## 1fsmea2019001

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### Key recent developments
- Real GDP growth: 5.0 (FY2015), 0.7 (FY2016), 2.4 (FY2017), 1.2 (FY2018). FY2018 slowdown to 1.2 percent was due to a contraction in construction.
- Employment growth: 0.1 (FY2015), 2.1 (FY2016), 1.5 (FY2017), 1.0 (FY2018); noted as remaining higher than the historical average.
- Inflation: 0.0 (FY2015), -0.9 (FY2016), 0.1 (FY2017), 1.5 (FY2018); low inflation attributed to the use of the U.S. dollar as legal tender.
- Fiscal balances and windfalls:
  - Revenue and grants as percent of GDP: 66.3 (FY2015), 69.1 (FY2016), 79.0 (FY2017), 96.4 (FY2018).
  - Revenue as percent of GDP: 37.1 (FY2015), 35.9 (FY2016), 41.7 (FY2017), 58.2 (FY2018).
  - Tax revenue as percent of GDP: 12.4 (FY2015), 12.9 (FY2016), 17.6 (FY2017), 34.7 (FY2018); corporate income tax component: 1.3 (FY2015), 1.8 (FY2016), 6.3 (FY2017), 22.7 (FY2018).
  - Fishing license fees (non-tax revenue component) as percent of GDP: 20.7 (FY2015), 19.1 (FY2016), 20.0 (FY2017), 19.4 (FY2018).
  - Grants (excluding contributions to the Compact Trust Fund) as percent of GDP: 29.3 (FY2015), 33.2 (FY2016), 37.3 (FY2017), 38.2 (FY2018).
  - Expenditure as percent of GDP: 55.9 (FY2015), 61.8 (FY2016), 64.4 (FY2017), 69.1 (FY2018).
  - Net lending/borrowing as percent of GDP: 10.4 (FY2015), 7.3 (FY2016), 14.6 (FY2017), 27.3 (FY2018).
- Trust funds and external assets:
  - Balance of trust funds (Compact Trust Fund and FSM Trust Fund) as percent of GDP: 145.4 (FY2015), 165.6 (FY2016), 187.4 (FY2017), 224.9 (FY2018); FSM Trust Fund reached 57 percent of GDP in FY2018; Compact Trust Fund rose to 168 percent of GDP.
  - Net international investment position (NIIP) was 130 percent of GDP at end-FY2017.
- External sector:
  - Trade balance (in millions of U.S. dollars): -127.9 (FY2015), -110.3 (FY2016), -120.2 (FY2017), -127.0 (FY2018).
  - Current account (in percent of GDP): 1.6 (FY2015), 3.9 (FY2016), 7.5 (FY2017), 24.5 (FY2018); FY2018 CA surplus surge driven by large corporate tax payments.
- Banking sector: Deposits (as percent of GDP, end of period): 80.3 (FY2015), 77.9 (FY2016), 88.1 (FY2017), 88.2 (FY2018); loans (as percent of GDP, end of period): 13.2 (FY2015), 14.7 (FY2016), 12.9 (FY2017), 13.1 (FY2018).

### Outlook and risks
- Medium-term projections:
  - Growth projected to converge to potential rate estimated at 0.6 percent over the medium term:
    - Real GDP: 0.8 (FY2020), 0.7 (FY2021), 0.6 (FY2022), 0.6 (FY2023), 0.6 (FY2024).
  - Inflation projected to stay at 2 percent over the medium term: 2.0 for FY2020–FY2024.
  - Employment projections: 0.8 (FY2019), 0.2 (FY2020), 0.1 (FY2021), 0.0 (FY2022–FY2024).
- Downside risks:
  - Primary risk: expiration/nonrenewal of the U.S. Compact Agreement arrangements in 2023 would cause loss of access to Compact grants, FDIC banking sector oversight, and post-disaster rehabilitation assistance, creating substantial macroeconomic uncertainty and a fiscal cliff.
  - Climate change: rising sea levels, higher temperatures, and increased frequency/intensity of natural disasters threaten livelihoods and constitute significant downside risks.
- Upside potential:
  - Decisive progress in pro-growth structural reforms could raise potential growth.
  - Renewal of economic supports under the Compact Agreement would reduce downside risks.

### Policy recommendations and priorities
- Fiscal policy:
  - Implement a fiscal adjustment of 4–5 percent of GDP through 2023 to cope with the fiscal cliff.
  - Gradually introduce growth-friendly tax measures (including recommendation to introduce a value added tax (VAT) noted in Board discussion) and rationalize nonessential expenditures while protecting priority spending on education, healthcare, and climate-resilient infrastructure.
  - Continue saving revenue windfalls into the FSM Trust Fund.
- Climate change and disaster resilience:
  - Improve resilience by strengthening capacity to implement adaptation projects.
  - Mitigate disaster risks using disaster insurance and disaster-contingent foreign financing.
  - Develop a disaster resilience strategy and close gaps in preparedness.
- Financial sector:
  - Strengthen domestic banking regulation and supervision capacity in anticipation of possible reduction in FDIC oversight in 2023.
  - Update banking laws, adopt prudential banking regulations, and develop a reform roadmap to strengthen the Banking Board’s supervision of commercial banks.
- Private sector and structural reforms:
  - Vitalize the private sector by improving the business and investment climate, including lowering business startup costs, digitalizing the land registry, and reducing undue regulatory burdens on FDI.
- Capacity and data:
  - Continue use of technical assistance for revenue administration, public financial management, financial sector supervision, and macroeconomic statistics.

### External position assessment
- Underlying current account (CA) balance in FY2018: surplus of 3.4 percent of GDP (after adjusting for windfall corporate tax payments).
- EBA-lite CA norm: 3.9 percent of GDP.
- CA gap: -0.5 percent of GDP.
- Policy gap: about -3 percent of GDP, mostly explained by medium-term fiscal adjustment needs of 4–5 percent of GDP to avoid the FY2024 fiscal cliff.
- Results caveat: heavy dependence on grants and fishing license fees, which can be volatile.

### Fiscal cliff and trust funds
- Baseline fiscal balance projected to remain in surplus through FY2023: surplus projected at 4–7 percent of GDP during FY2020–23 as grants and fishing license fees remain abundant.
- Combined value of CTF and FSMTF projected to reach 322 percent of GDP by FY2023, reflecting scheduled U.S. contributions to the CTF, transfers of budget surpluses to the FSMTF, and nominal rate of return assumed at 5 percent.
- Fiscal cliff risk in FY2024:
  - Compact grants amounting to 20 percent of GDP will expire in FY2023 and be replaced by investment returns accruing to the CTF, projected at around 11 percent of GDP in FY2024.
  - Overall balance projected to turn from a surplus of around 4½ percent of GDP in FY2023 to a deficit of 4½ percent of GDP in FY2024.
  - Distributions limited to investment returns; no distribution allowed in case of negative returns, increasing revenue volatility.

### Staff fiscal consolidation views and measures
- Needed adjustment: gradual fiscal adjustment of 4–5 percent of GDP through FY2023.
  - Expected effect on growth: adjustment can shave off GDP growth by 0.1–0.3 percent annually over FY2020–24; adjustment should be gradual and supported by grants-financed public investment and pro-growth structural reforms.
- Growth-friendly measures to achieve adjustment while preserving essential social spending:
  - Tax policy reforms (including introducing a VAT and selected excises on tobacco, alcohol, and fuel; tightening eligibility on concessional fishing license fees for the domestic fishing industry) — yield: 2.5-3.0 percent of GDP.
  - Tax administration reforms (improve filing rates via new IT system and strengthen audit) — yield: 0.5-1.0 percent of GDP.
  - Limit wage bill growth to 1 percent annually over FY2020–23 (achieved by slower salary increases) — yield: 1.2 percent of GDP; limiting wage bill growth to 1 percent would yield a saving of 1¼ percent of GDP by FY2023.
  - PFM reforms (rationalize goods and services spending via new IT system and improved procurement) — yield: 0.5-1.0 percent of GDP.
- Preserve spending on education, healthcare, and infrastructure (including climate change resilience).
- Save future revenue windfalls into the FSMTF: current rule — at least 50 percent of corporate tax payments and 20 percent of fishing license fees should be saved into the FSMTF.

