## 1. Fishing License Revenues

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### Background and context
- RMI characteristics and vulnerabilities:
  - Small, remote country in the Northern Pacific with dispersed population and low elevation; vulnerable to climate change, droughts, and floods.
  - Economy highly dependent on external aid; annual grants averaged about 35 percent of GDP over the past decade.
- Institutional and policy priorities:
  - Prepare for reduction in the U.S. Compact grant after FY2023 (about 10 percent of GDP).
  - Adapt to climate change and promote sustainable growth.
  - One domestic commercial bank: Bank of Marshall Islands (BOMI); faces risk of losing last U.S. dollar correspondent banking relationship (CBR).
- Digital currency law:
  - Law enacted in February 2018 recognizes a decentralized digital currency (SOVEREIGN or “SOV”) as a second legal tender in addition to the U.S. dollar; SOV to be issued by a foreign private company.

### Macroeconomic outlook and key statistics
- Real GDP growth:
  - Estimated to have accelerated to about 3½ percent in FY2017.
  - Projected at about 2½ percent in FY2018.
  - Projected at about 1½ percent over the medium term.
- Inflation:
  - Annual CPI inflation at 1.0 percent in 2018Q2.
  - Expected to rise gradually to around 2 percent over the medium term.
- Fishing license revenue and fiscal balances:
  - Government revenue from fishing licenses (including a one-off transfer of reserves from the Marine Resources Authority) increased from 6¼ percent of GDP in FY2014 to 18 percent in FY2017.
  - Overall fiscal surplus estimated to have narrowed by ¼ percentage point to 3 percent of GDP during the FY2014–FY2017 period.
  - Fiscal surplus projected to narrow to 1¾ percent of GDP in FY2018.
  - Projected to turn into a deficit of 1½ percent by FY2023, driven by continued strong growth in government spending while fishing license revenues remain stable in nominal terms.
- Current account:
  - Widened to a surplus of 15 percent of GDP in FY2015.
  - Narrowed to 7½ percent of GDP in FY2016.
  - Estimated to have turned into a small deficit in FY2017.
  - Projected to widen to about 3½ percent of GDP in the medium term as infrastructure-related imports rise while fishing license fee income remains stable in nominal terms.
- Financing outlook:
  - Projected medium-term current account deficit can reasonably be expected to be financed by concessional financing from donors and investment earnings from the Compact Trust Fund.

### Analysis of the SOV (decentralized digital currency) issuance
- Structure and planned allocation:
  - A foreign private company (Israel-based start-up) will issue the SOV and receive half of the initial issuance.
  - 20 percent of the initial coins accruing to RMI will be distributed to resident RMI citizens to jump-start use.
  - The rest of initial coins will be allocated to trust funds to supplement the Compact Trust Fund, support citizens affected by prior U.S. nuclear tests, and finance infrastructure projects.
- Legal and operational status:
  - Law passed in February 2018 recognizes SOV as second legal tender and aims to help the foreign private company secure financing for development.
- Identified weaknesses and governance concerns:
  - KYC and AML/CFT: law requires “standard KYC procedures” and identity recording on the blockchain, but content and implementation modalities not established; transaction monitoring, suspicious transaction reporting, compliance monitoring, and sanctioning are not addressed.
  - Governance: issuance and management of SOV protocol are outside authorities’ control; dual role of issuer and private investor creates conflict of interest.
  - Telecommunications infrastructure is limited, impeding wide SOV adoption.
  - Monetary policy: absence of a monetary policy framework raises monetary instability and exchange-rate/convertibility risks given SOV price volatility on global cryptocurrency exchanges.
- Quantified monetary expansion risk example:
  - If the SOV was issued at the price of about $50 as targeted at the Initial Coin Offering and distributed to resident RMI citizens as planned, it would be equivalent to a transfer to households of about 11 percent of GDP per year over the next five years.
- Staff recommendation on SOV:
  - Authorities should seriously reconsider issuance of the digital currency as legal tender, given significant economic, reputational, AML/CFT, and governance risks.
  - Potential benefits from revenue gains appear considerably smaller than potential costs.
  - Some risks might be mitigated by technology, but others require institutional changes.
  - Widespread use of the SOV as a means of exchange would require significant costs to upgrade RMI’s telecommunications infrastructure.

### Financial stability, AML/CFT, and maintaining the CBR
- Progress reported:
  - Banking Act amended to align AML/CFT provisions with FATF 40 recommendations.
  - First national risk assessment started with World Bank support.
  - Banking Commission re-establishing prudential supervision framework and undertaking regulatory reform with PFTAC assistance.
  - BOMI strengthening AML/CFT controls (software upgrade) and undertaking an independent audit of its AML/CFT system.
  - Authorities support BOMI’s effort to obtain U.S. Federal Reserve approval to establish a clearing house in Hawaii.
  - Association Law amended November 2017 to require reasonable measures to identify beneficial owners and register bearer shares.
- Remaining risks and vulnerabilities:
  - Issuance of SOV as second legal tender could increase macroeconomic and financial integrity risks and elevate risk of losing the last U.S. dollar CBR.
  - SOV would be an international currency subject to large volatility in exchange rates.
  - Distribution of SOVs to citizens would be equivalent to a monetary expansion through “helicopter money.”
  - Liquidity backstop limitations: absence of deposit insurance and small government deposits constrain backstop; however, with a loan-to-deposit ratio of less than 60 percent, BOMI holds a substantial share of its assets abroad which could help boost liquidity if pressures arise.
  - Without effective AML/CFT measures, issuance of SOV could offset progress in strengthening the AML/CFT framework and lead to increased scrutiny and potential countermeasures including possible immediate loss of the CBR.
  - Offshore and maritime registries continue to present ML/TF risks; reputational risks remain elevated despite legal amendments.
- Staff’s further recommendations to lower CBR loss risk (irrespective of SOV issuance):
  - AML/CFT measures:
    - Complete the national risk assessment and develop an action plan to address main risks identified.
    - Strengthen domestic AML/CFT capacity with international technical assistance.
    - Impose AML/CFT obligations on relevant registries (offshore and maritime) and ensure requirements for beneficial ownership transparency are fully implemented (including existing legal persons and prior bearer shares).
    - Ensure competent authorities have timely access to up-to-date beneficial ownership information of non-resident companies.
  - Banking supervision:
    - Enhance prudential banking supervision framework and comply with relevant international standards.
    - Introduce prudential requirements covering key banking risk areas and strengthen implementation.
    - Regularize offsite supervision and banking sector report production to monitor developments and act timely.
    - Introduce a ceiling on the debt service ratio to help control household debt, which is mostly consumer credit and amounts to about 40 percent of GDP.
  - Cooperation:
    - Further enhance communication with the last U.S. dollar correspondent bank and U.S. regulators.

