for fiscal and structural reforms, as envisaged in the “2023 Action Plan,” and noted challenges in achieving national consensus across states.
- They highlighted progress in tourism, renewable energy, and climate change preparedness, and interest in accelerating Compact infrastructure projects.

### Policies for building resilience and growth — priority areas
- Four macro-critical and high priority areas: (i) securing fiscal and external sustainability, (ii) adapting to climate change, (iii) facilitating private sector growth, and (iv) promoting safe financial inclusion.

### Securing fiscal sustainability
- A gradual medium-term fiscal adjustment of 4 percent of GDP is needed to achieve long-term sustainability and build buffers ahead of the FY2023 expiration of U.S. Compact grants.
- Projected investment earnings from the CTF and FSM Trust Fund are expected to fall short of expiring Compact grants by FY2024.
- A cumulative fiscal adjustment of US$15 million (4 percentage points of GDP) over the next six years would be needed to finance the shortfall and preserve the projected value of trust funds in real terms over the long-run.
- The fiscal adjustment can be achieved through a combination of:
  - Revenue mobilization (2 percent of GDP): scope to raise domestic revenues via tax administration and tax policy reforms. Suggested tax administration measures include (i) implementing a Compliance Improvement Strategy; (ii) strengthening on-time filing and payment; and (iii) management of tax arrears and outstanding returns. Tax policy reforms could include (i) reforming the personal income tax; (ii) introducing a net profits and value-added tax; and (iii) replacing the import duties on alcohol, tobacco, motor vehicles and fuels with excise taxes.
  - Expenditure reforms (1 percent of GDP): rationalize current expenditures through efficiency improvements, including in health and education. Efficiency gains that lead to a 4 percent reduction in health and education spending, through curbing nonessential recurrent spending, would generate savings of 1 percent of GDP.
  - Increased Trust Fund contributions (1 percent of GDP): raise annual budget contributions to the FSM Trust Fund by US$10 million (3 percent of GDP) from existing fiscal surpluses. Staff estimates saving current surpluses in the trust fund instead of low-yielding bank deposits would generate additional investment income of 1 percent of GDP after FY2023.
- Debt sustainability would be significantly improved with this adjustment; the debt level could remain below the DSA thresholds.
- Timely action is emphasized to avoid delays that could worsen growth outcomes; additional adjustment over the medium term would help build buffers against fishing revenue volatility and climate change costs.
- Example sensitivity: a 10 percent change in fishing license fees set by the PNA would swing the fiscal balance by 2 percentage points of GDP.

### Social security fund and public financial management
- Social security fund reserves: US$50 million (16 percent of GDP) as of end-2016.
- The fund runs a small deficit of around 0.5 percent of GDP, financed by US$1 million annual budget transfers.
- Major past reforms (FY2011-13) included raising the full retirement age from 60 to 65 and the payroll tax rate from 14 to 15 percent.
- Staff recommends eliminating the deficit and budget transfer, potentially by rationalizing dependency benefits.
- PFM reforms: implement the PEFA roadmap; priorities include (i) acquiring a revenue management system, (ii) including annual spending projections of multi-year investment projects in the budget, and (iii) implementing limited PEFA assessments for the four states.
- Staff encourages undertaking a Public Investment Management Assessment (PIMA).

### Trust funds
- Staff encourages an external review of the FSM Trust Fund, similar to the independent external evaluation of the CTF conducted in FY2015.
- The FY2015 review found the CTF generally well governed and suggested moving to a more conservative portfolio as FY2023 nears.
- Staff recommends preparing the FSM Trust Fund for the drawdown phase and appointing a Board for the FSM Trust Fund.
- Staff encourages considering adoption of the Santiago Principles for both trust funds.
- The authorities agreed on the size of the fiscal adjustment need and noted that raising annual budget contributions to the FSM Trust Fund should be feasible but requires national Congress approval.

### Maintaining external stability
- The external sector position is currently comfortable, but a high buffer is needed to manage the transition in FY2024.
- IMF external balance assessment models assess FSM’s external position as weaker than fundamentals would suggest, but models are not fully suitable given FSM characteristics and the FY2024 structural change.
- Under the baseline without major reforms, concessional external loans from FY2024 onward would be needed to safeguard priority development spending, leading to breaches of some debt sustainability thresholds.
- The use of the U.S. dollar as official currency is appropriate given small economy size, close linkages with the United States, and limited administrative capacity for independent monetary and exchange rate policies.
- Authorities agreed an external sector buffer is needed for the post-FY2023 period and confirmed appropriateness of the U.S. dollar.

### Adapting to climate change
- FSM vulnerability: adaptation costs could be around 1–3 percent of GDP every year and are built into the fiscal baseline.
- Contingent costs: could be around 10 percent of GDP every 20 years (losses and damages), to be recognized as a fiscal risk and included in public debt management considerations.
- The impact of climate change on fish migration should be carefully monitored given the importance of fishing revenues.
- Recommended actions:
  - Explicit recognition of adaptation and contingent fiscal costs in the budget.
  - Prioritization of climate-related spending in the Infrastructure Development Plan and finalization of Joint State Action Plans (JSAPs) for all states.
  - Develop diverse sources for contingent financing for natural disasters; consider participation in the Pacific Catastrophe Risk Insurance (PCRAFI) Facility.
- Authorities highlighted milestones: securing US$10 million funding from the Adaptation Fund and submitting proposals to the Green Climate Fund; noted adaptation and contingent fiscal costs are not currently recognized for budget planning.

### Building resilience to disaster and climate risk (Box highlights)
- Typhoon Maysak (March 2015) effects: 5 deaths; FEMA/USAID provided US$13 million (4 percent of GDP) in relief and recovery assistance; national government allocated US$6.4 million (2 percent of GDP) for relief.
- In early 2016, severe drought due to protracted El Niño conditions.
- Adaptation cost estimates: 1–3 percent of GDP (World Bank, 2016).
- FSM Infrastructure Development Plan (IDP) includes US$31 million of climate adaptation public investment over ten years.
- Contingent cost estimate: 10 percent of GDP every 20 years (PCRAFI, 2011) — incorporated in the DSA as a contingent liability shock.
- Resilience enhancements: identify risks; invest in risk reduction (IDP includes public projects at ~1 percent of GDP per year); develop contingency plans and financing (self-insurance, emergency support, risk-transfer arrangements), and pursue donor financing (Green Climate Fund, PCRAFI, IMF RCF/RFI).

*Source: IMF staff report excerpt (cr17280).*

### 25. Facilitating private sector development is necessary for sustainable growth, especially

### 25. Facilitating private sector development is necessary for sustainable growth, especially

### Private sector role and constraints
- The public sector absorbs about half of total employment and remains the main source of economic activity.
- Over the past two decades the economy has stagnated: FY2015 real GDP is about the same level as in FY1995.
- Private sector output is lower by more than 25 percent relative to two decades earlier, and employment has stayed broadly unchanged as the public–private wage gap widened.
- Main constraints identified:
  - High transportation costs due to smallness and remoteness.
  - Regulatory burdens from complex decision-making processes across a loose political federation and geographically dispersed states.
  - Limited access to finance, including land tenure and property right issues that hinder use of land as collateral.