### Trust fund simulations and scenarios
- Monte Carlo simulations assumptions:
  - Economic growth: long-run real growth rate of 0.6 percent from FY2024; inflation at 2 percent; nominal GDP grows by 2.6 percent annually.
  - Starting values (projected end-FY2023): CTF: US$979 million (231 percent of GDP); FSMTF: US$383 million (90 percent of GDP).
  - Return assumptions: safe asset fixed at 3 percent; risky asset mean 6 percent, standard deviation 18 percent.
- Distribution benchmark scenarios:
  - Scenario 1 (status quo): annual distribution benchmark set at 16 percent of GDP per year in FY2024 and fixed thereafter.
  - Scenario 2 (fiscal consolidation over FY2019–23): annual distribution benchmark set at 11 percent of GDP per year in FY2024 and fixed thereafter.
  - Scenario 3 (further fiscal consolidation beyond FY2023): annual distribution benchmark decreases gradually from 11 percent of GDP in FY2024 to 6 percent of GDP by FY2034 and fixed thereafter.
- Simulation results — key outcomes:
  - Scenario 1: mean combined trust fund path hits zero around FY2048; 18 percent probability of FSMTF value remaining positive through FY2050.
  - Scenario 2: 84 percent probability of combined CTF and FSMTF value remaining positive through FY2050; 62 percent probability FSMTF positive through FY2050; mean combined value decreasing to 135 percent of GDP in FY2050.
  - Scenario 3: sustains mean combined CTF and FSMTF at around 270 percent of GDP over the long run; 96 percent probability FSMTF value positive through FY2050.
- Sensitivity analyses (FY2050 numeric outcomes):
  - Baseline assumptions:
    - Scenario 1: average balance = -20.2 (% of GDP); probability of positive FSMTF = 17.7 (%)
    - Scenario 2: average balance = 135.2 (% of GDP); probability = 61.7 (%)
    - Scenario 3: average balance = 268.3 (% of GDP); probability = 96.1 (%)
  - Lower return for CTF and FSMTF for FY2020-23: 3 percent p.a.
    - Scenario 1: average balance = -90.4 (% of GDP); probability = 0.0 (%)
    - Scenario 2: average balance = 47.3 (% of GDP); probability = 9.9 (%)
    - Scenario 3: average balance = 169.3 (% of GDP); probability = 95.8 (%)
  - Lower safe asset return: 2 percent p.a.
    - Scenario 1: average balance = -47.5 (% of GDP); probability = 11.8 (%)
    - Scenario 2: average balance = 98.6 (% of GDP); probability = 50.9 (%)
    - Scenario 3: average balance = 222.2 (% of GDP); probability = 93.4 (%)
  - Lower expected return for risky asset: 4 percent p.a.
    - Scenario 1: average balance = -68.0 (% of GDP); probability = 7.7 (%)
    - Scenario 2: average balance = 66.3 (% of GDP); probability = 40.3 (%)
    - Scenario 3: average balance = 186.2 (% of GDP); probability = 89.1 (%)
  - Higher standard deviation for risky asset: 23 percent
    - Scenario 1: average balance = -20.7 (% of GDP); probability = 22.2 (%)
    - Scenario 2: average balance = 138.5 (% of GDP); probability = 59.4 (%)
    - Scenario 3: average balance = 270.3 (% of GDP); probability = 92.4 (%)

### Banking sector structure, risks, and supervision
- Sector structure and key statistics:
  - Two commercial banks and one government-owned development bank dominate the FSM’s financial sector.
  - Deposits at the Bank of FSM (BFSM), a domestic commercial bank, and a branch of the Bank of Guam total 90 percent of GDP.
  - Private sector credit low: loan-to-deposit ratio as low as 15 percent; FSM Development Bank (FSMDB) accounts for 30 percent of total private sector credit.
  - FSMDB funded mostly by capital contributed by the national government and retained earnings.
  - As of end-March 2019, BFSM’s tier-1 risk-based capital ratio was 40.4 percent (FDIC-insured banks average 19.7 percent).
- FDIC oversight and related risks:
  - BFSM deposits (~40 percent of total deposits) insured by the FDIC under the Compact Agreement; Bank of Guam also FDIC insured.
  - FSM expected to lose access to FDIC oversight unless service agreement renewed; Compact Agreement’s economic supports set to expire in FY2023.
- Staff supervision and reform priorities:
  - Upgrade legal and regulatory framework for prudential supervision.
  - Strengthen monitoring of commercial banks.
  - Develop reform roadmap for Banking Board.
  - Upgrade Banking Act to address gaps (fit and proper, licensing, corrective/sanctioning powers).
  - IMF and PFTAC TA to support Banking Act upgrade and supervisory reforms.
- FSMDB, credit access, and private sector credit:
  - Main bottleneck: lack of collateral due to land tenure prohibiting non-FSM citizens from owning land; potential use of land lease as collateral not yet practiced.
  - FSMDB lending grew by 15 percent annually over last three years; developed loan guarantee scheme for start-ups.
  - Recommendation: place FSMDB and credit unions under Banking Board supervision.

### Private sector constraints and reform recommendations
- Constraints: remoteness, small size, geographical dispersion; private sector accounts for only a quarter of economic activity.
- Recommendations:
  - Lower business license fees.
  - Reduce time and cost for settling commercial disputes; improve judicial process.
  - Digitalize land registry to make land tenure more business-friendly.
  - Clarify and harmonize FDI regime; upgrade Foreign Investment Act to harmonize FDI laws across states, expand national priority sectors, streamline licensing, and establish national single window.
- Authorities’ actions:
  - Bill to amend Foreign Investment Act to establish a one stop shop for FDI applications and fast-track processing for priority sectors is being prepared.
  - Some state governments embarking on judicial reforms for faster business dispute resolution.

### Data adequacy, capacity building, and TA
- Data shortcomings:
  - Timeliness issues: national accounts and external sector statistics compiled annually with nearly a year lag.
  - GDP not rebased for more than 10 years (current base year FY2004).
  - Expenditure approach to GDP not compiled; fixed ratios used for private sector operating surplus estimates.
  - Employment: annual data from Social Security; unemployment data only for 2013.
  - CPI: quarterly, rebased to 2017Q1, releases often delayed.
  - Monetary statistics: monthly monetary data compiled with a three-month lag; depository survey not using IMF SRFs.
  - External sector: annual BOP and IIP up to 2017; large errors and omissions.
- Capacity building and TA:
  - Banking Board requested training for bank examiners; PFTAC planned training for FY21.
  - FSM implemented e-GDDS in July 2017.
  - PFTAC missions planned for real sector statistics; GFS TA provided in February 2019.
  - Authorities interested in hands-on TA (e.g., manuals for tax administrators).
- e-GDDS timeliness highlights (as of July 8, 2019):
  - Broad Money: Latest observation May 2018; Date received Mar 2019.
  - Consolidated Balance Sheet of the Banking System: Latest observation Apr 2018; Date received Mar 2019.
  - Interest Rates: Latest observation May 2018; Date received Mar 2019.
  - Consumer Price Index: Latest observation End-FY2017; Date received Nov 2018.
  - GDP/GNP: Latest observation FY2017; Date received Nov 2018.
  - External Current Account Balance: Latest observation FY2017; Date received Nov 2018.
  - Stocks of Central Government and Central Government-Guaranteed Debt: Latest observation End-FY2018; Date received Feb 2019.

### Debt sustainability, risks, and DSA findings
- Composite Indicator (CI):
  - CI index = 1.69 (Weak).
  - CI components preserved exactly (CPIA contribution 1.066 (63%), others small).
- DSA projections and risk assessment:
  - External debt-to-GDP (baseline): rises from 12 percent in FY2023 to 30 percent in FY2029 and 57 percent in FY2039; PV of external debt-to-GDP breaches threshold (30 percent) in FY2033.
  - Public debt-to-GDP projected rise: from 12 percent in FY2023 to 43 percent in FY2029 and 67 percent in FY2039; PV of public debt-to-GDP breaches 35 percent threshold in FY2030.
  - Risk of external debt distress: High; Overall risk of debt distress: High.
  - Mechanical DSA ratings moderate over 10-year horizon, but extended 20-year horizon warranted due to fiscal cliff.
- Key DSA metrics (selected):
  - Total public debt (end-FY2018): 76 (Millions of U.S. dollars); In percent of GDP: 20.
  - Debt composition end-FY2018: Multilateral 53 (70% of debt; 14% of GDP), Bilateral 22 (28% of debt; 6% of GDP), Commercial 2 (20% of debt share), Domestic 0.
  - Debt service: total debt service reached 5.8 percent of exports in FY2018.
- Stress tests and tailored natural disaster test:
  - Natural disaster scenario: one-off 10 percentage point shock to debt-GDP in FY2019; real GDP growth lowered by 5.0 percentage points in shock year; exports growth lowered by 3.5 percentage points in shock year.
  - Natural disaster stress test results: PV of external debt-to-GDP rises to 41 percent in FY2029 and 83 percent in FY2039; breach in FY2027 (six years earlier than baseline).
  - Public debt can rise sharply under negative growth and disaster shocks (examples show PV public debt-to-GDP up to 115 percent in FY2039 under extreme shocks).
- Policy implications:
  - Implement fiscal adjustments to lower debt distress risk.
  - Preserve budget space for critical development spending.
  - Strengthen climate change resilience and debt management capacity.