### Compact Trust Fund (CTF): design, projections, and scenarios
- Purpose and current position:
  - CTF set up in FY2004 to compensate for the expiring portion of the U.S. Compact grant after FY2023.
  - CTF assets amounted to US$357 million (203 percent of GDP) as of the end of FY2017.
  - CTF assets projected to reach US$615 million (230 percent of GDP) by the end of FY2023.
- Fund rules and accounts:
  - Withdrawals from CTF not available prior to FY2024.
  - From FY2024 onwards, annual investment earnings can be withdrawn up to a limit equivalent to expired grant assistance as of FY2023, fully adjusted for inflation.
  - Investment earnings above 6 percent are transferred to the C account; C account capped at three times the projected grant assistance in FY2023. As of end-FY2016, C account held US$59.8 million (about 2.2 times of the projected amount).
  - D account (contributed by RMI and Taiwan POC) can be used as a buffer while assets exceed US$10 million; D account amounted to US$13 million as of end-FY2016.
- Investment strategy and performance:
  - Asset allocation (adjusted in 2014): 30 percent in U.S. equities; 30 percent in international equities; 20 percent in fixed income; 20 percent in alternative investments.
  - Fund average annual nominal return since inception (as of end-FY2016): 6.7 percent, net of fees.
- Scenarios assessed:
  - Baseline scenario:
    - Assumes the CTF earns a 5 percent nominal return annually from FY2018 onwards.
    - Distribution from estimated assets for FY2024 would generate sufficient income to fully offset the revenue loss implied by the expiring Compact grants (US$27 million).
    - Under this scenario, the real value of the CTF will likely decline over time and long-term self-sufficiency would not be secured.
  - Policy action scenario:
    - Government undertakes a fiscal adjustment of about 4 percentage of GDP over the medium term (FY2018–FY2023) to build an overall fiscal surplus of 2½ percent of GDP (about US$7 million) by FY2023.
    - Under this course of action, drawdowns from the CTF can be contained at around 3 percent (about US$20 million) of fund balances and preserve the real value of the CTF with about 2 percent inflation adjustment.
  - Sensitivity and alternative assumptions:
    - Lower return scenario: assume 4 percent return from FY2018, achieve fiscal surplus of 2.5 percent by FY2023.
    - Staff estimates a permanent decrease in expected returns of 1 percentage point (from 5 to 4 percent) would increase the fiscal adjustment need by 2¼ percentage point of GDP from the recommended policy action scenario.
    - GAO projection: with a 15 percent probability, the CTF would not be able to disburse any funds in 1 or more years during the first decade due to return volatility.
- Key numeric figures (preserved exactly):
  - Reduction of US Compact grants in FY2024: US$27 million (about 10 percent of GDP).
  - CTF value (excluding D account) as of end-FY2017: US$357 million.
  - Contribution breakdown of US$219 million: U.S.: US$161 million; RMI: US$33 million; Taiwan POC: US$26 million.
  - Policy action fiscal-surplus target by FY2023: 2½ percent of GDP (about US$7 million).
  - Contained drawdown under policy action: around 3 percent (about US$20 million) of fund balances.
  - Assumed nominal return in baseline and policy scenarios: 5 percent from FY2018 onwards.
  - Inflation adjustment targeted for preserving real value: about 2 percent.

### Fiscal adjustment, PFM, SOE reform, social security, and climate adaptation
- Fiscal adjustment needs and recommended measures:
  - With fiscal adjustment of 4 percentage points of GDP relative to the baseline by FY2023, real value preservation for the CTF could be achieved and risks to long-term fiscal sustainability reduced.
  - Drawing on 3 percent of the CTF assets annually rather than the full investment return of 5 percent would require a fiscal surplus of 2½ percent of GDP (US$7 million) by FY2023 to absorb the revenue loss implied by the expiring U.S. Compact grant (US$27 million, 10 percent of GDP).
  - Without this adjustment, additional external financing would raise external debt distress risks.
- Staff recommended multi-pronged fiscal measures (priority order):
  - Reverse the recent increase in recurrent spending (3½ ppt) while improving revenue administration and implementing tax reform (½ ppt).
  - Expenditure compression: support to lower recurrent spending (travel, supplies, personnel) while preserving health and education; proposed ceilings for ministries’ recurrent spending (yet to be approved).
  - Revenue administration improvements (PFTAC-supported measures): (i) improve information exchange between Social Security Administration and the government to increase taxpayer registration; (ii) improve return and payment collection processes; (iii) strengthen tax audits.
  - Tax reform package (expected revenue neutral but less-distortionary): (i) reform personal income tax; (ii) introduce a net profits tax; (iii) introduce a consumption tax to replace the gross revenue tax; (iv) replace existing import duties with excise taxes.
  - MTFF and PFM: prepare multi-year budget framework, improve baseline revenue estimates, introduce new ministries’ budget submission template classifying expenditure by output and type; improve legal and policy framework, budgeting, accounting, fiscal reporting, cash management; strengthen debt management function.
- Social security reform (Box 2 highlights):
  - Measures adopted in FY2017: increase contribution rate by 1 percentage point (from 7 to 8 percent) for both employers and employees; gradual increases in retirement age from 60 to 65 (by 1 year every two years); increase in maximum annual taxable income from US$20,000 to US$40,000; reduction in benefit for those receiving US$300 or more per month.
  - Projected fiscal impact: annual fiscal savings of more than US$4 million (2 percent of GDP); SSF reserves improved from US$66 million in FY2016 to US$72 million in FY2017; remaining gap about US$3 million in FY2017.
  - Remaining need: more ambitious reforms required; if government did not provide subsidies, SSF reserves would start declining from FY2021.
- SOE reform and private sector:
  - Subsidies to SOEs rose from 5¾ percent of GDP in FY2014 to 7½ percent in FY2017.
  - Establishment of SOE monitoring unit within the Ministry of Finance welcomed; recommended to reduce subsidies to SOEs not justified by CSOs to help fiscal consolidation.
  - Business environment constraints: remoteness, small economic size, geographic dispersion, poor regulatory framework; need land registration reforms to help collateralization and long-term land leases.
- Climate change adaptation and fiscal implications:
  - RMI among countries most affected by climate change due to low elevation.
  - Historical average likelihood of a severe natural disaster: 5.4 percent per year, with about 25 percent of total population being affected by a severe disaster event.
  - Staff estimates expected annual GDP growth would be lower by about 0.1 percent if baseline projection adjusted for expected impact of severe natural disasters.
  - In case of a one-time extreme disaster event, annual GDP growth could be lower by about 2 percentage points compared to the baseline; LIC-DSA indicates debt-to-GDP ratio could rise further by about 5 percent.
  - Climate-change adaptation costs estimated to be about 2½ percent of GDP per year.
  - Staff recommends recognizing these costs explicitly in the budget and the MTFF and continuing climate resilience projects.

### Debt sustainability, DSA findings, and risks
- Overall DSA assessment:
  - RMI remains at high risk of debt distress.
  - Ratios of PV of external PPG debt to GDP and to exports currently just below respective policy-dependent indicative thresholds; projected to start increasing and exceed thresholds in medium to long term.
  - Stress tests confirm vulnerability of the debt position to lending terms and macroeconomic shocks.
- Key debt and projection figures (preserved exactly where reported):
  - PV of PPG external debt (in percent of GDP): ......29.0 26.9 25.7 26.3 27.6 29.6 32.4 50.2 85.7
  - PV of external debt (in percent of exports): ......106.7 98.5 94.4 96.4 100.6 107.3 116.0 175.3 291.2
  - PV of PPG external debt (in percent of exports): ......98.4 90.6 86.7 88.9 93.4 100.2 109.2 169.2 286.5
  - PV of PPG external debt (in percent of government revenues): ......75.6 86.8 84.5 87.8 93.6 102.0 112.9 135.1 254.2
  - Debt service-to-exports ratio (in percent): 11.4 13.0 10.7 10.2 10.9 9.3 9.4 9.4 9.4 9.7 14.6
  - PPG debt service-to-revenue ratio (in percent): 15.3 10.9 8.2 9.8 10.6 9.2 9.4 9.5 9.7 7.8 12.9
  - Grant-equivalent financing (in percent of GDP): .........32.5 32.3 32.2 32.1 32.1 21.1 19.1 16.8 18.6
  - Government revenues (excluding grants, in percent of GDP): 27.5 32.2 38.4 31.0 30.5 29.9 29.4 29.0 28.7 37.2 33.7 36.2
  - Nominal GDP (Millions of US dollars): 181.3 196.3 222.3 229.9 237.7 245.8 253.8 260.7 267.4 300.2 383.1
  - PV of PPG external debt (in Millions of US dollars): 64.6 61.9 61.2 64.6 70.0 77.2 86.6 150.8 328.5
- Public debt dynamics:
  - PV of total public debt-to-GDP ratio projected to increase from 29 percent of GDP in FY2017 to 50 percent of GDP in FY2028, exceeding benchmark of 38 percent.
  - Holding annual primary surplus at FY2018 level of 2.6 percent (versus projected average of 0.2 percent for FY2018–FY2028) would decrease PV of public debt-to-GDP ratio by 13 percentage points in FY2028.
- Policy implication:
  - Containing the risk of debt distress requires continuation of grants and implementation of fiscal and structural reforms; fiscal consolidation early in projections would substantially improve debt sustainability prospects.