### Reforms to promote private sector growth (overview)
- Priority reform areas noted: reducing transportation costs, strengthening regulatory frameworks, improving access to finance.
- Specific measures encouraged:
  - Enact the amended Foreign Direct Investment (FDI) Act (pending with Congress) to streamline the FDI process and establish a national Investment Promotion Agency.
  - Invest to upgrade ports and port services and build new transit routes to reduce transportation costs.
  - Advance reforms in the energy sector, including further investments in renewable energy to improve energy efficiency and reduce high energy costs.
  - Promote sustainable tourism (Nan Madol became a World Heritage Site in 2016) and create stronger links with target markets in Asia.
  - Targeted financial sector reforms to improve access to finance (see Financial Inclusion section and Box 3).

### Box 2 — Private Sector Development (key points)
- Background:
  - FSM is generally open to international trade with low tariff and non-tariff barriers and preferential access to the U.S., EU, and Australia.
  - Distortions from state-owned enterprises are limited, allowing potential to leverage natural endowments (e.g., fisheries and aquaculture).
- Constraints reiterated: high transportation costs; regulatory burdens; limited access to finance.
- Policy advice summarized:
  - Reduce transportation costs via port upgrades and renewable energy investments.
  - Reduce regulatory burdens by streamlining government permit steps and standardizing them across the four states, including through pending FDI legislation.
  - Improve access to finance by supporting small business development, expanding lenders’ use of the secured transactions framework, and other measures to mobilize credit to SMEs.
- Specific growth areas:
  - Niche products (e.g., coffee, pepper, traditional clothing, handicrafts) — success dependent on certification/quality standards, responsiveness to buyers, and community-based business models.
  - High-value sustainable tourism anchored on unique attractions: Nan Madol (Pohnpei), Lelu ruins (Kosrae), Chuuk lagoon wreck dives, and Rai sites (Yap).
  - Increased flights (direct flights by Nauru Airlines and Air Niugini) can create stronger links with Asia to support tourism growth.

### Financial sector, inclusion, and constraints
- Banking system features:
  - Co-supervised by the Banking Board and the Federal Deposit Insurance Corporation (FDIC).
  - Tier 1 capital is 25 percent of risk-weighted assets.
  - Interest rate spreads: around 7 percent for corporate loans and 15 percent for consumer loans.
  - Loan-to-deposit ratio is around 20 percent (exceptionally low—one of the lowest in the region).
  - Banks prefer lending to consumers with secure public sector jobs; commercial credit has been stagnant.
- Credit unions:
  - Currently small, with assets less than 1 percent of GDP.
  - Recommendation: bring credit unions under the oversight of the Banking Board by enacting the draft Credit Union Act (bill prepared, now with the Attorney General’s office per authorities).
- Measures to facilitate more lending:
  - Promote contracting of secure long-term land leases to generate collateral for bank lending.
  - Expand utilization of the online secured transactions registry (established via the Secured Transactions Act of 2006 and an online registry).
  - Strengthen small business development training programs; FSM Development Bank’s Development and Finance Training Institute (DFI) is a welcomed step.
  - Address skills gaps in business plan and financial statement preparation, including outsourcing bookkeeping/accounting through ICT.
  - FSM Development Bank should refocus lending to SMEs while remaining a profitable, independent bank operating without interest rate caps or budget transfers.

### Box 3 — Promoting Financial Inclusion (key points)
- Background and recent developments:
  - Financial inclusion can enhance growth through better access to credit for SMEs and wider banking use by households.
  - Only about half of the population has deposit accounts.
  - Number of deposit accounts dropped after implementing a minimum balance requirement of US$100 on savings accounts.
  - Two commercial banks serve mainly urban areas, with eight branches and ten ATMs; no mobile banking for outer islands.
  - Only one-quarter of bank loans are for firms (the rest for households).
- Policy recommendations (coordinated efforts):
  - Promote contracting of secure long-term land leases.
  - Expand use of the online secured transactions registry to facilitate secured lending.
  - Strengthen small business development training programs and use the DFI.
  - Address skills gaps and enable outsourcing of bookkeeping/accounting via ICT.
  - Enact the draft Credit Union Act to put credit unions under Banking Board supervision.

### Authorities’ views and recent actions
- Authorities broadly agreed on the main constraints: high transportation costs, regulatory burdens, and access to finance.
- Steps and developments cited by authorities:
  - Prepared a National Tourism Policy for sustainable tourism and State Tourism Investment Plans; since FY2016 Congress has appropriated annual budget allocations of US$2 million (0.6 percent of GDP) for these plans.
  - Measures to reduce transportation costs: two new international airline routes, arrival of mid-size planes donated by China for domestic air service, and new marine links to outer islands.
  - Agriculture/fishing: rehabilitating the coconut industry and establishing a “competent authority” to facilitate fish exports to the European Union.
  - World Bank project expected to provide all four states with access to broadband internet, facilitating private sector development, financial inclusion (possibly through mobile banking), and remote education and healthcare.
  - Banking Board worked with PFTAC to prepare a Credit Union bill; key constraint to bank lending emphasized as the land tenure system prohibiting land as collateral.
  - Authorities support FSM Development Bank maintaining profitable, independent status without interest rate caps or budget transfers.

### Staff appraisal and recommendations
- Medium-term challenges:
  - Reduction in Compact grants from the United States after FY2023, climate change, limited private sector growth, and weak access to finance.
  - Fiscal balance likely to fall into deficit after FY2023 without sustained fiscal adjustment.
  - FSM is currently at a high risk of debt distress.
- Fiscal policy recommendations:
  - Implement a gradual medium-term fiscal adjustment comprising domestic revenue mobilization, expenditure reforms, and saving surpluses in trust funds (rather than low-yielding bank deposits).
  - Explicitly budget adaptation costs for climate change to improve spending efficiency and sustainability of donor funding.
- External sector and buffers:
  - Estimated current account gap is negative, with relatively stable external funding for trade deficits at least until FY2023.
  - High buffers are needed to manage the post FY2023 period; external stability can be enhanced by saving more in trust funds.
  - Use of the U.S. dollar remains appropriate.
- Private sector and financial system recommendations reiterated:
  - Improve access to finance, reduce transportation costs through port upgrades and renewable energy, and strengthen regulatory frameworks including streamlining the FDI process.
  - Oversight of credit unions by the Banking Board is necessary to promote safe financial inclusion.
  - Further focus on SME lending, including by an independent FSM Development Bank, would support financial inclusion and growth.
- Data and statistics:
  - FSM implemented the enhanced General Data Dissemination System (e-GDDS); National Summary Data Page launched in July 2017.
  - Authorities encouraged to rebase GDP and complete ongoing rebasing of CPI (expected in 2018) and to improve coverage and timeliness of merchandise trade data.