### Executive Board and authorities’ views
- Executive Board highlights:
  - Directors welcomed strong recent performance and improved fiscal/external positions.
  - Noted significant challenges: expected expiration of Compact Agreement, climate vulnerability, weak private sector activity.
  - Emphasized need for steadfast policy actions and reforms to reduce uncertainty and promote private sector-led growth.
  - Recommended gradual fiscal adjustment through revenue mobilization and expenditure efficiency; encouraged VAT and growth-friendly measures; limit wage bill growth and nonessential expenditures; safeguard priority spending.
  - Welcomed joint IMF-World Bank Climate Change Policy Assessment and urged strengthened disaster preparedness and greater use of disaster risk transfer mechanisms.
- Authorities’ views:
  - Broad agreement with staff on outlook and risks.
  - Support using a 20-year forecast horizon in DSA because of expected fiscal cliff.
  - Endorse gradual fiscal adjustment through FY2023; will consider VAT and continue PFM reforms with World Bank and EU support.
  - Continue saving revenue windfalls into FSMTF; disagree with staff recommendation to draw from FSMTF to offset CTF volatility, preferring to build FSMTF further.

### Climate change policy assessment and adaptation simulation
- FSM highly vulnerable: rising sea levels, higher temperatures, increased natural disaster frequency/intensity.
- CCPA progress: Nationally Determined Contribution, national climate change policy, Infrastructure Development Plan (IDP), state-level disaster risk action plans.
- Gaps: no overarching National Adaptation Plan fully integrated with sectoral/state strategies; lack of comprehensive disaster resilience strategy.
- Staff recommendations:
  - Strengthen public investment management and mobilize grant financing for adaptation.
  - Prioritize grant financing given debt vulnerability; strengthen project appraisal and implementation capacity at state level.
  - Increase use of risk transfer mechanisms (e.g., regional parametric schemes under PCRAFI) and broaden disaster-contingent financing.
- Climate impact and adaptation simulation (illustrative):
  - Without adaptation: if a disaster hits in 2030, real GDP declines by 5 percent and public debt rises by 10 percent of GDP.
  - With adaptation (higher adaptation investment over 2020–30): if a disaster hits in 2030, real GDP declines by 3 percent and public debt rises by 4 percent of GDP.
  - Implication: higher adaptation investment lowers reconstruction costs, output losses, and public debt impact.

### Public service efficiency and wage bill recommendations
- Summary conclusion: Slower wage increases combined with public sector efficiency reforms can help long-term fiscal sustainability.
- Key reform recommendations:
  - Simplify job grading and pay structures; draft national bill prepared to simplify pay scales and levels.
  - Consolidate public service: integrate contract positions performing core civil service functions into regular public service under a unified compensation framework; retain noncore contract positions for limited durations.
  - Strengthen performance-based contracts (PBC) in education and health: require clear objectives and performance indicators, data collection/validation systems, and incentives tied to measurable targets.
- Implementation priorities:
  - Align wage growth with fiscal sustainability by slowing wage increases while improving efficiency.
  - Enact draft bill to simplify pay scales.
  - Transition plan to integrate core contract positions into regular public service.
  - Design and pilot PBC framework in education and health with data and incentive mechanisms.

*Source: Federated States of Micronesia: Staff Report for the 2019 Article IV Consultation (text and tables provided).*

### 1.2 percent in FY2018 due to a contraction in construction. Employment growth has also

### 1fsmea2019001 - 1.2 percent in FY2018 due to a contraction in construction. Employment growth has also

### Key recent developments
- Real GDP growth: 5.0 (FY2015), 0.7 (FY2016), 2.4 (FY2017), 1.2 (FY2018). FY2018 slowdown to 1.2 percent was due to a contraction in construction.
- Employment growth: 0.1 (FY2015), 2.1 (FY2016), 1.5 (FY2017), 1.0 (FY2018); noted as remaining higher than the historical average.
- Inflation: 0.0 (FY2015), -0.9 (FY2016), 0.1 (FY2017), 1.5 (FY2018); low inflation attributed to the use of the U.S. dollar as legal tender.
- Fiscal balances and windfalls:
  - Revenue and grants as percent of GDP: 66.3 (FY2015), 69.1 (FY2016), 79.0 (FY2017), 96.4 (FY2018).
  - Revenue as percent of GDP: 37.1 (FY2015), 35.9 (FY2016), 41.7 (FY2017), 58.2 (FY2018).
  - Tax revenue as percent of GDP: 12.4 (FY2015), 12.9 (FY2016), 17.6 (FY2017), 34.7 (FY2018); corporate income tax component: 1.3 (FY2015), 1.8 (FY2016), 6.3 (FY2017), 22.7 (FY2018).
  - Fishing license fees (non-tax revenue component) as percent of GDP: 20.7 (FY2015), 19.1 (FY2016), 20.0 (FY2017), 19.4 (FY2018).
  - Grants (excluding contributions to the Compact Trust Fund) as percent of GDP: 29.3 (FY2015), 33.2 (FY2016), 37.3 (FY2017), 38.2 (FY2018).
  - Expenditure as percent of GDP: 55.9 (FY2015), 61.8 (FY2016), 64.4 (FY2017), 69.1 (FY2018).
  - Net lending/borrowing as percent of GDP: 10.4 (FY2015), 7.3 (FY2016), 14.6 (FY2017), 27.3 (FY2018).
- Trust funds and external assets:
  - Balance of trust funds (Compact Trust Fund and FSM Trust Fund) as percent of GDP: 145.4 (FY2015), 165.6 (FY2016), 187.4 (FY2017), 224.9 (FY2018); FSM Trust Fund reached 57 percent of GDP in FY2018; Compact Trust Fund rose to 168 percent of GDP (text).
  - Net international investment position (NIIP) was 130 percent of GDP at end-FY2017 (text).
- External sector:
  - Trade balance (in millions of U.S. dollars): -127.9 (FY2015), -110.3 (FY2016), -120.2 (FY2017), -127.0 (FY2018).
  - Current account (in percent of GDP): 1.6 (FY2015), 3.9 (FY2016), 7.5 (FY2017), 24.5 (FY2018); FY2018 CA surplus surge driven by large corporate tax payments.
- Banking sector: Deposits (as percent of GDP, end of period): 80.3 (FY2015), 77.9 (FY2016), 88.1 (FY2017), 88.2 (FY2018); loans (as percent of GDP, end of period): 13.2 (FY2015), 14.7 (FY2016), 12.9 (FY2017), 13.1 (FY2018).

### Outlook and risks
- Medium-term projections:
  - Growth projected to converge to potential rate estimated at 0.6 percent over the medium term (table projects Real GDP: 0.8 (FY2020), 0.7 (FY2021), 0.6 (FY2022), 0.6 (FY2023), 0.6 (FY2024)).
  - Inflation projected to stay at 2 percent over the medium term (table: 2.0 for FY2020–FY2024).
  - Employment projections: 0.8 (FY2019), 0.2 (FY2020), 0.1 (FY2021), 0.0 (FY2022–FY2024).
- Downside risks:
  - Primary risk: expiration/nonrenewal of the U.S. Compact Agreement arrangements in 2023 would cause loss of access to Compact grants, FDIC banking sector oversight, and post-disaster rehabilitation assistance, creating substantial macroeconomic uncertainty and a fiscal cliff.
  - Climate change: rising sea levels, higher temperatures, and increased frequency/intensity of natural disasters threaten livelihoods and constitute significant downside risks.
- Upside potential:
  - Decisive progress in pro-growth structural reforms could raise potential growth.
  - Renewal of economic supports under the Compact Agreement would reduce downside risks.

### Policy recommendations and priorities
- Fiscal policy:
  - Implement a fiscal adjustment of 4–5 percent of GDP through 2023 to cope with the fiscal cliff.
  - Gradually introduce growth-friendly tax measures (including recommendation to introduce a value added tax (VAT) noted in Board discussion) and rationalize nonessential expenditures while protecting priority spending on education, healthcare, and climate-resilient infrastructure.
  - Continue saving revenue windfalls into the FSM Trust Fund.
- Climate change and disaster resilience:
  - Improve resilience by strengthening capacity to implement adaptation projects.
  - Mitigate disaster risks using disaster insurance and disaster-contingent foreign financing.
  - Develop a disaster resilience strategy and close gaps in preparedness.
- Financial sector:
  - Strengthen domestic banking regulation and supervision capacity in anticipation of possible reduction in FDIC oversight in 2023.
  - Update banking laws, adopt prudential banking regulations, and develop a reform roadmap to strengthen the Banking Board’s supervision of commercial banks.
- Private sector and structural reforms:
  - Vitalize the private sector by improving the business and investment climate, including lowering business startup costs, digitalizing the land registry, and reducing undue regulatory burdens on FDI.
- Capacity and data:
  - Continue use of technical assistance for revenue administration, public financial management, financial sector supervision, and macroeconomic statistics.

### Executive Board assessment highlights
- Directors welcomed Micronesia’s strong economic performance and improved fiscal and external positions.
- Directors noted significant remaining challenges: expected expiration of the U.S. Compact Agreement, climate change vulnerability, and weak private sector activity.
- Directors emphasized the need for steadfast policy actions and reforms to reduce uncertainty and risks, strengthen resilience, and promote private sector-led growth.
- Directors recommended a gradual fiscal adjustment through domestic revenue mobilization and improved expenditure efficiency, encouraged implementation of growth-friendly tax reforms (including VAT), limited wage bill growth and nonessential expenditures, and safeguarding priority spending.
- Directors welcomed the joint IMF-World Bank Climate Change Policy Assessment and urged strengthened disaster preparedness and greater use of disaster risk transfer mechanisms.