### Data, TA, and statistical capacity
- Technical assistance outcomes:
  - Public sector consolidation elements mapped to GFSM 2014.
  - Monetary statistics reporting system established for domestic banking institutions based on monthly reporting forms and guidelines from 1993 STA mission; data reported to Banking Commissioner but not published or reported to the Fund.
  - BPM6 adopted; balance of payments and IIP statistics started to be submitted to STA in 2014.
  - EPPSO implemented a unit dedicated to compilation of statistics; compilation currently conducted largely by external consultants with sole compiler on staff.
  - Further actions needed to collect proper data on external debt statistics (EDS), foreign direct investment (FDI) statistics, banks’ external assets and liabilities.
- Data standards and reporting:
  - RMI does not participate in IMF’s General Data Dissemination System.
  - No data ROSC is available.
  - BOP data reported to STA by EPPSO (optional).

*IMF staff report (Republic of the Marshall Islands) contained in content unit cr18270.*

### 1. Fishing License Revenues ______________________________________________________________________ 16

### 1. Fishing License Revenues

### Background and context
- The Republic of the Marshall Islands (RMI) is a small and remote country in the Northern Pacific with a dispersed population and low elevation, making it vulnerable to climate change, droughts, and floods.
- The economy is highly dependent on external aid, with annual grants averaging about 35 percent of GDP over the past decade.
- Policy priorities: prepare for a reduction in the U.S. Compact grant after FY2023 (about 10 percent of GDP), adapt to climate change, and promote sustainable growth.
- RMI has one domestic commercial bank, Bank of Marshall Islands (BOMI), which faces the risk of losing its last U.S. dollar correspondent banking relationship (CBR). The CBR is currently renewed every year, conditional on progress in improving the AML/CFT framework.
- RMI enacted a law in February 2018 recognizing a decentralized digital currency (SOVEREIGN or “SOV”) as a second legal tender in addition to the U.S. dollar; the SOV is to be issued by a foreign private company.

### Recent developments and macroeconomic outlook
- Real GDP growth:
  - Estimated to have accelerated to about 3½ percent in FY2017.
  - Projected at about 2½ percent in FY2018.
  - Projected at about 1½ percent over the medium term.
- Inflation:
  - Annual CPI inflation at 1.0 percent in 2018Q2.
  - Expected to rise gradually to around 2 percent over the medium term.
- Fishing license revenue:
  - Government revenue from fishing licenses (including a one-off transfer of reserves from the Marine Resources Authority) increased from 6¼ percent of GDP in FY2014 to 18 percent in FY2017.
- Fiscal balances:
  - Overall fiscal surplus is estimated to have narrowed by ¼ percentage point to 3 percent of GDP during the FY2014–FY2017 period.
  - Fiscal surplus projected to narrow to 1¾ percent of GDP in FY2018.
  - Projected to turn into a deficit of 1½ percent by FY2023, driven by continued strong growth in government spending (goods and services) while fishing license revenues remain stable in nominal terms.
- Current account:
  - Widened to a surplus of 15 percent of GDP in FY2015.
  - Narrowed to 7½ percent of GDP in FY2016.
  - Estimated to have turned into a small deficit in FY2017.
  - Projected to widen to about 3½ percent of GDP in the medium term, as infrastructure-related imports rise while fishing license fee income remains stable in nominal terms.
- Financing:
  - The projected medium-term current account deficit can reasonably be expected to be financed by concessional financing from donors and investment earnings from the Compact Trust Fund.

### Key risks and vulnerabilities
- Overall risk outlook: risks remain tilted to the downside.
- Digital currency risks:
  - Issuance of SOV as second legal tender could increase macroeconomic and financial integrity risks and elevate the risk of losing the last U.S. dollar CBR.
  - The SOV would be an international currency subject to large volatility in its exchange rates.
  - Distribution of SOVs to citizens would be equivalent to a monetary expansion through “helicopter money.”
  - Example: If the SOV was issued at the price of about $50 as targeted at the Initial Coin Offering and distributed to resident RMI citizens as planned, it would be equivalent to a transfer to households of about 11 percent of GDP per year over the next five years.
  - Liquidity backstop limitations: absence of deposit insurance and small government deposits constrain backstop; however, with a loan-to-deposit ratio of less than 60 percent, BOMI holds a substantial share of its assets abroad which could help boost liquidity if pressures arise.
- Reputational and AML/CFT risks:
  - Without effective AML/CFT measures, issuance of SOV could offset progress in strengthening the AML/CFT framework, lead to increased scrutiny from the AML/CFT standard setter, and potential countermeasures including possible immediate loss of the CBR.
  - Offshore and maritime registries continue to present ML/TF risks; reputational risks remain elevated despite legal amendments.
- Fiscal sustainability risks:
  - Insufficient fiscal consolidation after FY2023 is the main medium- to long-term risk to growth.
  - Additional external financing to offset grant losses would raise external debt distress risks, which is already high as indicated by DSA analysis.
- Other risks:
  - Extreme weather-related events remain a downside risk.
  - Limited international linkages (other than to the U.S. via the Compact) insulate RMI from external spillovers but concentrate vulnerability to U.S.-linked developments.

### Analysis of the SOV (decentralized digital currency) issuance
- Structure and planned allocation:
  - A foreign private company (Israel-based start-up) will issue the SOV and receive half of the initial issuance.
  - 20 percent of the initial coins accruing to RMI will be distributed to resident RMI citizens to jump-start use.
  - The rest of initial coins will be allocated to trust funds to supplement the Compact Trust Fund, support citizens affected by prior U.S. nuclear tests, and finance infrastructure projects.
- Legal and operational status:
  - Law passed in February 2018 recognizes SOV as second legal tender and aims to help the foreign private company secure financing for development.
- Identified weaknesses in design and governance:
  - KYC and AML/CFT: The law requires “standard KYC procedures” and identity recording on the blockchain, but the content and implementation modalities of these procedures are not established; transaction monitoring, suspicious transaction reporting, compliance monitoring, and sanctioning are not addressed.
  - Governance concerns: issuance and management of SOV protocol are outside authorities’ control; dual role of issuer and private investor creates conflict of interest.
  - Telecommunications infrastructure is limited, posing an obstacle to wide SOV adoption.
  - Monetary policy: absence of a monetary policy framework raises monetary instability risks and exchange-rate/convertibility risks given SOV price volatility on global cryptocurrency exchanges.