*Source: IMF staff report (cr17280).*

### 39. It is recommended that the next Article IV consultation take place on the current 24-

### It is recommended that the next Article IV consultation take place on the current 24-month cycle.

### Recommendation
- It is recommended that the next Article IV consultation take place on the current 24-month cycle.

### Real sector developments (highlights from Figure 1 and Table 1)
- Nominal GDP (FY2016): US$323 million
- Population (FY2016): 102,249
- GDP per capita (FY2016): US$3,157
- Real GDP (annual percent change, FY2012–FY2022 series excerpt):
  - FY2012: -1.7
  - FY2013: -3.0
  - FY2014: -2.4
  - FY2015: 3.7
  - FY2016: 3.0
  - FY2017 (Est.): 2.0
  - FY2018 (Proj.): 1.4
  - FY2019 (Proj.): 0.9
  - FY2020 (Proj.): 0.7
  - FY2021 (Proj.): 0.7
  - FY2022 (Proj.): 0.6
- Consumer prices (annual percent change, FY2012–FY2022 excerpt):
  - FY2012: 6.3
  - FY2013: 2.2
  - FY2014: 0.7
  - FY2015: -0.2
  - FY2016: 0.5
  - FY2017 (Est.): 0.9
  - FY2018 (Proj.): 2.0
  - FY2019 (Proj.): 2.0
  - FY2020 (Proj.): 2.0
  - FY2021 (Proj.): 2.0
  - FY2022 (Proj.): 2.0
- Employment (annual percent change, FY2012–FY2022 excerpt):
  - Total employment FY2012: -2.2, FY2013: -2.0, FY2014: -2.5, FY2015: -0.3, FY2016: 2.4, FY2017 (Est.): 1.4, FY2018 (Proj.): 0.8, FY2019 (Proj.): 0.3, FY2020 (Proj.): 0.1, FY2021 (Proj.): 0.1, FY2022 (Proj.): 0.0

### Fiscal developments (highlights from Figure 2 and Table 2)
- Consolidated government finance (in percent of GDP, FY2012–FY2022 excerpts):
  - Revenue and grants FY2012: 65.9; FY2013: 62.0; FY2014: 64.8; FY2015: 66.0; FY2016: 70.2; FY2017 (Est.): 68.9; FY2018 (Proj.): 68.4; FY2019 (Proj.): 68.4; FY2020 (Proj.): 67.9; FY2021 (Proj.): 67.4; FY2022 (Proj.): 67.2
  - Revenue FY2016: 36.9 (percent of GDP)
  - Grants (from abroad) FY2016: 33.3 (percent of GDP)
  - Expenditure FY2016: 59.8 (percent of GDP)
  - Overall balance FY2016: 9.0 (percent of GDP)
  - Overall balance (excl. grants) FY2016: -24.3 (percent of GDP)
- General government operations (in millions of U.S. dollars, FY2012–FY2022 excerpts):
  - Revenue FY2016: 226.6 (m)
  - Grants (from abroad) FY2016: 107.5 (m)
  - Non-tax revenue FY2016: 76.4 (m)
  - Fishing license fees FY2016: 63.4 (m)
  - Expenditure FY2016: 197.5 (m)
  - Wages and salaries FY2016: 73.7 (m)
  - Net acquisition of nonfinancial assets FY2016: 39.1 (m)
  - Net lending/borrowing FY2016: 29.1 (m)
- Memorandum: GDP in nominal prices FY2016: 322.8 (m)

### External and credit developments (highlights from Figure 3, Tables 3–4)
- External debt (end of period, in millions of U.S. dollars, FY2012–FY2016 series excerpt):
  - FY2012: 88.4
  - FY2013: 87.7
  - FY2014: 89.7
  - FY2015: 81.1
  - FY2016: 81.6
- External debt (in percent of GDP, FY2012–FY2016 excerpt):
  - FY2012: 27.1
  - FY2013: 27.7
  - FY2014: 28.2
  - FY2015: 25.8
  - FY2016: 25.3
- Current account balance (including official transfers, percent of GDP, FY2012–FY2016):
  - FY2012: -13.4
  - FY2013: -10.1
  - FY2014: 1.2
  - FY2015: 4.2
  - FY2016: 3.2
- Balance of trust funds (CTF and FSMTF) (in millions of U.S. dollars, FY2012–FY2022 series excerpt):
  - FY2012: 82.3
  - FY2013: 106.5
  - FY2014: 126.8
  - FY2015: 145.5
  - FY2016: 170.0
  - FY2017 (Proj.): 188.5
  - FY2018 (Proj.): 206.9
  - FY2019 (Proj.): 226.9
  - FY2020 (Proj.): 248.3
  - FY2021 (Proj.): 270.4
  - FY2022 (Proj.): 294.4

### Financial sector indicators (highlights from Tables 5–6)
- Commercial banks (end of period, percent of GDP, FY2012–FY2016 excerpts):
  - Loans FY2016: 15.1 (percent of GDP)
  - Deposits FY2016: 80.3 (percent of GDP)
- Deposit money banks (in millions of U.S. dollars, FY2010–FY2016 excerpts):
  - Assets FY2016: 288.4
  - Foreign assets FY2016: 231.1
  - Claims on private sector FY2016: 48.8
  - Deposits FY2016: 258.3
  - Loan/deposit ratio FY2016: 18.9 (percent)
- Financial soundness indicators (FY2013–FY2016 excerpts):
  - Regulatory capital to risk-weighted assets FY2016: 24.4
  - NPL to total loans ratio FY2016: 2.4 (percent)
  - Return on assets FY2016: 1.5 (percent)
  - Return on equity FY2016: 15.0 (percent)
  - Liquid assets to total assets FY2016: 64.8 (percent)
  - Loan to deposit ratio FY2016: 18.9 (percent)

### Trust funds and long-term outlook (Appendix I)
- Purpose and context:
  - The FSM has two trust funds to support economic advancement and budgetary self-reliance after the expiration of the Compact grants in FY2023.
  - The current trajectory of the Compact Trust Fund (CTF) is not on track to compensate for expiring Compact grants in FY2023. The FSM Trust Fund (FSMTF) can only partially offset the shortfall. Fiscal adjustment is therefore needed.
- Compact Trust Fund (CTF) — key facts:
  - Objective: provide ongoing revenue after Compact grants (about US$80 million, 20 percent of GDP) expire after FY2023.
  - Value as of end-FY2016: US$467 million.
  - Accumulated contributions included in that value: US$280 million from the United States and US$30 million from the FSM.
  - From FY2024, annual investment gains of the CTF can be withdrawn to finance budget needs up to a limit equivalent to the expired grants.
  - If investment earnings are insufficient in a given year, the C account of the fund can be used to make up for the shortfall.
  - CTF investment strategy (at time of review): 51 percent equities, 19 percent fixed income, 30 percent alternative investments.
  - CTF compound average annual return between FY06 and FY16: 5.4 percent, net of fees (performed exactly at its benchmark).
  - Returns have been volatile with negative returns in FY08, FY09, FY11, and FY15.
  - Governance: independent committee with three voting members appointed by the United States (Departments of Education, Interior, and State) and two by the FSM; custodian bank State Street Bank; investment advisor Mercer Investment Management.
  - C account rules: Annual investment earnings above 6 percent are transferred to the C account, capped at three times the projected grant assistance in FY2023. As of end-FY2016, the C account held US$94 million (around 40 percent of the cap).
  - Independent external evaluation (FY2015) recommended a more conservative investment strategy and a “glide path” toward that goal.
- FSM Trust Fund (FSMTF) — key facts:
  - Created in 1999; at end-FY2004 its accumulated balance was transferred to the CTF as part of FSM’s contribution to the CTF.
  - National government resumed investing in FSMTF after FY2004; stepped up contributions in recent years as the CTF was deemed insufficient to fully compensate for expiring Compact grants.
  - Amendments in FY2016 (Public Law 19–67) specify no withdrawals before FY2024; from FY2024 the Board determines maximum distributable investment income up to applicable limits.
  - Value as of end-FY2016: US$82 million.
  - Contributions since FY2004 to end-FY2016: US$68 million (US$66 million from FSM government; US$2 million from China).
  - Since FY2016, the national government has been saving about US$5 million of tax revenue in the fund on behalf of states.
  - Fund performance between FY2010 and FY2016: average compound annual return 5.9 percent; net investment income was negative in FY10 and FY11.
  - Governance: Fund to be governed by a Board of Trustees with five members nominated by the President per Public Law 10–150; as the Board has not been established, the Secretary of the Department of Finance and Administration administers the fund; custodian bank Bank of New York Mellon; investment advisor Wilshire Associates.