### Selected context and background facts
- Nominal GDP (FY2017): US$363 million; Population (FY2017): 102,259; GDP per capita (FY2017): US$3,549; IMF Quota: SDR 5.1 million.
- Fiscal year ends on September 30.
- The Compact Trust Fund and FSM Trust Fund are central to the country’s medium- and long-term fiscal position.

*Source: Federated States of Micronesia: Staff Report for the 2019 Article IV Consultation (text and tables provided). *

### 7.      The FSM’s external position is assessed to be broadly consistent with the level implied

### 7.      The FSM’s external position is assessed to be broadly consistent with the level implied

### External position
- Underlying current account (CA) balance in FY2018: surplus of 3.4 percent of GDP (after adjusting for windfall corporate tax payments).
- EBA-lite CA norm: 3.9 percent of GDP.
- CA gap: -0.5 percent of GDP.
- Policy gap: about -3 percent of GDP, mostly explained by medium-term fiscal adjustment needs of 4–5 percent of GDP to avoid the FY2024 fiscal cliff.
- Results caveat: heavy dependence on grants and fishing license fees, which can be volatile.

### Outlook and risks
- Growth projections:
  - FY2019: 1.4 percent (reflecting a recovery in construction).
  - Converging to potential at 0.6 percent by FY2022.
  - Underpinned by labor productivity growth of 0.7 percent and a slight contraction in employment.
- Inflation: projected to converge to 2 percent over the medium term (in line with U.S. inflation).
- FY2019 fiscal and CA surpluses (owing to corporate tax windfall in 2019Q1): 19 percent and 16 percent of GDP, respectively.
- Downside risks:
  - Substantial uncertainty about post-2023 relationship with the United States and capacity to cope with the fiscal cliff.
  - Disaster rehabilitation and weaknesses in financial sector supervision may discourage private investment and cause emigration.
  - Weather-related natural disasters remain a major downside risk.
  - Sharp tightening of global financial conditions may reduce prices of risky financial assets held by the CTF and FSMTF, hindering planned buildup.
- Upside potential:
  - Decisive public investment management reforms and private sector development.
  - Renewal of the Compact Agreement or new grants from development partners.

### Authorities’ views (on outlook and risks)
- Broad agreement with staff’s assessment on the economic outlook and risks.
- A government committee, Joint Committee on Compact Review and Planning, has been working on economic and other implications for over a year.

### Policy discussions — Overview
- With scheduled expiration of the Compact Agreement heightening medium-term uncertainty, authorities should start implementing:
  - fiscal consolidation,
  - climate change resilience measures,
  - stronger banking sector supervision,
  - acceleration of private sector development.

### A. Start fiscal consolidation to avoid fiscal cliff — Background
- Fiscal balance projected to remain in surplus through FY2023 under baseline (no consolidation).
  - Surplus projected at 4–7 percent of GDP during FY2020–23 as grants and fishing license fees remain abundant.
- Combined value of CTF and FSMTF projected to reach 322 percent of GDP by FY2023, reflecting:
  - scheduled U.S. contributions to the CTF,
  - transfers of budget surpluses to the FSMTF,
  - nominal rate of return assumed at 5 percent.
- Fiscal cliff risk in FY2024:
  - Compact grants amounting to 20 percent of GDP will expire in FY2023 and be replaced by investment returns accruing to the CTF, projected at around 11 percent of GDP in FY2024.
  - Overall balance projected to turn from a surplus of around 4½ percent of GDP in FY2023 to a deficit of 4½ percent of GDP in FY2024.
  - Distributions limited to investment returns; no distribution allowed in case of negative returns, increasing revenue volatility.
- Debt distress risk:
  - Under baseline, post-FY2023 deficits would put debt on an upward trajectory.
  - External debt-to-GDP ratio projected to rise from 12 percent in FY2023 to 57 percent in FY2039.
  - DSA thresholds on PV of external debt-to-GDP and public debt-to-GDP expected to be breached within a 20-year horizon.

### A. Start fiscal consolidation — Staff’s views and recommendations
- Needed adjustment: gradual fiscal adjustment of 4–5 percent of GDP through FY2023 to cope with the fiscal cliff.
  - Expected effect on growth: adjustment can shave off GDP growth by 0.1–0.3 percent annually over FY2020–24; adjustment should be gradual and supported by grants-financed public investment and pro-growth structural reforms.
- Growth-friendly measures to achieve adjustment while preserving essential social spending:
  - Tax policy reforms (including introducing a VAT and selected excises on tobacco, alcohol, and fuel; tightening eligibility on concessional fishing license fees for the domestic fishing industry) — yield: 2.5-3.0 percent of GDP.
  - Tax administration reforms (improve filing rates via new IT system and strengthen audit) — yield: 0.5-1.0 percent of GDP.
  - Limit wage bill growth to 1 percent annually over FY2020–23 (achieved by slower salary increases) — yield: 1.2 percent of GDP; limiting wage bill growth to 1 percent would yield a saving of 1¼ percent of GDP by FY2023.
  - PFM reforms (rationalize goods and services spending via new IT system and improved procurement) — yield: 0.5-1.0 percent of GDP.
- Importance of preserving spending on education, healthcare, and infrastructure (including climate change resilience).
- PFM reforms are critical:
  - Identified weaknesses: reliance on manual processing, inadequate procurement procedures, and capital project screening.
  - Ongoing reform roadmap for 2017–20; upgrading PFM regulations and IT system with World Bank and PFTAC support.
  - Benefits: identify expenditure savings, speed up execution of capital grants, and improve public investment management for climate adaptation.
- Saving future revenue windfalls into the FSMTF:
  - Staff welcomes decisions to save revenue windfalls during FY2017–18 and newly adopted mechanism to save fixed proportions of corporate income tax collections and fishing license fees to the FSMTF.
  - Current rule: at least 50 percent of corporate tax payments and 20 percent of fishing license fees should be saved into the FSMTF.
  - Budget process reforms should reduce scope for ad-hoc spending increases.
- Trust fund distribution arrangement risks and simulation findings:
  - Current arrangement restricting post-2023 distributions from the CTF to investment returns will result in large revenue volatility unless Trust Fund Agreement is amended.
  - Distributions can be offset by FSMTF drawdowns as needed, but distributions from both trust funds should be set to sustain long-run balances.
  - Staff simulations: setting annual distributions at 11 percent of GDP from the two trust funds (as in the fiscal adjustment scenario) would lead to a decrease in combined value of the funds as percent of GDP in the long run.
  - Gradual fiscal adjustment beyond FY2023 and reducing annual distributions to 6 percent of GDP by FY2034 would stabilize expected value of the trust funds at about 270 percent of GDP through FY2050.

### A. Start fiscal consolidation — Authorities’ views
- Authorities broadly concur with staff’s assessments and recommendations on fiscal policy.
  - Support using a 20-year forecast horizon in DSA because of expected fiscal cliff.
  - Endorse gradual fiscal adjustment through FY2023 to preserve budget space for critical development spending (education and health).
  - Will continue efforts to enhance tax compliance; VAT will be considered.
  - Ongoing PFM reforms supported by World Bank and EU will help improve spending quality.
  - Revenue windfalls to continue being saved into the FSMTF, ensured by amendment to FSMTF law; limited use of windfalls for high-quality government spending could be warranted if growth slows more than envisaged.
- Authorities disagree with staff recommendation to draw from the FSMTF to offset CTF volatility, preferring to continue building the FSMTF beyond FY2023.

### B. Strengthen climate change resilience — Background
- FSM is highly vulnerable to climate change: rising sea levels and temperatures threaten livelihoods, particularly on low-lying islands; frequency and intensity of natural disasters have risen, resulting in significant macroeconomic costs.
- U.S. Compact Agreement currently insures FSM for natural disaster risks via USAID and FEMA post-disaster reconstruction for public and private property; this assistance will no longer be available post-2023 unless renewed.
- A Climate Change Policy Assessment (CCPA) was conducted as part of the 2019 Article IV Consultation to review macro-relevant climate policies (mitigation, adaptation, disaster risk financing).

### B. Strengthen climate change resilience — Staff’s views and recommendations
- Progress: Nationally Determined Contribution under the Paris Agreement, national climate change policy, Infrastructure Development Plan (IDP) with mitigation and adaptation projects, and state-level disaster risk action plans.
- Gaps: no overarching National Adaptation Plan fully integrated with sectoral and state-level strategies; lack of comprehensive disaster resilience strategy covering early warning, disaster response, and risk financing.
- Need to accelerate adaptation by strengthening public investment management and mobilizing further grant financing:
  - Finishing ambitious adaptation projects over next 10 years requires substantially increasing public investment.
  - Main bottleneck: limited capacity to implement capital projects; recommended action: strengthen public investment management, particularly at state level, and establish standardized methodology for project appraisal and selection across states.
  - Given high risk of debt distress and fiscal adjustment need through FY2023, prioritize mobilizing grant financing and prioritizing projects.
- Disaster resilience strategy recommendations:
  - Increase use of risk transfer mechanisms to reduce budget burden post-2023 (e.g., regional parametric schemes under PCRAFI).
  - Broaden range of disaster-contingent financing from World Bank and AsDB.
  - Further build up fiscal buffers to enable immediate post-disaster response; FSMTF could provide an additional buffer but only as last resort.