### Staff recommendations regarding the digital currency
- Staff recommends that the authorities seriously reconsider issuance of the digital currency as legal tender, given the significant economic, reputational, AML/CFT, and governance risks.
- Key points:
  - Potential benefits from revenue gains appear considerably smaller than potential costs.
  - Some risks might be mitigated by technology, but others require institutional changes.
  - Widespread use of the SOV as a means of exchange would require significant costs to upgrade RMI’s telecommunications infrastructure.

### Progress and recommendations to protect financial stability and maintain CBR
- Progress made:
  - Banking Act amended to align AML/CFT provisions with FATF 40 recommendations.
  - First national risk assessment started with World Bank support.
  - Banking Commission re-establishing prudential supervision framework and undertaking regulatory reform with PFTAC assistance.
  - BOMI is strengthening AML/CFT controls (software upgrade) and undertaking an independent audit of its AML/CFT system.
  - Authorities support BOMI’s effort to obtain U.S. Federal Reserve approval to establish a clearing house in Hawaii to gain direct access to check-clearing and wire transfer services in the U.S.
  - Association Law amended November 2017 to require reasonable measures to identify beneficial owners and register bearer shares.
- Staff’s further recommendations to lower CBR loss risk (irrespective of SOV issuance):
  - AML/CFT:
    - Complete the national risk assessment and develop an action plan to address main risks identified.
    - Strengthen domestic AML/CFT capacity with international technical assistance.
    - Impose AML/CFT obligations on relevant registries (offshore and maritime) and ensure requirements for beneficial ownership transparency are fully implemented (including existing legal persons and prior bearer shares).
    - Ensure competent authorities have timely access to up-to-date beneficial ownership information of non-resident companies.
  - Banking supervision:
    - Enhance prudential banking supervision framework and comply with relevant international standards.
    - Introduce prudential requirements covering key banking risk areas and strengthen implementation.
    - Regularize offsite supervision and banking sector report production to monitor developments and act timely.
    - Introduce a ceiling on the debt service ratio to help control household debt, which is mostly consumer credit and amounts to about 40 percent of GDP.
  - Cooperation:
    - Further enhance communication with the last U.S. dollar correspondent bank and U.S. regulators, especially given the potential impact of SOV issuance on RMI’s ML/FT risk profile.

*IMF staff report: Republic of the Marshall Islands (excerpt).*

### 16.      The authorities agreed on the need to further strengthen financial supervision and

### 16.      The authorities agreed on the need to further strengthen financial supervision and 

### Financial supervision and AML/CFT
- Framework for onsite and offsite AML/CFT supervision of financial institutions was strengthened with technical assistance.
- The BOMI was recently inspected and found to have put in place the main pillars for effective AML/CFT controls.
- Strengthening of the financial intelligence unit’s technical expertise and new requirements to identify the beneficial owners of offshore companies helped ease the short-term risk of losing the last U.S. dollar CBR.
- The enactment of the law on the digital currency in February 2018 increased the country’s risk profile and raised the risk of the CBR not being renewed if the digital currency is issued without adequate AML/CFT measures.

### Securing long-term fiscal sustainability — Compact Trust Fund (CTF)
- CTF set up in FY2004 to compensate for the expiring portion of the U.S. Compact grant after FY2023.
- CTF assets amounted to US$357 million (203 percent of GDP) as of the end of FY2017.
- CTF assets projected to reach US$615 million (230 percent of GDP) by the end of FY2023.
- Fund design expects investment earnings will replace the expiring portion of the U.S. Compact grant after FY2023, although it does not provide for real value preservation.

### Fiscal adjustment scenarios and risks
- With fiscal adjustment of 4 percentage points of GDP relative to the baseline by FY2023, real value preservation for the CTF could be achieved and risks to long-term fiscal sustainability reduced.
- Reinvesting a portion of investment earnings rather than using them for revenue purposes would be sufficient to achieve real value preservation.
- Drawing on 3 percent of the CTF assets annually rather than the full investment return of 5 percent would require a fiscal surplus of 2½ percent of GDP (US$7 million) by FY2023 to absorb the revenue loss implied by the expiring U.S. Compact grant (US$27 million, 10 percent of GDP).
- Without this adjustment, the government would need additional external financing to maintain government spending on the baseline path, endangering long-term fiscal sustainability.

### Staff recommended multi-pronged fiscal measures (priority order)
- Reverse the recent increase in recurrent spending (3½ ppt) while improving revenue administration and implementing tax reform (½ ppt).
- Expenditure compression:
  - Support to lower recurrent spending, including costs of travel, supplies and personnel, while preserving spending on health and education.
  - Recently proposed ceilings for ministries’ recurrent spending (yet to be approved by the Cabinet) should discipline total expenditure.
- Revenue administration:
  - Continue progress in registration, filing, and payment voluntary compliance.
  - Recommended PFTAC-supported measures include: (i) further improving information exchange between Social Security Administration and the government to increase taxpayer registration, (ii) improving return and payment collection processes, and (iii) strengthening tax audits.
- Tax reform:
  - Enact tax reform bill including: (i) reforming the personal income tax; (ii) introducing a net profits tax; (iii) introducing a consumption tax to replace the gross revenue tax; and (iv) replacing existing import duties with excise taxes.
  - Reform package expected to be revenue neutral but less-distortionary and growth-friendly; could bring additional revenues from efficiency improvement.
  - Authorities should increase implementation capacity with international institutions, including PFTAC.

### Medium-term fiscal framework (MTFF), PFM, and social security
- MTFF:
  - Prepare multi-year budget framework and refine it (with PFTAC assistance), improve baseline revenue estimates, and introduce a new ministries’ budget submission template classifying expenditure by output and expenditure type.
- PFM:
  - Improve legal and policy framework, budgeting framework, accounting system, fiscal reporting, and cash management.
  - Strengthen debt management function given growing appetite for project loans.
- Social security:
  - Recent reform includes gradual increase of retirement age to 65 and increase of the contribution rate by 1 percent, expected to generate annual savings of more than US$4 million (2 percent of GDP).
  - Remaining annual financing gap of about US$3 million will widen over the medium to long term; more ambitious reform (further reduction in benefits) is needed.

### Authorities’ view on fiscal outlook
- Authorities broadly agreed that fiscal adjustment of 4 percentage points of GDP by FY2023 was needed to prepare for the reduction of the U.S. Compact grant.
- Acknowledged fiscal balance had not improved in recent years despite large revenue gains from fishing license fees; recurrent spending containment necessary to avoid medium-term deterioration.
- Noted larger adjustment might be required if negative shocks materialize, including natural disasters.
- Emphasized progress in fiscal reforms, including social security reform, and intention to pursue further reforms (revenue mobilization, PFM, growth-friendly tax reforms) and seek additional donor contributions to the CTF.

### Climate change adaptation and fiscal implications
- RMI one of the countries most affected by climate change due to low elevation and exposure to droughts and floods.
- Historical data indicate average likelihood of a severe natural disaster is 5.4 percent per year, with about 25 percent of total population being affected by a severe disaster event.
- Staff estimates expected annual GDP growth would be lower by about 0.1 percent if baseline projection is adjusted for expected impact of severe natural disasters.
- In case of a one-time extreme disaster event, annual GDP growth could be lower by about 2 percentage points compared to the baseline; LIC-DSA indicates debt-to-GDP ratio could rise further by about 5 percent.
- Climate-change adaptation costs estimated to be about 2½ percent of GDP per year.
- Staff recommends recognizing these costs explicitly in the budget and the medium-term fiscal framework to ensure continuity and efficiency in spending and funding.
- Staff encourages continuation of climate resilience projects (with World Bank and Green Climate Fund) to strengthen early disaster warning system, improve coastal protection and planning, promote renewable energy, and provide contingency funds for emergency response to medium-size hazards.