*Prepared by IMF staff; figures and tables drawn from FSM authorities and IMF staff estimates as presented in the source document.*

### 10. Audit. An audit of the FSM Trust Fund by the National Public Auditor was conducted in

### 10. Audit. An audit of the FSM Trust Fund by the National Public Auditor was conducted in

### Audit findings and immediate actions
- The 2015 audit found several shortcomings:
  - lack of a Board of Trustees
  - lack of annual reports and audits
  - instances of improper maintenance of the books of accounts
  - a transfer from the budget to the fund without an allotment, as required by law
- Authorities’ response:
  - Broad agreement with the findings
  - Established a procedure to ensure all budget transfers have an allotment

### Long-term outlook for trust funds and fiscal implications
- Staff baseline assumptions:
  - 5 percent nominal return on trust fund assets
  - continued pace of contributions, as scheduled
- Projection:
  - Combined assets of the CTF and the FSM Trust Fund projected to reach US$1.2 billion at end-FY2023
- Drawdown policy and fiscal effects:
  - Drawdowns from the trust funds for FY2024 and beyond assumed at 3 percent of fund balances to maintain their value in real terms, with a 2 percent inflation adjustment
  - This would generate US$35 million of revenues in FY2024
  - Shortfall relative to expiring Compact grants (US$80 million): US$45 million
  - Fiscal position change:
    - Projected surplus of about US$30 million in FY2023
    - Estimated deficit of US$15 million (4 percent of GDP) in FY2024
- Risk sensitivity:
  - Does not consider risk of subsequent fiscal shocks from multi-year weaker nominal returns
  - A 0.5 percentage point decline in long-term returns, compared to the baseline, would raise the deficit by 2 percentage points of GDP
- Mitigation note:
  - The buffer in the CTF’s C Account could mitigate the risk of a revenue shortfall from weak investment returns for several years, but not permanently

### Appendix II — Main Recommendations of the 2015 Article IV Consultation (selected policy actions and progress)
- Fiscal Policy
  - Formulate a medium- to long-term fiscal framework to achieve budgetary self-reliance in the post-2023 period
    - The fiscal position improved with higher fishing license fees; the new administration retained most recommendations of the "2023 Action Plan."
    - A Debt Management bill was sent to Congress in 2016.
  - Undertake tax reform
    - FSM has a very low tax-to-GDP ratio
    - A pilot program supported by PFTAC improved tax compliance, resulting in significant increase in tax collections in FY2015–16 (0.5 percent of GDP)
    - Tax policy reforms are being revisited at the state level
  - Extend Unified Revenue Authority (URA) to remaining two states (Pohnpei and Yap)
    - URA Act was repealed in April 2015 amid objections of two states
    - Progress with fiscal federalism in FY2016: states’ share of tax revenues rose from 50 to 70 percent
  - Undertake expenditure reform
    - State governments continued implementing Long-Term Fiscal Frameworks (LTFFs) started in FY2014
    - National government completed a PEFA self-assessment in November 2016 and is preparing a PFM Roadmap for 2017–20
  - Transfer fiscal surpluses in full to the trust funds
    - Authorities have been contributing beyond initial commitment in the Action Plan
    - Since FY2016: annual contributions of US$10 million on behalf of the national government and US$5 million on behalf of states
    - Allocated about $60 million (20 percent of GDP) to the FSM Trust Fund over FY2014–16
  - Update infrastructure development plan (IDP)
    - IDP updated in FY2015; new IDP for FY2016-25 prioritized and includes projects linked to climate change adaptation
- Private Sector
  - Increase efforts at land reform (expedite land survey and registration)
    - Little progress reported
  - Enhance tourism development
    - Nan Madol designated a UN World Heritage site in 2016
    - National Tourism Policy completed and submitted to Congress; four State Tourism Investment Plans completed
    - Congress appropriated US$4 million for financing these plans during FY2016-17
  - Improve business environment and promote inward FDI
    - Amended Foreign Investment Act submitted to Congress to streamline FDI process and establish an Investment Promotion Agency
    - Donor-assisted renewable energy projects across all states expected to lower electricity costs and reduce reliance on diesel imports
    - Plans for a coconut rehabilitation project
- Financial Sector
  - Strengthen the regulatory framework
    - New Credit Union Act prepared to expand supervisory oversight of the Banking Board to credit unions; draft awaiting submission to Congress
- Statistical capacity
  - Improve reliability, coverage, and timeliness of economic statistics
    - TA from the Fund and PFTAC building capacity
    - In FY2016, FSM began to compile and report FSI data for the banking sector
    - In FY2017, authorities implemented the enhanced General Data Dissemination System (e-GDSS)

### Appendix III — MDG and Strategic Surveillance matrix (selected outcomes)
- MDG assessments (summary):
  - Goal 1: Eradicate extreme poverty and hunger — Not achieved
  - Goal 2: Achieve universal primary education — Mixed
  - Goal 3: Promote gender equality and empower women — Mixed
  - Goal 4: Reduce child mortality — Achieved
  - Goal 5: Improve maternal health — Not achieved (assessment partly due to data gaps)
  - Goal 6: Combat HIV/AIDS, malaria and other diseases — Mixed
  - Goal 7: Ensure environmental sustainability — Achieved
  - Goal 8: Develop a global partnership for development — Not Assessed

### Appendix IV — Risk Assessment Matrix (selected risks and policy advice)
- External risks
  - Natural disasters and climate change
    - Relative Likelihood: H
    - Impact if Realized: H
    - Potential Impact: Growth slowdown due to impairment of infrastructure, weaker agricultural production, impaired fishing activity
    - Staff advice: Ensure fiscal buffers; develop contingency plans; if realized, change expenditure composition or seek additional revenues/foreign aid for reconstruction
  - Persistently low rates of return on trust funds below 5 percent nominal
    - Relative Likelihood: L-M
    - Impact if Realized: M
    - Potential Impact: A 0.5 percent decline in expected return would require about 2 percentage points of GDP in additional fiscal consolidation
    - Staff advice: Save additional fiscal savings to ensure long-term sufficiency of the trust funds in real terms beyond FY2023
  - Lower energy prices
    - Relative Likelihood: L
    - Impact if Realized: M
    - Potential Impact: Improvement in current account, moderate positive impact on growth
    - Staff advice: Save fiscal gains to ensure long-term sufficiency of Trust Funds in real terms beyond FY2023
- Domestic risks
  - Delays in infrastructure projects
    - Relative Likelihood: M
    - Impact if Realized: H
    - Potential Impact: Short-term growth adversely affected
    - Staff advice: A Public Investment Management Assessment (PIMA) could identify bottlenecks; request TA on project implementation if needed
  - Faster progress on fiscal reforms
    - Relative Likelihood: M
    - Impact if Realized: H
    - Potential Impact: Fiscal position deteriorates less than expected due to implementation of measures under the 2023 Action Plan
    - Staff advice: Save additional fiscal savings to ensure long-term sufficiency of the trust funds in real terms beyond FY2023