### B. Strengthen climate change resilience — Authorities’ views
- Authorities appreciated CCPA findings and recommendations.
  - Noted increasing intensity and frequency of disasters causing severe damages in main and outer islands.
  - All four states have adopted Joint State Action Plans for climate change.
  - Acknowledged need to identify disaster risk financing options due to expected expiration of U.S. post-disaster assistance in 2023.
  - Emphasized need for climate finance institutions to streamline access requirements for small state capacity and for development partners to mobilize technical support to fill implementation capacity gaps.

### Climate impact and adaptation simulation (illustrative)
- Without adaptation:
  - If a disaster hits in 2030: real GDP declines by 5 percent and public debt rises by 10 percent of GDP.
- With adaptation (higher adaptation investment over 2020–30):
  - If a disaster hits in 2030: real GDP declines by 3 percent and public debt rises by 4 percent of GDP.
- Implication: higher adaptation investment lowers reconstruction costs and output losses and mitigates public debt impact.

*Source: IMF staff report (FSM Article IV Consultation, 2019).*

### 28.      Two commercial banks and a

### 28.      Two commercial banks and a government-owned development bank dominate the FSM’s financial sector

### Banking sector structure and key statistics
- Two commercial banks and one government-owned development bank dominate the FSM’s financial sector.
- Deposits at the Bank of FSM (BFSM), a domestic commercial bank, and a branch of the Bank of Guam total 90 percent of GDP.
- Private sector credit remains low, with the loan-to-deposit ratio at as low as 15 percent; the rest of deposits invested abroad.
- The FSM Development Bank (FSMDB), a non-deposit-taking and state-owned bank, accounts for 30 percent of total private sector credit.
- The FSMDB is funded mostly by capital contributed by the national government and retained earnings from the past.
- As of end-March 2019, the BFSM’s tier-1 risk-based capital ratio was 40.4 percent, well above the average for FDIC-insured banks (19.7 percent).

### FDIC oversight and related risks
- Deposits at the BFSM, accounting for about 40 percent of total deposits, are insured by the FDIC under the Compact Agreement; the Bank of Guam is also FDIC insured.
- The BFSM is regulated by the FDIC under the standards applicable for FDIC-insured banks, and is described as well capitalized, liquid, and profitable.
- The FSM is expected to lose access to FDIC oversight unless the service agreement under the Compact Agreement providing for FDIC insurance is renewed.
- The Compact Agreement’s economic supports and services (including FDIC deposit insurance and supervisory oversight) are set to expire in FY2023.

### Staff’s views on banking supervision and reform priorities
- Strengthening banking sector supervision is important to cope with a possible reduction in FDIC oversight.
- Recommended priorities:
  - Upgrade the legal and regulatory framework for prudential supervision.
  - Strengthen monitoring of commercial banks.
  - Develop a reform roadmap with actions needed to maintain financial sector stability and corresponding banking relationships.
  - Upgrade the Banking Act to address legislative gaps, including on fit and proper requirements, licensing criteria, and corrective and sanctioning powers.
- IMF and PFTAC technical assistance (TA) will support the Banking Act upgrade and supervisory reforms.

### FSMDB, credit access, and private sector credit
- Main bottleneck to private sector credit: lack of collateral due to land tenure prohibiting non-FSM citizens from owning land.
- Potential resolution: using land lease as collateral (has not been put into practice yet).
- Strengthening business climate and enhancing financial literacy can help create bankable private sector projects.
- FSMDB contribution:
  - Lending grew by 15 percent annually over the last three years.
  - Recently developed a scheme for loan guarantees to provide start-up businesses with access to finance.
- Credit unions can play a role but their contribution would likely remain small.
- To ensure prudent lending, the FSMDB and credit unions should be placed under the supervision of the Banking Board.

### Authorities’ views on supervision and FSMDB oversight
- Authorities value U.S. FDIC presence; it has safeguarded the banking sector.
- Authorities agree FSM should strengthen its own capacity for banking supervision.
- Upgrading the Banking Act, with IMF TA support, is warranted to modernize prudential supervision and maintain corresponding banking relationships.
- Authorities noted FSMDB will remain profitable and fully funded by government capital and retained earnings, viewing expanded oversight of FSMDB as premature currently.
- The Banking Board agreed that credit unions should be brought under its oversight.

### Vitalize the private sector — constraints and reform recommendations
- Background context:
  - FSM’s long-term economic growth has been the lowest among Pacific Island countries.
  - The private sector accounts for only a quarter of economic activity.
  - Constraints include remoteness, small size, and geographical dispersion.
- Staff recommendations to improve business and investment climate:
  - Lower business license fees.
  - Reduce the time and cost for settling a commercial dispute.
  - Improve the quality of the judicial process.
  - Make land tenure management business-friendly through digitalizing the land registry.
- FDI regime reforms to foster private sector development:
  - Clarify the FDI regime and reduce undue regulatory burdens.
  - Upgrade the Foreign Investment Act to harmonize FDI laws and regulations across states, expand the list of national priority sectors, streamline licensing processes, and establish a national single window.
- Authorities’ actions:
  - A bill to amend the Foreign Investment Act to establish a one stop shop for FDI applications and fast-track processing for priority sectors is being prepared in consultation with state governments.
  - Some state governments are embarking on judicial reforms for faster business dispute resolution.

### Data adequacy and capacity development
- Data shortcomings hamper macroeconomic surveillance despite ongoing implementation of the enhanced General Data Dissemination System.
- Coverage of key macroeconomic data is broadly sufficient but not compiled in a timely manner.
- Resolving tax data sharing issues between the Department of Finance and the Statistics Office, with PFTAC support, is critical to improve national accounts accuracy.
- Authorities expressed interest in hands-on TA tailored to FSM needs, with tangible outputs (e.g., manuals for tax administrators).
- Further capacity building is needed on revenue administration, PFM, financial sector supervision, and macroeconomic statistics.

### Staff appraisal — outlook, risks, and fiscal policy advice
- Recent performance and outlook:
  - The economy performed well in recent years with output and employment growth higher than the historical average and low inflation due to use of the U.S. dollar.
  - Fiscal balance has recorded large surpluses since FY2017.
  - External position assessed as broadly consistent with fundamentals and desirable policies.
  - Growth is projected to converge to a potential rate of 0.6 percent, in line with the last two decades’ performance.
- Main risks:
  - Risks to the outlook are tilted to the downside.
  - Unless arrangements under the Compact Agreement providing economic supports are renewed, the government is expected to lose access to Compact grants and various services by 2023, resulting in substantial macroeconomic uncertainty.
- Fiscal adjustment recommendation:
  - A gradual fiscal adjustment of 4–5 percent of GDP through FY2023 would be needed to balance the budget in FY2024.
  - Recommended measures: growth-friendly tax measures and tax administration reforms; rationalization of the wage bill and nonessential expenditures; protect spending on education, healthcare, and infrastructure.
  - Continue prudent policy to save revenue windfalls to further build up the FSMTF and strengthen fiscal resiliency.
- Resilience to climate change:
  - Strengthen preparedness, speed up adaptation, and develop a disaster resilience strategy.
  - Develop an overarching adaptation plan integrated with sectoral and state-level strategies.
  - Mobilize grant financing, prioritize projects, strengthen public investment implementation capacity, and use disaster risk transfer mechanisms including disaster insurance.

### Key policy recommendations (condensed)
- Update banking laws and adopt prudential banking regulations; develop a supervisory reform roadmap for the Banking Board.
- Place FSMDB and credit unions under Banking Board supervision to ensure prudent lending.
- Use land leases as collateral where feasible; digitalize land registry to improve collateral and property registration.
- Lower business startup costs, reduce dispute settlement time, and improve judicial processes.
- Upgrade the Foreign Investment Act to harmonize and streamline FDI processes and establish a national single window.
- Pursue a gradual fiscal adjustment of 4–5 percent of GDP through FY2023 to balance the budget in FY2024 and build fiscal resilience.
- Strengthen data sharing, tax administration, PFM, and statistical capacity with IMF and PFTAC support.

*Source: IMF staff report excerpt (Federated States of Micronesia), content unit 1fsmea2019001 - 28.*

### Box 2. Improving the Efficiency of the Public Service in the FSM (concluded)

### Box 2. Improving the Efficiency of the Public Service in the FSM (concluded)

### Summary conclusion
- A combination of slower wage increases and reforms to enhance public sector efficiency can help promote longer-term fiscal sustainability.