### Promoting sustainable growth — SOE reform and private sector
- SOE reforms should be fully implemented.
- Subsidies to SOEs rose from 5¾ percent of GDP in FY2014 to 7½ percent in FY2017, indicating deteriorating budget discipline.
- Staff welcomes establishment of SOE monitoring unit within the Ministry of Finance to oversee implementation of the SOE Act and estimate costs for community service obligation (CSO).
- Staff recommends reducing subsidies to SOEs that are not justified by CSOs to help fiscal consolidation and free up resources.
- Business environment constraints: remoteness, small economic size, geographical dispersion, poor regulatory framework.
- World Bank ease of doing business survey indicates RMI lags peers in registering property and resolving insolvency.
- Staff recommends land registration reforms to help collateralize properties and lower hurdles for long-term land leases by nonresidents to facilitate foreign direct investment.
- Authorities plan to accelerate SOE reforms, focus SOE monitoring unit on four SOEs to develop CSO frameworks, and consider novel approaches in land registration reform. Skilled labor shortage due to migration to the U.S. remains a hurdle.

### Data and statistical capacity
- Progress in improving domestic capacity for independent national account data compilation due to PFTAC TAs and trainings.
- Staff encourages continued cooperation with PFTAC for independent national accounts compilation and moving to independent BOP compilation over the medium term.
- Staff recommends development of standard financial soundness indicators for the overall banking sector.

### Staff appraisal — outlook, risks, and policy priorities
- Outlook:
  - Economic activity rebounded in FY2016 and growth accelerated in FY2017 driven by fisheries and construction; growth expected to remain robust in near term from infrastructure investment.
  - External sector broadly in line with fundamentals but vulnerable to risks from fiscal adjustment challenges, unresolved AML/CFT issues, and planned issuance of digital currency.
- Risks:
  - Overall risks tilted to the downside.
  - Issuance of a decentralized digital currency as a second legal tender without adequate risk-mitigating measures would increase macroeconomic and financial integrity risks and elevate risks of losing the last U.S. dollar CBR.
  - Inadequate fiscal consolidation before reduction of the U.S. Compact grant in FY2023 is the main medium- to long-term risk.
- Digital currency:
  - Unless strong AML/CFT measures are implemented, issuance of the SOV will elevate risks of losing the last U.S. dollar CBR.
  - SOV issuance in absence of a monetary policy framework could produce monetary instability and pose significant macroeconomic management challenges.
  - Potential benefits from revenue gains appear considerably smaller than potential costs from economic, reputational, AML/CFT, and governance risks.
  - Staff advises authorities to seriously reconsider issuance of the digital currency as a second legal tender.
- Financial sector policy:
  - Additional steps needed to strengthen AML/CFT framework, develop an action plan following the national risk assessment, strengthen domestic AML/CFT capacity, and impose AML/CFT obligations on offshore and maritime registries.
  - Prudential banking supervision should be further enhanced, including compliance with relevant international standards and introduction of prudential requirements covering key banking areas.
- Fiscal policy:
  - Fiscal adjustment of 4 percentage points of GDP relative to the baseline by FY2023 is needed.
  - Multi-pronged efforts required: reverse recent increase in recurrent spending, improve revenue administration, implement tax reform, and accelerate MTFF and PFM reforms.
- Climate change and SOE recommendations reiterated.
- Data:
  - Continue progress on independent national accounts and move to independent BOP compilation.

*Source: IMF staff report (Republic of the Marshall Islands) contained in content unit cr18270.*

### Box 2. Social Security Reform

### Box 2. Social Security Reform

### Reform measures adopted in FY2017
- Increase in the contribution rate by 1 percentage point (from 7 to 8 percent) for both employers and employees.
- Gradual increases in retirement age from 60 to 65 years old (by 1 year every two years).
- Increase in the maximum annual taxable income from US$20,000 to US$40,000.
- Reduction in benefit for those receiving US$300 or more per month, among other measures.

### Projected fiscal and fund impacts
- The reform is projected to produce annual fiscal savings of more than US$4 million (2 percent of GDP).
- SSF reserves improved from US$66 million in FY2016 to US$72 million in FY2017, supported by favorable investment returns and government subsidies.
- The remaining gap between benefits and contributions was about US$3 million in FY2017.
- If the government would not provide subsidies, SSF reserves would start declining from FY2021.

### Remaining challenges and policy implications
- Despite improvements, more ambitious reforms are needed to put the social security system on a sustainable path over the medium to long term.
- The remaining gap between benefits and contributions is projected to further increase over the medium to long term, posing additional fiscal burdens.
- Given that about 90 percent of current beneficiaries have received more than what they contributed, the authorities intend to focus on further reduction in benefits.

*Prepared by Kazuaki Miyachi.*

### Appendix I. The Compact Trust Fund and Its Long-Term Outlook

### Appendix I. The Compact Trust Fund and Its Long-Term Outlook

### Overview
- The Compact Trust Fund (CTF) was created in 2004 to contribute to the long-term budgetary self-reliance of the RMI.
- The CTF aims to provide a stable source of revenue to compensate for the reduction of US Compact grants after FY2023. This reduction will amount to US$27 million (about 10 percent of GDP) in FY2024.
- To preserve the value of the fund in real terms, medium-term fiscal adjustment of about 4 percentage of GDP is needed.

### Fund structure and contributions
- Withdrawals:
  - Contributions to the CTF are not available for withdrawal prior to FY2024.
  - From FY2024 onwards, annual investment earnings from the CTF can be withdrawn to finance budget needs up to a limit.2
  - In years when investment earnings are not sufficiently high, the C account of the fund can be used to make up for the shortfall.3
  - A separate Account D (contributed to by the RMI and Taiwan POC) can be used as a buffer as long as its assets exceed US$10 million.
- Fund value and contributions:
  - Value of the CTF (excluding the D account) was US$357 million as of end-FY2017.
  - Of this US$357 million, US$219 million came from contributions by the U.S. (US$161 million), the RMI (US$33 million), and Taiwan POC (US$26 million).
  - The D account amounted to US$13 million as of end-FY2016.
- Drawdown and caps:
  - Annual distributions from the CTF, starting in FY2024, can only come from investment earnings from the previous year up to a maximum limit equivalent to expired grant assistance amount as of FY2023, fully adjusted for inflation.2
  - Investment earnings above 6 percent are transferred to the C account of the fund. The C account is capped at three times the projected grant assistance in FY2023. As of end-FY2016, it held US$59.8 million (about 2.2 times of the projected amount).3

### Fund performance and governance
- Investment strategy (adjusted in 2014):
  - 30 percent in U.S. equities
  - 30 percent in international equities
  - 20 percent in fixed income
  - 20 percent in alternative investments
- Performance:
  - As of end-FY2016, the fund’s average annual nominal return rate since inception was 6.7 percent, net of fees.
- Governance:
  - The CTF is administered by an independent committee that exercises oversight and fiduciary responsibility over the fund (except for the D account).
  - Committee appointments: four voting members appointed by the United States (from Departments of Education, Interior, and State), two by the RMI, and one by Taiwan POC.
  - State Street Bank is the custodian bank and Mercer Investment Management is the professional investment advisor.