### Appendix V — 2016 External Sector Assessment (key findings)
- Overall assessment:
  - External sector position assessed as weaker than fundamentals and desirable policies
  - Expiration of U.S. Compact grants will lead to a large structural change in FY2024
  - Need for larger buffers and a stronger external position now, given policy gap related to real value of trust funds
- External position and balances:
  - Net international investment position estimated at US$235 million in FY2016, based on increases in portfolio investment assets
  - Current account balance improved from a deficit of 10 percent of GDP in FY2013 to a surplus of 3 percent of GDP in FY2016
  - To build buffers for post-FY2023, external position needs further strengthening
- External balance assessment:
  - External sustainability approach estimate:
    - Current account norm (including official transfers): 2.3 percent of GDP
    - Underlying current account at end-FY2016: deficit of 1 percent of GDP
    - Current account gap: -3.3 percent of GDP
    - Conclusion: external position weaker than fundamentals and desirable policies, consistent with need for more buffers
  - Current account approach provides similar results but is less applicable due to structural break in FY2023
  - REER approach not applied due to inability to account for structural break and data limitations
- Reserves and fiscal liquidity:
  - No central bank or foreign exchange reserves; government deposits serve to absorb short-term liquidity shocks
  - Central government deposits around 20 percent of GDP in 2016, corresponding to 4 months of imports and 5 months of general government current spending
  - This exceeds the one month of government spending proposed by Wiegand (2013) as a standard yardstick for fiscal reserves
- External financing and competitiveness:
  - Trade deficit offset by official transfers and fishing license fees
  - Compact-related grants provide stable funding until FY2023
  - Fishing license fees stabilized around 20 percent of GDP over the last three years and expected to remain broadly unchanged under current policies
  - FSM’s manufacturing unit labor cost has increased, outpacing the United States, due to skilled worker shortages and migration to the United States; migration can increase remittance inflows

*Source: cr17280 - 10. Audit. An audit of the FSM Trust Fund by the National Public Auditor was conducted in (staff report excerpts from the IMF informational annex).*

### 2.      In line with the FSM’s policy priorities, the AsDB supports: (i) developing key growth

### cr17280 - 2.      In line with the FSM’s policy priorities, the AsDB supports: (i) developing key growth

### Asian Development Bank (AsDB) support and focus areas
- AsDB Country Partnership Strategy with the FSM: Pacific Approach 2016–20 supports:
  - (i) developing key growth drivers;
  - (ii) providing efficient and sustainable infrastructure; and
  - (iii) establishing better public sector management.
- AsDB is exploring support for developing sustainable ecotourism, while continuing efforts to improve the business environment and encourage private investment.
- AsDB infrastructure investments include projects for:
  - water and sanitation;
  - renewable energy and improving the efficiency of power utilities;
  - basic education services.
- Technical assistance and policy dialogue focus on measures to improve policymaking at national and state levels, including support for public administration reforms and tourism strategy and planning.

### Active AsDB loan and project pipeline
- Currently, there is only one active AsDB loan:
  - Yap Renewable Energy Development project totaling US$9 million, approved in 2013.
  - Project objectives: reduce dependency on imported diesel fuel; raise energy efficiency on the supply side of the electricity grid.
  - Project resources also support capacity development of the Yap power utility.
- AsDB assistance pipeline includes:
  - Regional project: Improving Quality of Basic Education in the North Pacific (covers the FSM and the Marshall Islands).
  - Ongoing technical assistance: supports public administration reforms at the FSM state-level through preparation of a medium-term public sector reform plan.

### Loans to the Federated States of Micronesia — summary by sector (Table 1)
- Data are in millions of U.S. dollars, at end-2016.
- Sector / No. / Amount
  - Agriculture and Natural Resources: 1 / 6.5
  - Energy: 2 / 9.0
  - Industry and Nonfuel Minerals: 0 / 0.0
  - Transportation: 0 / 0.0
  - Communications: 0 / 0.0
  - Law, Economic Management and Public Policy: 3 / 31.0
  - Water Supply, Sanitation & Waste management: 3 / 29.6
  - Multisector: 1 / 8.0
  - Other: 0 / 0.0
  - Total: 10 / 84.2
- Memorandum:
  - Technical Assistance Provided: 51 / 23.4

### Loan approvals and disbursements to the FSM, 2007–16 (Table 2) — selected figures
- Loan Approvals (2007–2016 row totals shown as 1990–2016): 84.2
- Loan Disbursements by year:
  - 2007: 3.5
  - 2008: 3.6
  - 2009: 0.8
  - 2010: 1.0
  - 2011: 6.3
  - 2012: 2.6
  - 2013: 3.0
  - 2014: 3.1
  - 2015: 2.0
  - 2016: 5.4
  - 1990–2016 total: 48.6
- Undisbursed Balance (at end of the year) by year:
  - 2007: 29.7
  - 2008: 23.8
  - 2009: 19.0
  - 2010: 17.7
  - 2011: 11.5
  - 2012: 8.9
  - 2013: 15.0
  - 2014: 11.5
  - 2015: 9.1
  - 2016: 3.7
- Memorandum: TA Approval by year (selected):
  - 2007: 0.4
  - 2008: 0.8
  - 2011: 0.7
  - 2012: 1.1
  - 2013: 0.2
  - 2014: 0.6
  - 2015: 0.5
  - 1990–2016 total: 23.4

### Relations with the Pacific Financial Technical Assistance Centre (PFTAC)
- Background:
  - FSM has been a moderate user of PFTAC technical assistance (TA).
  - Recent support has been fiscal in nature: public financial management (PFM) and revenue reforms, as well as support with government finance statistics and national accounts statistics.
  - With the Unified Revenue Agency establishment reversed in 2015, efforts redirected to strengthening core tax administration functions.
  - Following the Public Expenditure and Financial Accountability (PEFA) assessment in November 2016, PFM support is now directed towards developing a PFM roadmap.
  - Fiscal support will continue into FY2018, and volume of TA planned for FY2018 expected to marginally increase from FY2017.
- Strategy 2017–18:
  - PFTAC TA strategy guided by the Fund’s capacity development framework and APD’s Regional Strategy Note (RSN); consistent with PFTAC’s results framework.
  - TA aims to support authorities to move towards long-term fiscal sustainability, with emphasis on strengthening tax compliance.
  - PFM focus: support development of a PFM roadmap following November 2016 PEFA assessment; plan medium-term implementation in coordination with partners including AsDB; expected measures include strengthened monitoring of state-owned enterprises and state governments, and multi-year budgeting.
  - Tax administration focus: assist design of a Compliance Improvement Strategy; strengthen on-time filing and payment and management of arrears and outstanding returns; FY2018 TA to continue focus on core tax functions.
  - Financial supervision: assist the Banking Board in enhancing regulatory framework for banks and provide training on supervision of key banking risks; Banking Board attended PFTAC’s Regulatory Framework Workshop in July 2017; training for bank examiners earmarked for FY2018.
  - Statistics: FSM implemented the enhanced General Data Dissemination System (e-GDDS) in July 2017 with IMF’s Statistics Department support.
    - PFTAC to support enhancements in national accounts and provide hands-on annual training in compilation methods, subject to adequate staffing in the Statistics Office.
    - Government Finance Statistics (GFS): FSM received TA and training under the Japan Funded Administered Account (JSA 1) up to October 2015; with JSA 1 concluded, PFTAC and IMF headquarters assumed responsibility for GFS capacity development; most recent GFS mission was October 2016 focused on expanding coverage of GFS data and increasing frequency of reporting for the budgetary central government.
    - External sector statistics (ESS): a PFTAC mission tentatively planned for later 2017 to assess progress since November 2015 mission.
  - Macroeconomics: no direct input currently anticipated, but support to forecasting of long-term economic and fiscal scenarios may be provided in cooperation with other TA providers.