### Key reform recommendations (from recent public administration reviews supported by AsDB)
- Simplifying job grading and pay structures.
  - Overlaps in job grading and pay structures have undermined incentives for good performance.
  - A draft bill effectively simplifying the pay scale and levels for national government employees has been prepared by the national government.
- Consolidating the public service system.
  - Special service contracts have been increasingly used to attract skilled personnel.
  - Clear compensation advantages for contract personnel seem to have reduced incentives to perform among regular staff.
  - Contract positions performing core civil service functions should be integrated into the regular public service under a reformed and unified compensation structure, while noncore positions can remain contracted out for limited durations.
- Strengthening performance-based contracts for education and health.
  - The FSM Strategic Development Plan 2004–24 highlights the need for performance-based contracting (PBC) for teaching and health services personnel, but current arrangements are missing several critical components.
  - A well-designed PBC framework requires:
    - a clear set of objectives and performance indicators,
    - systems for collecting and validating data on these indicators,
    - and appropriate incentives to motivate achievement of agreed upon goals and targets.

### Implementation priorities
- Align wage growth with fiscal sustainability objectives by slowing wage increases while improving efficiency.
- Enact the draft national bill to simplify pay scales and levels for national government employees to restore clearer performance incentives.
- Develop a transition plan to integrate contract positions performing core functions into the regular public service under a unified compensation framework.
- Design and pilot a PBC framework in education and health that includes:
  - clearly defined objectives and indicators,
  - data collection and validation mechanisms,
  - incentive structures tied to measurable targets.

*Sources: AsDB staff calculations.*

### Appendix I. Main Recommendations of the 2017 Article IV

### Appendix I. Main Recommendations of the 2017 Article IV Consultation

### Fiscal policy: recommendations and reported policy actions
- Implement a gradual medium-term fiscal adjustment through domestic revenue mobilization, expenditure reforms, and higher trust fund savings, in line with the authorities’ 2023 Action Plan.
  - Authorities have contributed to the FSMTF beyond their commitment in the 2023 Action Plan, with substantial revenue windfalls in FY2017–18 saved in the trust fund.
  - Little progress has been made on revenue mobilization and expenditure rationalization.
- Eliminate the deficit of, and budget transfer to, the Social Security Fund (SSF), which could be achieved by rationalizing dependency benefits.
  - Benefit payments remained above contributions by 0.5 percent of GDP in FY2017.
  - Following an actuarial study, the government submitted to Congress a bill to introduce parametric reforms with a view to improve the sustainability of the SSF. The bill has not been passed yet.
- Implement public financial management (PFM) reforms by acquiring a revenue management system, improving budgeting of multiyear capital projects, implementing Public Expenditure and Financial Accountability Assessments (PEFA) for states, and undertaking Public Investment Management Assessment (PIMA).
  - Authorities adopted a PFM reform roadmap for 2017–20.
  - With World Bank support, preparation is underway for IT systems on tax administration and PFM, covering national and state governments, with tender processes starting soon.
  - A focused PIMA was conducted in the context of the Climate Change Policy Assessment.
- Undertake external review of the FSM Trust Fund (FSMTF).
  - Financial statements for the FSMTF have been prepared and audited, but external review of the FSMTF has not been done.
- Continue efforts to adapt to climate change, including explicit recognition of fiscal costs in the budget.
  - Recent progress includes establishment of the Department of Environment, Climate Change, and Emergency Management to oversee climate change efforts.
  - Projects for climate change adaptation financed by development partners remain excluded from the budget.

### Structural reforms, financial sector supervision, and statistics: recommendations and reported policy actions
- Improve access to finance.
  - Credit by the two commercial banks remains directed mostly toward consumer loans due to the lack of collateral.
  - The government-owned FSM Development Bank expanded its loan portfolio by 15 percent annual in the last 3 years.
- Reduce transportation costs through port upgrades and renewable energy.
  - With donor assistance, renewable energy projects are being implemented across all states; once completed, these projects can lower the cost of electricity and enhance access to electricity.
  - For the maritime sector, authorities focused on upgrading terminal buildings and facilities and port planning to improve safety and efficiency, with World Bank support.
- Strengthen regulatory frameworks, including through streamlining the foreign direct investment process.
  - A bill to amend the Foreign Investment Act to streamline the FDI process and establish a one-stop shop for FDI applications is under preparation in consultation with state governments.
- Increase oversight of credit unions by the Banking Board to promote safe financial inclusion.
  - Draft legislation of Credit Union Act, aimed at expanding the supervisory oversight of the Banking Board to credit unions, is under preparation.
- Improve national accounts and external sector statistics to enhance coverage and timeliness.
  - Efforts are underway with support from PFTAC, but progress remains slow.

_*Source: Appendix I. Main Recommendations of the 2017 Article IV Consultation*_

### Appendix II. External Sector Assessment — key findings and metrics

### External position and current account
- Current account balance developments:
  - Deficit of 12 percent of GDP in FY2013 to an estimated surplus of 24.5 percent of GDP in FY2018.
  - The FY2018 surplus reflected a corporate income tax windfall amounting to 21 percent of GDP, official transfers, secondary income inflows, and fishing license fees.
- Net international investment position (NIIP):
  - Positive NIIP amounting to 130 percent of GDP at end-FY2017, mainly reflecting bank deposits invested abroad and buildup of the FSMTF.
  - Note: The NIIP does not include accumulated U.S. contributions to the CTF.

### External Balance Assessment (EBA) results
- Underlying current account balance in FY2018 (after removing the corporate tax windfall): 3.4 percent of GDP.
- EBA-lite estimated current account norm: 3.9 percent of GDP.
- Model-estimated current account gap: -0.5 percent (difference between underlying current account balance and norm).
- Policy gap: around -3 percent of GDP, largely explained by medium-term fiscal adjustment needs of 4–5 percent of GDP to avoid the expected fiscal cliff in FY2024.
- A positive model residual of 3 percent of GDP partially offset the policy gap.
- Staff assessment: external position in 2018 is broadly consistent with fundamentals and desirable policies, but results carry large uncertainties given FSM’s dependence on volatile grants and fishing license fees.
- Without fiscal adjustment, the current account would turn to deficit after expected expiration of Compact Agreement; a gradual fiscal adjustment would help keep the current account at surplus starting FY2024.

### Exchange rate regime and reserves
- Use of the U.S. dollar as official currency is appropriate given small economy size, close U.S. linkages, and limited capacity for independent monetary policy.
- Government deposits as fiscal reserves:
  - National government deposits were around 17 percent of GDP in 2018.
  - This corresponds to 2.8 months of imports and 4 months of general government current spending.
  - This exceeds the Wiegand (2013) yardstick of one month of government spending.

### Competitiveness indicators
- Real and nominal effective exchange rates:
  - Nominal and real effective exchange rates appreciated in 2015 (mimicking strengthening of U.S. dollar); real effective exchange rate has since depreciated due to low inflation relative to trading partners.
- Manufacturing unit labor cost:
  - FSM manufacturing unit labor cost has decreased in the past 5 years.
  - FSM manufacturing wages proxied by total private sector.

_*Source: Appendix II. External Sector Assessment*_

### Appendix III. Risk Assessment Matrix — key risks, likelihoods, impacts, and policy advice
- Greater uncertainty surrounding post-2023 relationship with the U.S., including capacity to cope with the fiscal cliff, disaster rehabilitation, and financial sector supervision.
  - Relative likelihood: M
  - Impact if realized: H (downside)
  - Potential impact: Growth slowdown due to lower private investment and higher emigration.
  - Staff advice: Implement fiscal consolidation through revenue mobilization and expenditure rationalization; strengthen climate change resilience; build capacity for financial supervision; implement structural reforms to vitalize the private sector.
- Natural disasters and climate change.
  - Relative likelihood: H
  - Impact if realized: H (downside)
  - Potential impact: Growth slowdown due to impairment of infrastructure (floods), weaker agricultural production (droughts or floods), and impaired fishing activity.
  - Staff advice: Build up infrastructure for climate change adaptation by strengthening capacity for public investment management and mobilizing further grant financing. Develop a disaster risk financing strategy.
- Sharp tightening of global financial conditions.
  - Relative likelihood: L-M
  - Impact if realized: M (downside)
  - Potential impact: Hinders buildup of the CTF and FSMTF; reduces government revenue from these funds; a rise in U.S. interest rates can tighten FSM financial conditions.
  - Staff advice: Implement fiscal consolidation; strengthen capacity for financial sector supervision.
- Decisive push for growth-friendly structural reforms, renewal of U.S. Compact Agreement, or new external grants.
  - Relative likelihood: M
  - Impact if realized: H (upside)
  - Potential impact: Raises potential growth and improves fiscal position.
  - Staff advice: Invest fiscal savings from such reforms to enhance fiscal buffers.