### Scenarios and projections
- Two scenarios assessed: Baseline scenario and Policy action scenario.
- Baseline scenario:
  - Assumes the CTF earns a 5 percent nominal return annually from FY2018 onwards.
  - Distribution from estimated assets for FY2024 would generate sufficient income to fully offset the revenue loss implied by the expiring Compact grants (US$27 million).
  - Under this scenario, the real value of the CTF will likely decline over time and long-term self-sufficiency would not be secured.
- Policy action scenario:
  - Government undertakes a fiscal adjustment of about 4 percentage of GDP over the medium term (from FY2018 to FY2023) to build an overall fiscal surplus of 2½ percent of GDP (about US$7 million) by FY2023.
  - Under this course of action, drawdowns from the CTF can be contained at around 3 percent (about US$20 million) of fund balances.
  - The remaining 2 percent of fund balances can be preserved in the CTF, enabling maintenance of the real value of the CTF (with about 2 percent inflation adjustment).
- Alternative assumptions shown in staff charts:
  - Baseline: Assume 5 percent return from FY2018, with no fiscal adjustment.
  - Policy action: Assume 5 percent return from FY2018, achieve fiscal surplus of 2.5 percent by FY2023.
  - Lower return: Assume 4 percent return from FY2018, achieve fiscal surplus of 2.5 percent by FY2023.
  - (Additional chart notes present slightly different fiscal surplus assumptions of 2.8 percent in some figures.)

### Sensitivity to investment returns and risks
- Volatility and sensitivity:
  - CTF investment returns are highly volatile; scenario outcomes are sensitive to return assumptions.
  - Staff estimates: a permanent decrease in expected returns of 1 percentage point (from 5 to 4 percent) would increase the fiscal adjustment need by 2¼ percentage point of GDP from the recommended policy action scenario.
- GAO projection:
  - The U.S. Government Accountability Office (GAO) projected that, with a 15 percent probability, the CTF would not be able to disburse any funds in 1 or more years during the first decade due to return volatility, underscoring the importance of further building assets in the CTF.4
- Fiscal shortfall from lower returns:
  - Persistent low rates of return on CTF: The revenue shortfall would be US$2½ million (about 1 percent of GDP) in FY2024 if the expected return on the CTF assets is lower by 1 percent permanently.
  - Policy response: Secure additional contributions to the CTF from donors; for temporary lower return, seek budget support from WB/ADB if temporary spending cuts are not enough.

### Policy recommendations (from scenarios and analysis)
- Undertake medium-term fiscal adjustment of about 4 percentage of GDP (FY2018–FY2023) to preserve the real value of the CTF and build fiscal buffers.
- Aim to build an overall fiscal surplus of 2½ percent of GDP (about US$7 million) by FY2023 under the policy action scenario.
- Contain drawdowns from the CTF at around 3 percent (about US$20 million) of fund balances to preserve roughly 2 percent of fund balances for real-value maintenance (with about 2 percent inflation adjustment).
- Secure additional contributions to the CTF from donors to reduce vulnerability to investment-return volatility.

### Key statistics and exact figures
- Reduction of US Compact grants in FY2024: US$27 million (about 10 percent of GDP).
- CTF value (excluding D account) as of end-FY2017: US$357 million.
- Contribution breakdown of US$219 million:
  - U.S.: US$161 million
  - RMI: US$33 million
  - Taiwan POC: US$26 million
- D account as of end-FY2016: US$13 million.
- C account as of end-FY2016: US$59.8 million (about 2.2 times the projected amount).
- Fund average annual nominal return since inception (as of end-FY2016): 6.7 percent, net of fees.
- Assumed nominal return in baseline and policy scenarios: 5 percent from FY2018 onwards.
- Sensitivity: permanent 1 percentage point lower return (5→4 percent) raises fiscal adjustment need by 2¼ percentage point of GDP.
- Policy action fiscal-surplus target by FY2023: 2½ percent of GDP (about US$7 million).
- Contained drawdown under policy action: around 3 percent (about US$20 million) of fund balances.
- Inflation adjustment targeted for preserving real value: about 2 percent.

*Source: Prepared by Kazuaki Miyachi; Fund staff estimates.*

### 13.  Recent  TA  work

### 13.  Recent  TA  work

### Technical assistance outcomes: fiscal frameworks and statistics
- Public sector consolidation: elements successfully mapped to GFSM 2014 to enable public sector consolidation.
- Monetary statistics:
  - A reporting system established for domestic banking institutions based on monthly reporting forms and guidelines developed by the 1993 STA mission.
  - Data are reported by banks to the Banking Commissioner but are not published or reported to the Fund.
  - Tables on basic balance sheet items as well as income and expenses are prepared for inclusion in the Annual Compact Report.
- Balance of payments:
  - EPPSO made important progress in improving Marshall Islands’ ESS during the JSA ESS Project.
  - BPM6 was adopted and balance of payments and IIP statistics started to be submitted to STA in 2014.
  - EPPSO implemented a unit dedicated to compilation of statistics and took over ownership of ESS compilation; compilation is currently conducted solely by external consultants.
  - The EPPSO unit is staffed by a sole compiler and some reliance on consultants remains.
  - Further actions needed by EPPSO to collect proper data on:
    - external debt statistics (EDS),
    - foreign direct investment (FDI) statistics,
    - banks’ external assets and liabilities.

### Data standards and reporting
- Does not participate in the IMF’s General Data Dissemination System.
- No data ROSC is available.
- Reporting to STA (Optional): BOP data is reported to STA by EPPSO.

### Table of Common Indicators Required for Surveillance (As of July 2018) — selected entries
- Exchange Rates: Date of Latest Observation Jun 2018; Date Received Jun 2018; Frequency of Data D; Frequency of Reporting D; Frequency of Publication D.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of Latest Observation FY2016; Date Received Aug 2017; Frequency of Data A; Frequency of Reporting A; Frequency of Publication A.
- Consolidated Balance Sheet of the Banking System: Date of Latest Observation FY2016; Date Received Aug 2017; Frequency of Data A; Frequency of Reporting A; Frequency of Publication A.
- Consumer Price Index: Date of Latest Observation FY2016; Date Received Aug 2017; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q.
- General Government and Central Government revenue/expenditure/balance: Date of Latest Observation FY2016; Date Received Aug 2017; Frequency of Data A; Frequency of Reporting A; Frequency of Publication A.
- Gross External Debt: Date of Latest Observation FY2016; Date Received Aug 2017; Frequency of Data A; Frequency of Reporting A; Frequency of Publication A.
- International Investment Position: Date of Latest Observation FY2016; Date Received Aug 2017; Frequency of Data A; Frequency of Reporting A; Frequency of Publication A.
- Frequency codes: Daily (D), Weekly (W), Monthly (M), Quarterly (Q), Annually (A); Irregular (I); Not Available (NA).

### Debt Sustainability Analysis — key findings
- Overall assessment:
  - The 2018 DSA assesses that the Republic of the Marshall Islands (RMI) remains at high risk of debt distress.
  - Ratios of the PV of external public and publicly-guaranteed (PPG) debt to GDP and to exports are currently just below their respective policy-dependent indicative thresholds.
  - The PV of the PPG debt-to-GDP ratio is expected to decline slightly in the near term, but to start increasing and exceed its indicative threshold in the medium to long term.
  - Stress tests confirm vulnerability of the debt position to lending terms and macroeconomic shocks.
  - Although RMI does not currently face debt servicing risks—helped by fishing license revenue and a stable flow of U.S. Compact grants until FY2023—a lack of fiscal buffers after FY2023 and contingent liability risks call for a fiscal reform strategy.
  - Containing the risk of debt distress requires continuation of grants and implementation of fiscal and structural reforms.