### Statistical issues and data adequacy (as of July 19, 2017)
- General assessment:
  - Data provision has serious shortcomings that significantly hamper surveillance.
  - Coverage of key macroeconomic data is broadly sufficient (except external sector statistics), but not compiled in a timely manner.
  - Most affected areas: national accounts and external sector statistics, compiled annually with nearly a year lag.
  - Authorities implemented the enhanced General Data Dissemination System (e-GDDS) in July 2017, with STA technical assistance.
- National accounts:
  - Prepared dating back to FY1995 with U.S. Graduate School support.
  - Annual GDP estimates (production and income approaches) compiled and released with a lag of 11 months.
  - GDP data have not been rebased for more than 10 years (current base year is FY2004).
  - A national census was conducted in 2010 and a household survey in 2013.
  - GDP estimates based on the expenditure approach are not compiled, leading to lack of investment/savings indicators.
  - Fixed ratios used in estimating value added for private sector operating surplus.
  - Authorities plan a business survey to help with rebasing of GDP.
- Employment:
  - Data on employment and wages available annually and classified by sectors based on filings to Social Security Administration.
  - No unemployment data available except for 2013 household survey.
- Price statistics:
  - Quarterly consumer price index (CPI), rebased to 2008Q2 and using expenditure weights from an earlier household survey, is published for FSM and each state.
  - Data releases often delayed; authorities are in process of rebasing the CPI.
- Government finance:
  - Fiscal data for central and general government prepared back to FY2004 with U.S. Graduate School support.
  - Data compiled in line with Government Finance Statistics Manual 2001 (GFSM 2001) based on annual audit reports of national and state governments.
  - Fiscal accounts consolidated between national and state governments; government agencies and local governments (municipalities) not covered.
  - Work to improve coverage and periodicity of fiscal data submitted to the Government Financial Statistics Yearbook continues with PFTAC support.
- Monetary statistics:
  - Banking Board compiles monthly monetary data with a three-month lag: interest rates, accounts of commercial banks, and FSM Development Bank.
  - Depository survey data are not compiled with standardized report forms (SRFs), hindering international comparability.
- Financial sector surveillance:
  - FSM started compiling Financial Soundness Indicators (FSIs) data in 2016 (quarterly data back to 2013).
  - FSM participates in the Financial Access Survey (FAS) with data back to 2004.
  - Both data often reported with delays.
- External sector statistics:
  - Authorities compile annual balance of payments and international investment position statistics in broad conformity with BPM6.
  - Persistent large errors and omissions in the balance of payments complicate assessment of external sustainability.
  - Coverage and classification of imports of goods, personal transfers, direct investment liabilities, and public external assets require enhancements.
  - A PFTAC TA mission planned for 2017 to follow up on these shortcomings.
- Data standards and quality:
  - Participant in the Fund’s General Data Dissemination System (GDDS) since November 2014.
  - Implemented the enhanced GDDS (e-GDDS) in July 2017.
  - National Summary Data Page (NSDP) is available at: http://www.fsmstats.fm/?page_id=605
  - Data ROSC is not available.

### Debt Sustainability Analysis (DSA) — key findings and background
- The 2017 DSA assesses the Federated States of Micronesia (FSM) remains at high risk of debt distress.
- Current situation and projections:
  - Currently, the ratios of the present value (PV) of external public and publicly-guaranteed debt to GDP and exports are below their respective policy-dependent thresholds.
  - They are expected to exceed the thresholds over the projection horizon.
  - For most indicators of external debt, thresholds would be breached under stress test scenarios.
- Debt servicing and vulnerabilities:
  - FSM does not currently face any debt servicing risks due to concessionality of debt obligations and access to stable flow of funds from Compact grants until FY2023.
  - Vulnerability to natural disasters and climate change call for a prudent debt management strategy.
- Policy implications:
  - Containing the risk of debt distress requires continuation of grants to support the country’s large development needs, and implementation of fiscal and further structural reforms to promote fiscal sustainability and growth.
- Background on debt and funds:
  - FSM is a small state in the North Pacific with total population of around 100,000.
  - FSM dependent on external grants and fishing license fees to finance public spending.
  - Loosely federated structure makes policy decisions difficult.
  - FSM faces long-term fiscal challenge as U.S. Compact grants will expire FY2024 onward, while private sector has not yet become engine of growth.
  - Part of Compact grants disbursed into Compact Trust Fund (CTF), jointly managed by U.S. and FSM, with goal that returns contribute to fiscal sustainability after FY2023.
  - FSM has been accumulating assets in its own trust fund (FSM Trust Fund), especially in recent years.
  - Current trajectory of the CTF is not on track to compensate for expiring Compact grants in FY2023; FSM Trust Fund can only partially offset the shortfall.
- Public debt profile:
  - FSM’s external public and publicly guaranteed (PPG) debt declined from a peak of 31 percent of GDP in FY2009 to 25 percent in FY2016 (21 percent on present value terms).
  - Most debt is concessional and contracted with official lenders.
  - About two-thirds is from the Asian Development Bank (ADB) and thirty percent from the U.S. Department of Agriculture (Rural Utilities Services).
  - Remaining 4 percent from the European Investment Bank (EIB) and a commercial lender (telecom vendor).
  - All loans, except for the EIB loan, are denominated in U.S. dollars, the legal tender and official currency in the FSM.
  - At 25 percent of GDP, FSM’s total public debt remains below the relevant benchmark of 38 percent, but stress tests suggest the benchmark could be breached with extreme shocks.
- DSA framework and thresholds:
  - DSA prepared jointly with the World Bank in accordance with the standard Debt Sustainability Framework for Low-income Countries.
  - FSM’s average Country Policy and Institutional Assessment (CPIA) score of 2.7 over the last three years classifies it as having weak policy and institutional capacity for DSA framework purposes, and assessed against relatively lower debt thresholds.
  - External debt burden thresholds for FSM are:
    - PV of debt-to-GDP ratio: 30 percent;
    - PV of debt-to-exports ratio: 100 percent;
    - PV of debt-to-revenue ratio: 200 percent;
    - debt service-to-exports ratio: 15 percent; and
    - debt service-to-revenue ratio: 18 percent.