_*Source: Appendix III. Risk Assessment Matrix*_

### Appendix IV. Simulations on Long-Run Sustainability of Trust Funds — methodology and results

### Context and problem statement
- If Compact Agreement arrangements are not renewed, government expected to lose access to Compact grants in 2023, creating a “fiscal cliff.”
- CTF institutional arrangements limit distributions: distributions in a given year effectively limited to investment returns in the previous year; no drawdown allowed in case of negative returns, increasing revenue volatility.
  - GAO Monte-Carlo simulations indicate probability of the CTF unable to disburse any funds in one or more years during FY2024–34 could be as high as 41 percent.
- Proposed mechanism to lower volatility: set a benchmark distribution amount; if CTF returns exceed benchmark, remainder transfers to FSMTF; if returns below benchmark, gap covered by drawdown from FSMTF. Sustainability depends on starting values, return distribution, and benchmarks.

### Simulation methodology — key assumptions
- Economic growth: long-run real growth rate of 0.6 percent from FY2024; inflation at 2 percent; nominal GDP grows by 2.6 percent annually.
- Starting values of trust funds (projected end-FY2023):
  - CTF: US$979 million (231 percent of GDP).
  - FSMTF: US$383 million (90 percent of GDP).
  - Projected CTF value includes U.S. government contributions as stipulated in the Compact Agreement and a nominal rate of return of 5 percent per annum during FY2019–23.
  - FY2023 value of FSMTF derived from annual contribution of $15 million and nominal rate of return of 5 percent per annum during FY2020–23.
- Probability distribution of investment returns:
  - Trust funds invested in equal-weight portfolio of safe and risky assets.
  - Safe asset: nonstochastic fixed rate of return at 3 percent (equals 6-month LIBOR rate projected for 2024 by April 2019 WEO).
  - Risky asset: normal distribution, no serial correlation, mean 6 percent, standard deviation 18 percent (based on historical S&P500 total returns).
- Distribution benchmark scenarios:
  - Scenario 1 (status quo): annual distribution benchmark set at 16 percent of GDP per year in FY2024 and fixed thereafter. Mimics baseline with no fiscal consolidation during FY2020–23; fiscal deficit excluding trust fund distributions reaches 16 percent of GDP in FY2024.
  - Scenario 2 (fiscal consolidation over FY2019–23): annual distribution benchmark set at 11 percent of GDP per year in FY2024 and fixed thereafter. Mimics implementation of fiscal adjustment amounting to 4–5 percent of GDP over FY2019–23; government able to balance budget from FY2024 onwards.
  - Scenario 3 (further fiscal consolidation beyond FY2023): annual distribution benchmark decreases gradually from 11 percent of GDP in FY2024 to 6 percent of GDP by FY2034 and fixed thereafter. Envisages additional long-run fiscal consolidation of 5 percent of GDP over 10 years after FY2024; government balances budget from FY2024 onwards with lower annual distribution than Scenario 2.
- Monte Carlo simulations:
  - Random draws of risky asset returns over FY2024–50 generate paths for CTF and FSMTF values.
  - 10,000 random draws generate fan charts for FY2024–50.

### Simulation results — key outcomes
- Scenario 1: status quo
  - Simulated combined trust fund values follow downward trajectories; mean path hits zero around FY2048.
  - FSMTF effectiveness as volatility buffer declines; only an 18 percent probability of FSMTF value remaining positive through FY2050.
  - Conclusion: continuing status quo with annual distribution of 16 percent of GDP is not sustainable in the long run.
- Scenario 2: fiscal consolidation over FY2019–23
  - Probability of combined CTF and FSMTF value remaining positive through FY2050 improves to 84 percent.
  - Life of FSMTF extended; 62 percent probability of FSMTF value remaining positive through FY2050.
  - Nonetheless, combined CTF and FSMTF value likely falls as percent of GDP, with mean value decreasing to 135 percent of GDP in FY2050, raising concerns for long-run sustainability and intergenerational equality.

_*Source: Appendix IV. Simulations on Long-Run Sustainability of Trust Funds*_

### 8.      Scenario 3: fiscal consolidation beyond FY2024 (Figure 3). Compared with Scenario 2,

### 8. Scenario 3: fiscal consolidation beyond FY2024 (Figure 3). Compared with Scenario 2,

### Scenario 3 — key findings
- Gradually reducing annual distributions to 6 percent of GDP would help sustain the mean value of the combined CTF and FSMTF at around 270 percent of GDP over the long run, ensuring intergenerational equity.
- The FSMTF would function as an effective buffer, with a 96 percent probability of its value remaining positive through 2050.

### C. Sensitivity Analysis — purpose
- Sensitivity analyses check robustness of results against parameter values worse than assumed in the baseline.
- Results (reported in Figure 4) further highlight the importance of fiscal consolidation through and beyond FY2023 in ensuring the long-run sustainability of the trust funds.

### Sensitivity scenarios and outcomes (summary)
- Lower rate of return for CTF and FSMTF for FY2020–23: assume 3 percent p.a. (instead of 5 percent in the baseline).
  - This produces lower values for the CTF and FSMTF in FY2023: US$905 million and US352 million, respectively.
  - Under Scenario 1 (status quo) the long-run decrease in the combined CTF and FSMTF is more pronounced and the FSMTF would deplete by FY2050 with a probability of 99.99 percent.
  - In Scenarios 2 and 3, the mean value of the combined CTF and FSMTF in FY2050 worsens, but the probability of the FSMTF remaining positive would remain at 96 percent in Scenario 3.
  - This highlights the importance of fiscal consolidation beyond FY2024.

- Lower rate of return for the safe asset from FY2024 onwards: assume 2 percent p.a. (instead of 3 percent in the baseline).
  - In all three scenarios, the mean value of the combined CTF and FSMTF in FY2050 decreases relative to baseline assumptions.
  - The probability of the FSMTF remaining positive in FY2050 also decreases in all three scenarios, but remains as high as 93 percent in Scenario 3.

- Lower expected rate of return for the risky asset: assume 4 percent p.a. (instead of 6 percent in the baseline).
  - Results are broadly similar to the case of a lower safe asset return, with more pronounced worsening in long-run trust fund values and in the probability of FSMTF depletion.

- Higher standard deviation for the risky asset: assume 23 percent (instead of 18 percent in the baseline).
  - Results are broadly in line with baseline assumptions, suggesting robustness of simulation results against higher asset return volatility.

### Figure 4 — numerical sensitivity outcomes (FY2050)
- Baseline assumptions
  - Scenario 1: average balance of CTF and FSMTF in FY2050, combined = -20.2 (% of GDP)
  - Scenario 1: probability of positive FSMTF balance in FY2050 = 17.7 (%)
  - Scenario 2: average balance of CTF and FSMTF in FY2050, combined = 135.2 (% of GDP)
  - Scenario 2: probability of positive FSMTF balance in FY2050 = 61.7 (%)
  - Scenario 3: average balance of CTF and FSMTF in FY2050, combined = 268.3 (% of GDP)
  - Scenario 3: probability of positive FSMTF balance in FY2050 = 96.1 (%)

- Lower return for CTF and FSMTF for FY2020-23: 3 percent p.a. (against 5 percent in the baseline)
  - Scenario 1: average balance = -90.4 (% of GDP)
  - Scenario 1: probability = 0.0 (%)
  - Scenario 2: average balance = 47.3 (% of GDP)
  - Scenario 2: probability = 9.9 (%)
  - Scenario 3: average balance = 169.3 (% of GDP)
  - Scenario 3: probability = 95.8 (%)

- Lower safe asset return: 2 percent p.a. (against 3 percent in the baseline)
  - Scenario 1: average balance = -47.5 (% of GDP)
  - Scenario 1: probability = 11.8 (%)
  - Scenario 2: average balance = 98.6 (% of GDP)
  - Scenario 2: probability = 50.9 (%)
  - Scenario 3: average balance = 222.2 (% of GDP)
  - Scenario 3: probability = 93.4 (%)

- Lower expected return for risky asset: 4 percent p.a. (against 6 percent in the baseline)
  - Scenario 1: average balance = -68.0 (% of GDP)
  - Scenario 1: probability = 7.7 (%)
  - Scenario 2: average balance = 66.3 (% of GDP)
  - Scenario 2: probability = 40.3 (%)
  - Scenario 3: average balance = 186.2 (% of GDP)
  - Scenario 3: probability = 89.1 (%)

- Higher standard deviation for risky asset: 23 percent (against 18 percent in the baseline)
  - Scenario 1: average balance = -20.7 (% of GDP)
  - Scenario 1: probability = 22.2 (%)
  - Scenario 2: average balance = 138.5 (% of GDP)
  - Scenario 2: probability = 59.4 (%)
  - Scenario 3: average balance = 270.3 (% of GDP)
  - Scenario 3: probability = 92.4 (%)

*Source: IMF staff calculations (from the Federated States of Micronesia staff report informational annex).*

### 2018. The Banking Board has also requested training for bank examiners, which PFTAC has planned

### 1fsmea2019001 - 2018. The Banking Board has also requested training for bank examiners, which PFTAC has planned

### Capacity building and technical assistance
- Banking supervision
  - The Banking Board requested training for bank examiners; PFTAC has planned training for FY21.
- Statistics capacity building
  - FSM implemented the enhanced General Data Dissemination System (e-GDDS) in July 2017, with support from the IMF’s Statistics Department.
  - PFTAC will continue to provide annual capacity building training to allow for GDP compilation independent from the US Graduate School, subject to staff resources remaining adequate in the Statistics Office.
  - PFTAC provided a mission of the real sector statistics advisor in April 2018, with an additional mission planned in FY20.
- Government finance statistics (GFS) technical assistance
  - Most recent GFS TA occurred in February 2019: hands-on training to compilers on using source data (annual financial statements) to derive the annual GFS statement of operations, stock data for the balance sheet and the functions of government for the budgetary central government (BCG) and state governments.
- Macroeconomics
  - No recent direct assistance provided; forecasting of long-term economic and fiscal scenarios will be supported if requested by the authorities, in cooperation with other TA providers.