### Background and recent debt profile
- Historical trajectory:
  - External PPG debt declined from 74 percent of GDP in FY2002 to 38 percent in FY2017.
  - About two-thirds of outstanding debt is central government debt with the ADB; the remainder is SOE debt guaranteed by the government.
  - Total debt service amounts to US$7 million in FY2018 and remains broadly stable over the medium term.
  - All loans denominated in U.S. dollars.
  - Private sector accounts for about 6 percent of total external debt.
- Fiscal dependency and Compact grants:
  - RMI dependent on external grants and fishing license fees to finance public spending.
  - A portion of Compact grants disbursed into the Compact Trust Fund (CTF) to generate investment earnings to replace expiring Compact grants after FY2023.
  - Current CTF trajectory is not on track to preserve the real value of the CTF (with about 2 percent inflation adjustment), highlighting risk of widening financial gaps.

### Underlying assumptions (macroeconomic and fiscal)
- Macroeconomic baseline:
  - Real GDP growth in the long run projected at 1.5 percent (incorporates potential effects of natural disasters).
  - GDP deflator expected to stabilize at around 1 percent in the long run.
- Fiscal outlook:
  - Overall fiscal surplus expected to decline gradually and turn into a deficit of 1.3 percent of GDP by FY2023, when U.S. Compact grants expire.
  - Compact grants in real terms projected to decrease as scheduled.
  - Grants from other donors and fishing license fees assumed stable in nominal terms but declining as a share of GDP.
  - Tax revenue-to-GDP ratio assumed broadly unchanged (baseline does not incorporate tax reforms).
  - Investment earnings from the CTF intended to replace the expiring portion of the U.S. Compact grants; projected CTF income cited as US$27 million but long-term self-sufficiency will not be secured because the real value of the CTF will decline over time.
  - Total expenditure peaked at 65 percent of GDP in FY2017 and projected to remain around 62–65 percent of GDP until FY2023.
  - Beyond FY2023, total expenditure projected to decrease to 58 percent of GDP in FY2033 as grants and fishing license fees decline as percent of GDP.
- External sector:
  - Current account deficit (including official current transfers) expected to worsen from 0.3 percent of GDP in FY2017 to 3.1 percent of GDP by FY2023 due to import demand for infrastructure while fishing license fees remain stable in nominal terms.
  - Financing gap assumed to be closed by bilateral loans and multilateral concessional lending; additional support from IDA and ADB assumed on credit terms.

### Incorporating the impact of natural disaster
- Vulnerability:
  - Average likelihood of a severe natural disaster is 5.4 percent per year, with about 25 percent of total population affected by a severe disaster event (Emergency Events Database).
- Modeling in DSA:
  - Baseline assumes no natural disasters for FY2018–2023, consistent with IMF Board Paper guidance.
  - Baseline projections after FY2023 adjust long-term growth downward by 0.1 percentage points to 1.5 percent (compared with a non-disaster potential growth rate of 1.6 percent) to account for average annual impact of natural disasters.
  - A one-off extreme natural disaster scenario (based on Lee, Zhang and Nguyen, IMF WP/18/108) assumes:
    - Decrease in real GDP growth by 2 percentage points,
    - Increase in the trade deficit by 5 percent of GDP,
    - Increase in public expenditure by 5 percent of GDP in the near term.

### External debt sustainability projections and stress tests
- Baseline projections:
  - PV of external debt-to-GDP ratio expected to ease in near term but to start increasing and exceed the threshold of 30 percent from FY2022.
  - PV of external debt-to-exports ratio expected to increase and remain above the threshold of 100 percent during most of the projection period.
  - Debt service relatively contained due to concessional terms, but debt service-to-exports ratio will gradually approach the indicative threshold by the end of the projection period because of continued debt accumulation.
- Alternative scenario:
  - If RMI continues to benefit from grant-only status, PV of debt-to-GDP ratio would gradually decline and stay below the threshold throughout the projection period.
- Stress tests:
  - Debt dynamics are particularly sensitive to changes in the terms of new lending.
  - Other stress scenarios, including the severe natural disaster scenario, illustrate vulnerability to external shocks.

### Public debt dynamics and policy implications
- Public debt projections:
  - PV of total public debt-to-GDP ratio projected to increase from 29 percent of GDP in FY2017 to 50 percent of GDP in FY2028, exceeding the benchmark of 38 percent.
- Sensitivity to fiscal policy:
  - Holding the annual primary surplus at the FY2018 level of 2.6 percent (versus projected average of 0.2 percent for FY2018–FY2028) would decrease the PV of public debt-to-GDP ratio by 13 percentage points in FY2028.
  - Fiscal consolidation early in projections would substantially improve debt sustainability prospects.
- Recommended fiscal measures:
  - Unwind surge in recurrent spending.
  - Improve revenue administration.
  - Implement growth-friendly tax reforms.

### The authorities' views and planned actions
- Authorities agree with DSA assessment that risk of debt distress is high.
- Need to build adequate fiscal buffers by FY2023 through fiscal adjustment to preserve real value of CTF after reduction of U.S. Compact grant.
- Ongoing fiscal reforms emphasized:
  - Revenue mobilization,
  - Targeted expenditure cuts,
  - Public finance management reforms.
- Authorities seeking additional concessional loans and grants from bilateral donors and IFIs to partly offset reduction in U.S. Compact grants.
- Authorities recognize need to comply with non-concessional borrowing policies to secure grant support from WB and ADB.

*Source: cr18270 - 13.  Recent  TA  work*

### 10.      The standard DSA framework for LICs suggests that the RMI is at high risk of debt distress.

### 10.      The standard DSA framework for LICs suggests that the RMI is at high risk of debt distress.

### Summary findings and risk assessment
- The baseline scenario indicates that the PV of PPG external debt-to-GDP ratio would breach the indicative threshold during most of the projection period.
- Stress tests suggest that RMI’s external PPG debt trajectory could even worsen under shocks.
- RMI is assessed as being at high risk of debt distress.

### Factors mitigating vulnerability
- The decline in external support from the Compact grants will be gradual, sheltering the country from the risk of a sudden stop in foreign financing.
- The government is building up the CTF that will provide a stable source of funding after FY2023.
- RMI currently benefits from its grant-only status.

### Factors exacerbating vulnerability
- Lack of fiscal buffers.
- Uncertainty about prospective SOE losses.
- Volatility in CTF investment returns.
- Contingent liabilities from climatic events and the social security system.

### Policy recommendation
- The government needs to implement fiscal and structural reforms to generate sufficient fiscal surpluses by FY2023 to shore up the CTF while safeguarding social spending and economic growth.