*Source: cr17280 (IMF staff report, August 4, 2017)*

### 4.       The key assumptions are consistent with the macroeconomic framework set out in Box 1.

### The key assumptions are consistent with the macroeconomic framework set out in Box 1.

### Baseline macroeconomic assumptions
- Long-run real GDP growth rate: 0.6 percent (based on historical track record since FY2000).
- Long-run growth adjusted down by 0.5 percentage points from a non-disaster potential growth rate of 1.1 percent (to 0.6 percent) to reflect the average annual impact of natural disasters.
- GDP deflator: expected to remain 1 percentage points below CPI inflation.
- CPI inflation: projected to follow the U.S. rate of inflation.
- Overall fiscal balance: fiscal surplus projected to decline gradually and turn into deficit of 4 percent of GDP in FY2024 (when Compact grants expire).
- Compact grants: projected to decrease in real terms until FY2023, as scheduled.
- Grants from other donors: expected to remain stable as a percentage of GDP.
- Tax-to-GDP ratio: assumed to remain unchanged (baseline does not assume tax reforms).
- Fishing license fees: assumed to remain stable in nominal terms.
  - Note: Fishing license fees have stabilized in the range of US$60-65 million (about 20 percent of GDP) over the last three years (FY2015-17).
- Wage bill: assumed to grow in line with the Compact current grants until FY2023 and then in line with nominal GDP.
- External financing: financing gap assumed to be financed by a combination of grants from development partners and bilateral concessional lending in absence of access to international capital markets and a very limited domestic market.
- Concessional loans: expected to finance one-third of public investment starting in FY2024 to safeguard priority development spending.
- Compact Trust Fund and FSM Trust Fund: projected to yield an average nominal return of 5 percent. Drawdowns from the trust funds will start from FY2024 onward; baseline assumes the real balance of the combined trust funds is kept intact.
- Current account (including official transfers): expected to worsen from a surplus of 3 percent of GDP in FY2016 to a deficit of 4 percent of GDP by FY2024; the deficit is assumed to be financed by bilateral and multilateral concessional loans.

### Incorporating the impact of natural disasters
- Historical experience:
  - FSM experienced seven natural disasters since FY2000.
  - Typhoon Maysak (2015) in Chuuk and Yap: 5 deaths and losses of US$11 million (4 percent of GDP).
  - Typhoon Sudan (2004): extensive damages to public and private properties, food crops and private homes.
  - Tropical Storm Chata’an (July 2002) in Chuuk: killed 47 and injured over 100.
- PCRAFI estimate: FSM expected to incur a severe tropical typhoon every 20 years resulting in losses and damages of 10 percent of GDP.
- DSA treatment:
  - From 2017–2021, projections assume no natural disasters (per 2016 IMF Board Paper guidance) to avoid complicating near-term policy discussions.
  - Baseline projections after 2021 incorporate the average annual impact of natural disasters by adjusting downward the average growth rate (long-term growth set at 0.6 percent versus non-disaster 1.1 percent).
  - Occurrences of natural disasters are also incorporated via the standard contingent liability shock scenario (PCRAFI-based): a typhoon producing losses and damages of 10 percent of GDP over 20 years is modelled as a contingent liability shock.

### External debt sustainability analysis (DSA)
- Under baseline:
  - PV of external debt-to-GDP ratio expected to exceed the threshold of 30 percent in FY2035.
  - PV of external debt-to-exports ratio expected to exceed the threshold of 100 percent in FY2034.
  - Debt service-to-export ratio will remain below the relevant threshold because the bulk of external debt is on concessional terms.
- Stress tests:
  - Vulnerability concentrated on natural disaster shocks modelled via the standard contingent liability shock scenario.
  - Under contingent liability shock, PV of external debt-to-GDP ratio would exceed the threshold earlier, particularly in FY2032.
  - Under the same shock, PV of external debt-to-exports ratio would exceed the threshold in FY2030.
  - A historical-average macro scenario would also lead to thresholds being breached.

### Public debt sustainability analysis
- Public debt trajectory:
  - PV of public debt-to-GDP ratio projected to increase from 21 percent of GDP in FY2016 to 35 percent of GDP in FY2037 (remains below benchmark of 38 percent).
- Sensitivities:
  - Debt dynamics are particularly sensitive to growth shocks; under the most extreme shock, PV of debt-to-GDP and debt-to-revenue would remain on an upward trend.
  - Under a shock to the primary balance, the debt service-to-revenue ratio would keep growing throughout the projection period.
- Alternative (policy) scenario:
  - Assumes potential GDP growth higher than baseline by ½ percentage points.
  - Implementation of fiscal reforms including domestic revenue mobilization and expenditure reforms would eliminate the financing gap in the post-FY2023 period, resulting in less borrowing.
  - Under this alternative scenario with policy actions, debt indicators remain well below thresholds throughout the projection period.

### Authorities’ view and policy implications
- Authorities’ assessment:
  - Agreed with DSA findings; current risk of debt distress is high.
  - Emphasized need for fiscal adjustment and improvements in public financial management (PFM) to prepare for scheduled expiration of Compact grants, as called for in their Action Plan 2023.
  - Noted that reforms, particularly tax reform, require broad support from states.
  - Reported development of a PFM roadmap building on the PEFA self-assessment in November 2016.
  - Noted a Debt Management bill is currently with Congress to strengthen institutional capacity to manage public debt.
- Recommended policy actions (implied by analysis):
  - Fiscal adjustment measures to prepare for post-FY2023 fiscal gap.
  - Domestic revenue mobilization and expenditure reforms to eliminate financing gap and reduce borrowing needs.
  - Strengthening PFM and debt management institutions.
  - Continued reliance on concessional financing and trust fund drawdowns consistent with preserving real balances.

### Conclusion
- The standard DSA framework for LICs assesses FSM to remain at high risk of debt distress.
- Baseline indicates PV of external debt-to-exports ratio could breach threshold in FY2034; PV of external debt-to-GDP crosses threshold in FY2035.
- Stress tests confirm vulnerability of the debt position to export and natural disaster shocks.
- Mitigating factors: most debt is on concessional terms from development partners; authorities are building up trust funds that can partly offset expiring Compact grants after FY2023.

*IMF staff summary based on the 2017 DSA section provided.*

### 0.5 percentage points on impact.

### cr17280 - 0.5 percentage points on impact.

### Investment returns and trust funds
- The 2015 Article IV report assumed a 6 percent nominal return on trust fund assets.
- The Compact Trust Fund’s compound average annual return has been 5.4 percent, net of fees, as of end-FY2016.
- The FSM Trust Fund’s compound average annual return has been 5.9 percent, as of end-FY2016.
- The authorities have been contributing to the FSM Trust Fund at a $10 million annual investment level specified in the Action Plan, with additional contributions in recent years (e.g., $28 million of windfall revenue transferred to the Trust Fund in 2015).
- Staff recommend raising the annual contribution to the Trust Fund; the authorities intend to maintain current annual Trust Fund savings while seeking additional contributions from other partners.

### External debt indicators and projections (baseline 2017–37)
- Public and publicly guaranteed external debt (nominal) in table: 28.2, 25.8, 25.3, 24.3, 22.3, 20.4, 18.6, 16.9, 15.3, 23.5, 48.7 (percent of GDP) — values presented in table sequence.
- Change in external debt: 0.5, -2.5, -0.5, -0.9, -2.0, -1.9, -1.8, -1.7, -1.6, 2.4, 2.0 (percent of GDP) — values presented in table sequence.
- Identified net debt-creating flows: -1.3, -3.9, -3.8, -3.8, -3.2, -3.1, -2.9, -2.9, -3.0, 5.2, 5.1 (percent of GDP) — values presented in table sequence.
- Non-interest current account deficit: -2.3, -5.4, -4.0, 8.6, 9.2, -4.0, -3.5, -3.4, -3.3, -3.3, -3.3, 5.1, 5.3, 4.6 (percent of GDP) — values presented in table sequence.
- PV of PPG external debt (percent of GDP): 21.3, 20.2, 18.7, 17.3, 16.0, 14.7, 13.4, 16.7, 34.6 — values as shown in table.
- PV of PPG external debt in percent of exports: 80.4, 75.6, 69.4, 64.1, 58.8, 53.9, 49.4, 61.5, 127.1 — values as shown in table.
- PV of PPG external debt in percent of government revenues (excluding grants): 57.6, 55.8, 52.3, 48.7, 45.2, 41.9, 38.5, 38.1, 78.7 — values as shown in table.
- Debt service-to-exports ratio (percent): 4.3, 4.4, 3.0, 8.3, 7.5, 7.2, 7.1, 6.6, 6.4, 5.1, 4.6 — values as shown in table.
- PPG debt service-to-revenue ratio (percent): 3.1, 3.2, 2.1, 6.2, 5.6, 5.5, 5.4, 5.1, 5.0, 3.2, 2.9 — values as shown in table.
- Total gross financing need (Millions of U.S. dollars): -3.5, -13.1, -10.2, -5.5, -4.9, -4.8, -4.6, -5.0, -5.4, 25.3, 29.3 — values as shown in table.
- Aid flows (in Millions of US dollars) 7/: 178.5, 172.2, 189.1, 187.7, 185.1, 183.0, 179.0, 175.3, 171.6, 130.0, 261.4 — values as shown in table.
- Of which: Grants (Millions of US dollars): 88.8, 91.1, 107.5, 107.6, 110.0, 112.8, 114.0, 115.1, 116.3, 39.4, 45.2 — values as shown in table.
- Grant-equivalent financing (in percent of GDP): 31.4, 30.1, 30.4, 30.2, 30.0, 29.9, 11.8, 11.8, 13.0 — values as shown in table.

### Key macroeconomic assumptions (from baseline projections)
- Real GDP growth (in percent): -2.4, 3.7, 3.0, 0.1, 2.6, 2.0, 1.4, 0.9, 0.7, 0.7, 0.6, 1.1, 0.6, 0.6, 0.6 — values as shown in table.
- GDP deflator in US dollar terms (change in percent): 3.1, -4.5, -0.5, 2.4, 3.3, -0.1, 1.0, 1.0, 1.0, 1.0, 0.8, 0.8, 0.8, 0.8, 0.8 — values as shown in table.
- Effective interest rate (percent) (current-year interest payments divided by previous period debt stock): 4.1, 4.1, 3.1, 3.2, 0.5, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 2.3, 0.9, 0.0, 0.7 — values presented in table sequence.
- Growth of exports of G&S (US dollar terms, in percent): -11.0, 0.0, 2.4, 7.0, 12.3, 3.2, 3.1, 2.2, 2.1, 2.1, 1.4, 2.3, 1.4, 1.4, 1.4 — values as shown in table.
- Growth of imports of G&S (US dollar terms, in percent): -10.3, 1.9, 7.3, 3.0, 6.7, 0.8, 2.7, 1.9, 1.8, 1.8, 1.4, 1.7, 1.3, 1.3, 1.3 — values as shown in table.
- Government revenues (excluding grants, in percent of GDP): 36.9, 37.1, 36.9, 36.2, 35.8, 35.6, 35.3, 35.0, 34.9, 44.0, 44.0, 44.0, 43.4 — values as shown in table.
- Nominal GDP (Millions of US dollars) (memorandum): 318.1, 315.0, 322.8, 329.2, 337.0, 343.5, 349.4, 355.4, 360.4, 386.4, 444.2 — values as shown in table.

### Sensitivity analysis and stress tests (high-level)
- The most extreme stress tests for various indicators correspond to Contingent Liability shocks in multiple figures and Exports shocks in others, with the most extreme shock defined as the test that yields the highest ratio on or before 2027.
- Table 2 and Table 4 present multiple alternative scenarios and bound tests (A1–A3; B1–B6), including:
  - A2: New public sector loans on less favorable terms (assumes interest rate on new borrowing is 2 percentage points higher than baseline).
  - B1: Real GDP growth at historical average minus one standard deviation in 2018–2019.
  - B6: 10 percent of GDP increase in other debt-creating flows in 2018.
- Memorandum item: Grant element assumed on residual financing is 33 (applies to stress scenarios except A2), shown as repeated 33 values in table.

### Authorities’ assessment and policy priorities (Statement by Grant Johnston and Eugene Amor, September 1, 2017)
- Fiscal outlook and compact transition:
  - Key challenge: forthcoming expiry of annual grants from the United States — equivalent to more than 20 percent of GDP.
  - After 2023, most grants will be replaced by distributions from investment funds, but current contribution and expected returns imply fund distributions will not fully compensate for the loss of grants while maintaining real value.
  - Sustainable long-term growth hinges on fiscal reforms and private sector development.
  - Action Plan 2023 targets annual growth of 2 percent, increased revenue mobilization, building fiscal buffers, and improving the private sector environment.
  - The new government formed a review and planning committee to evaluate progress and recommend further reforms.
- Fiscal policy measures:
  - Authorities agree on need for additional medium-term fiscal adjustments; aim to limit expenditure growth to 2 percent a year over the medium-to-long term.
  - Plan to lift the tax-to-GDP ratio from 12 percent to 16 percent and are revisiting the tax reform agenda (including a second attempt at introducing a value-added tax and a net profits tax).
  - Ongoing technical assistance from PFTAC and development partners supports revenue mobilization goals.
  - Authorities have developed a debt management policy and introduced a Debt Management Bill.
- Financial sector:
  - Commercial banking sector assessed by staff as sound and stable with adequate capital and ample liquidity.
  - Continued support for small and medium-sized enterprises via FSM Development Bank loan program and training initiatives.
  - Completion of the Credit Union Act to expand the supervisory mandate of the Banking Board, supported by PFTAC technical assistance.
- Private sector development:
  - Authorities committed to reducing regulatory burdens and improving the investment climate.
  - New Foreign Direct Investment Bill submitted for legislative approval and a Foreign Direct Investment Promotion Agency proposed.
  - A Corporate Act has been passed to improve investor protections and corporate governance.
  - Two new airline operators (Air Niguini and Nauru Airlines) welcomed; national sustainable tourism policy and State Tourism Investment Plans completed with annual budget allocations of $2 million.
  - World Bank-funded fiber optic cable project underway to connect the four states to broadband internet; commitment to liberalize telecommunications sector.
  - Authorities note need to harmonize and clarify land tenure practices while respecting local interests.
- Climate change and disaster financing:
  - Authorities intensified climate change adaptation efforts via the Infrastructure Development Plan and Joint-State Action Plans.
  - Continued efforts include explicit recognition of fiscal costs in the budget to support access to donor funding.
  - FSM will continue an annual contribution to the Disaster Assistance Emergency Fund and will seek other means of disaster financing (self-insurance, donor support, insurance arrangements) and technical assistance to access adaptation financing.

*International Monetary Fund, cr17280 - 0.5 percentage points on impact.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17280.pdf_