### Key statistics and projections (selected, preserved exactly as reported)
- PV of PPG external debt (in percent of GDP): ......29.0 26.9 25.7 26.3 27.6 29.6 32.4 50.2 85.7
- PV of external debt (in percent of exports): ......106.7 98.5 94.4 96.4 100.6 107.3 116.0 175.3 291.2
- PV of PPG external debt (in percent of exports): ......98.4 90.6 86.7 88.9 93.4 100.2 109.2 169.2 286.5
- PV of PPG external debt (in percent of government revenues): ......75.6 86.8 84.5 87.8 93.6 102.0 112.9 135.1 254.2
- Debt service-to-exports ratio (in percent): 11.4 13.0 10.7 10.2 10.9 9.3 9.4 9.4 9.4 9.7 14.6
- PPG debt service-to-revenue ratio (in percent): 15.3 10.9 8.2 9.8 10.6 9.2 9.4 9.5 9.7 7.8 12.9
- Grant-equivalent financing (in percent of GDP): .........32.5 32.3 32.2 32.1 32.1 21.1 19.1 16.8 18.6
- Grant-equivalent financing (in percent of external financing): .........98.5 95.3 91.7 89.9 88.4 86.9 78.4 75.9 78.0
- Government revenues (excluding grants, in percent of GDP): 27.5 32.2 38.4 31.0 30.5 29.9 29.4 29.0 28.7 37.2 33.7 36.2
- Aid flows (in Millions of US dollars): 58.7 59.1 65.9 75.8 80.5 86.2 90.5 94.6 98.7 73.3 85.0
  - of which: Grants: 58.7 59.1 65.9 73.8 72.9 71.8 71.7 71.7 71.6 39.1 43.0
  - of which: Concessional loans: 0.0 0.0 0.0 2.0 7.6 14.4 18.8 22.9 27.2 34.2 42.0
- Nominal GDP (Millions of US dollars): 181.3 196.3 222.3 229.9 237.7 245.8 253.8 260.7 267.4 300.2 383.1
- PV of PPG external debt (in Millions of US dollars): 64.6 61.9 61.2 64.6 70.0 77.2 86.6 150.8 328.5
- Gross workers' remittances (Millions of US dollars): 7.7 8.6 9.6 10.0 10.3 10.6 11.0 11.3 11.6 13.0 16.6

### Stress-test and scenario results (high-level)
- Most extreme stress tests (various shocks identified in figures and tables) raise debt indicators significantly on or before 2028 (examples of shocks: Terms shock, Exports shock, One-time depreciation shock, Severe Natural Disaster 2019).
- Sensitivity tables show large increases in PV of debt-to-exports, PV of debt-to-revenue, and PV of debt-to-GDP under adverse scenarios (specific scenario values are reported in the tables).

*Source: Statement by the Staff Representative on Republic of the Marshall Islands, September 5, 2018.*

### 1. This statement contains information that has become available since the staff report

### 1. This statement contains information that has become available since the staff report

### Recent data and macroeconomic outturns
- GDP growth in FY2017 was 3.8 percent, driven by a strong pick up in fisheries (contributing 0.9 percentage points) and continued strong construction growth (contributing 0.8 percentage points).
- The current account surplus narrowed to 3.7 percent of GDP in FY2017 on rising infrastructure-related imports.
- The overall fiscal balance improved slightly to 4.5 percent of GDP in FY2017 on strong fishing license revenues.

### Statement context and country characteristics
- Statement by Grant Johnston, Alternate Executive Director for Republic of the Marshall Islands and Gwibeom Kim, Advisor to the Executive Director, September 5, 2018.
- RMI comprises small, sparsely-populated and low-lying atolls and islands spread across 750,000 square miles of the Pacific Ocean.
- Grants make up around half of government revenue.
- RMI is very low lying, with an average elevation of only 2 meters, and is regularly affected by flooding, storms and drought.

### Economic outlook
- RMI’s economy has recovered from recession; a severe drought in 2016 affected agriculture, especially copra production, but there has been a pick-up in construction work related to schools, hospitals and government buildings.
- Authorities note staff’s medium-term growth projection of around 1.5 percent.
- Authorities consider climate change to be one of the main risks to the outlook, as extreme weather episodes have adversely affected the country in recent years.

### Fiscal sustainability and Compact financing
- Many current grants under the Compact of Free Association with the United States are set to expire; from 2024 these will be replaced by ongoing distributions from the Compact Trust Fund (CTF).
- The current track for contributions, together with expected investment returns, is not enough to ensure that the CTF can replace the expiring grants each year and also maintain the Fund’s real value over time.
- Authorities agree a significant fiscal adjustment is needed ahead of 2024 and have undertaken reforms to reduce expenditure pressures.
  - Social security reforms adopted in 2017 include an increase in the retirement age to 65 by 2025 and greater contributions by both employers and workers.
  - Public financial management reforms target accounting systems and reporting, the budgeting framework, procurement systems, tax administration and the management of non-tax revenue.
  - To contain recurrent expenditure, authorities are seeking Cabinet’s endorsement of expenditure ceilings before each ministry submits their budget estimate.
  - RMI has introduced a medium-term budget framework with a three-year horizon and will commence work on a long term fiscal framework in fiscal year 2019.
- Authorities would value additional donor contributions to the CTF.

### State-owned enterprises and revenue sources
- SOEs make up a significant portion of the economy but persistently make losses, partly due to the cost of providing electricity and transport services to remote islands.
- Authorities agree on the need to accelerate SOE reforms to reduce overall government subsidies and clarify remaining subsidies tied to community service obligations.
- An SOE monitoring unit has been established in the Ministry of Finance; initial focus will be on four SOEs – the airline, shipping, copra processing, and energy companies – to improve their performance.
- RMI receives considerable revenue from fishing license fees and also gets income from offshore corporate services and ship registration.
  - Fishing license revenue has increased significantly since the introduction of the Vessel Day Scheme benchmark price.
  - Domestic tax revenue has also risen, and tax administration has been strengthened.
  - Authorities appreciate technical assistance on tax reform and would welcome more, including lessons on the introduction of VAT.

### Climate change and external assistance
- RMI is expected to be one of the countries most affected by climate change and rising sea levels.
- Several climate-related projects are underway as part of the joint national action plan for climate change adaption and disaster risk management.
- Authorities request support for climate mitigation and adaption projects in addition to donor contributions to the CTF.

### Financial sector developments and risks
- The potential loss of the country’s remaining correspondent banking relationship is a very significant concern.
- Authorities amended the Banking Act to strengthen the legal framework for AML/CFT supervision in line with international standards.
- A national risk assessment is in progress with World Bank technical assistance.
- The Banking Commission has been working with PFTAC on improving monitoring:
  - Off-site monitoring has been implemented based on existing manuals, including submission of financial information on a regular basis.
  - On-site monitoring was performed for the Bank of Marshall Islands in February and is being planned for the Bank of Guam.
  - The Banking Commission is working on a financial sector development plan.
- Government concerns include high consumer debt, low financial literacy, and consumer lending practices by banks and lenders.

### Cryptocurrency (SOV) proposal and conditions
- RMI intends to issue a cryptocurrency – the SOV – as a second legal tender, alongside the US dollar, in partnership with a foreign private sector partner.
- Proposed issuance process and intended use of proceeds:
  - The foreign partner would share the first issuance of SOV with RMI before an initial coin offering (ICO) was undertaken.
  - Authorities plan to sell half the RMI’s initial allocation of SOV in the ICO and keep around a quarter in SOV in its trust funds.
  - The remainder would be distributed over time to RMI resident citizens.
- Authorities acknowledge many risks (reputational and CBR) and have created a high-ranking committee to examine all risks, including those raised by the IMF and the US Treasury and public hearings on the legislation.
- Authorities expect it will take a few years to issue the cryptocurrency.
- Issuance conditions: they will only issue the SOV once its use complies with the FATF standard and US regulations, and once its use in transactions in the US financial system has been approved by the US government.

*Statement by Grant Johnston, Alternate Executive Director for Republic of the Marshall Islands and Gwibeom Kim, Advisor to the Executive Director, September 5, 2018*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18270.pdf_