### Data adequacy for surveillance — key shortcomings
- General
  - Data provision has serious shortcomings that significantly hamper surveillance.
  - Coverage of key macroeconomic data is broadly sufficient, but not compiled in a timely manner; national accounts and external sector statistics are compiled annually with nearly a year lag.
- National accounts
  - Annual GDP estimates based on 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).
  - GDP estimates based on the expenditure approach are not compiled, leading to a lack of investment/savings indicators.
  - Fixed ratios are used in estimating value added for private sector operating surplus.
  - Authorities plan a business survey to help with rebasing GDP.
- Employment
  - Employment and wages data are available annually from Social Security Administration filings.
  - No unemployment data are available except for 2013 (household survey).
- Price statistics
  - Quarterly CPI, rebased to 2017Q1, published for FSM and each state; data releases are often delayed.
- Government finance statistics
  - Fiscal data for the budgetary central government and 4 state governments prepared going back to FY2004 with U.S. Graduate School support.
  - Data compiled in line with Government Finance Statistics Manual 2014 (GFSM 2014).
  - Fiscal accounts consolidated between national and state governments; government agencies and local governments (municipalities) are not covered.
  - Potential to expand coverage to general government by including extrabudgetary units and social security funds; source information is available from annual financial statements.
  - Financial information for public corporations is readily available and public sector GFS compilation may commence, considering local capacity.
- Monetary statistics and financial sector surveillance
  - Banking Board compiles monthly monetary data with a three-month lag; data include interest rates, accounts of commercial banks, and FSM Development Bank.
  - Depository survey data are not compiled based on IMF standardized report forms (SRFs), hindering international comparability.
  - FSM started compiling Financial Soundness Indicators (FSIs) data in 2016 (quarterly data back to 2013); FSIs and Financial Access Survey (FAS) indicators often reported with delays.
- External sector statistics
  - Annual balance of payments and IIP compiled in broad conformity with BPM6, with U.S. Graduate School assistance; data available up to 2017 but not reported to STA after 2014.
  - Large errors and omissions in the balance of payments undermine usability for external sustainability assessment.
  - PFTAC mission in April 2018 recommended enhancements for re-exports of fuel, imports, travel credits/debits, personal transfers, interest payments, and investment liabilities.

### Data dissemination and e-GDDS assessment (as of July 8, 2019)
- Participation and implementation
  - Participant in GDDS since November 2014.
  - Implemented the enhanced GDDS (e-GDDS) in July 2017.
  - National Summary Data Page (NSDP) available at: http://www.fsmstats.fm/?page_id=605
- Timeliness and periodicity highlights (selected entries from Table of Common Indicators Required for Surveillance, As of July 8, 2019)
  - Broad Money: Latest observation May 2018; Date received Mar 2019; Frequency: M; Frequency of reporting: M; Frequency of publication: M.
  - Consolidated Balance Sheet of the Banking System: Latest observation Apr 2018; Date received Mar 2019; Frequency: M; Frequency of reporting: M; Frequency of publication: M.
  - Interest Rates: Latest observation May 2018; Date received Mar 2019; Frequency: M; Frequency of reporting: M; Frequency of publication: M.
  - Consumer Price Index: Latest observation End-FY2017; Date received Nov 2018; Frequency: Q; Frequency of reporting: Q; Frequency of publication: Q.
  - GDP/GNP: Latest observation FY2017; Date received Nov 2018; Frequency: A; Frequency of reporting: A; Frequency of publication: A.
  - External Current Account Balance: Latest observation FY2017; Date received Nov 2018; Frequency: A; Frequency of reporting: A; Frequency of publication: A.
  - Stocks of Central Government and Central Government-Guaranteed Debt: Latest observation End-FY2018; Date received Feb 2019; Frequency: A; Frequency of reporting: A; Frequency of publication: A.

### Debt sustainability analysis — risk assessment and background
- Risk ratings
  - Risk of external debt distress: High
  - Overall risk of debt distress: High
  - Granularity in the risk rating: Sustainable
  - Application of judgement: Yes: the forecast horizon informing mechanical risk signals is extended to 20 years to take account of an expected fiscal cliff in FY2023.
- Fiscal cliff and implications
  - Compact Agreement grants from the United States amounting to 20 percent of GDP are expected to expire in FY2023.
  - Under the baseline without fiscal adjustments, external debt-to-GDP projected to reach 30 percent in FY2029 and 57 percent in FY2039.
  - Public debt-to-GDP projected to reach 43 percent in FY2029 and 67 percent in FY2039.
  - DSF thresholds on the present value of external debt-to-GDP and public debt-to-GDP ratios are projected to be breached within a 20-year horizon.
  - Mechanical DSF with a 10-year horizon would imply a moderate risk rating; extension to 20 years warrants high risk assessment.
- Public sector debt coverage and composition (end-FY2018)
  - Total public debt: 76 (In millions of U.S. dollars); As a share of total debt: 100; In percent of GDP: 20
  - External debt: 76; 100; 20
  - Multilateral: 53; 70; 14
    - ADB: 52; 69; 14
  - Bilateral: 22; 28; 6
    - U.S. Department of Agriculture: 21; 27; 6
    - European Investment Bank (EIB): 1; 10; (value given as 110 for EIB in table; interpreted as 1,10 in table layout)
  - Commercial: 2; 20
    - Telecom vendor: 2; 20
  - Domestic: 0; 0; 0
  - Notes: As of end-FY2018 (ending September 2018), all public sector debt is external, owed to nonresidents. Public debt coverage excludes loan guarantees and non-guaranteed SOE debt due to lack of data.
- Debt dynamics and servicing
  - FSM’s public sector debt decreased to 20 percent of GDP in FY2018 from a peak of 31 percent of GDP in FY2009.
  - About 70 percent of the debt is from the Asian Development Bank (AsDB), 27 percent from the U.S. Department of Agriculture, and the rest (3 percent) from the European Investment Bank (EIB) and a commercial private lender.
  - All loans except from the EIB are denominated in U.S. dollars.
  - Total debt service reached 5.8 percent of exports in FY2018 and is expected to remain broadly stable over the medium term.
  - FSM has not borrowed debt since FY2009; principal repayments have been proceeding, producing a downward trajectory since FY2009.

### Macroeconomic baseline assumptions and projections (Box 1 highlights)
- GDP growth projections
  - GDP growth is projected to moderate from 2.4 percent in FY2017 to 1.2–1.4 percent in FY2018–19, 0.7–0.8 percent in FY2020–21, and 0.6 percent in FY2022 and thereafter.
  - Potential growth estimated at 0.6 percent; labor productivity growth of 0.7 percent and slight contraction in employment.
  - IMF staff cross-country regression suggests a moderate downward adjustment in long-run GDP growth by 0.1 percentage point due to high vulnerability to natural disasters.
- Inflation and GDP deflator
  - Inflation projected to pick up from 1.5 percent in FY2018 to 2 percent from FY2020 onwards.
  - GDP deflator assumed to move in tandem with inflation.
- Fiscal balance and Compact Trust Fund effects
  - Fiscal balance projected in surplus of around 4-7 percent of GDP during FY2020–23.
  - Compact grants amounting to 20 percent of GDP expire in FY2023 and be replaced by investment returns from the Compact Trust Fund, projected at around 11 percent of GDP in FY2024.
  - Overall balance projected to turn from a surplus of around 4½ percent of GDP in FY2023 to a deficit of 4½ percent of GDP in FY2024.
  - Baseline assumes no fiscal consolidation during FY2019–23.
  - Fiscal deficit projected to rise further to around 6 percent of GDP in FY2029.
- Current account
  - Projected to remain in a surplus of around 2–3 percent of GDP during FY2020–23 but turn into a deficit of 4 percent of GDP in FY2024 due to the fiscal cliff.
- Financing mix
  - With fiscal balance in surplus, no new debt disbursement projected until FY2023.
  - Beyond FY2023, financing mix envisages external project loans financing 90 percent of the fiscal deficit and distributions from the FSM Trust Fund.
  - Distribution projected at $20 million per year after FY2030, as stipulated by law.
  - Remainder assumed financed by domestic borrowing from banks; low loan-to-deposit ratio suggests limited crowding out of private sector credit.
- Tabulated comparison (selected figures)
  - Real GDP (y/y growth): 2017 = 2.4; 2018 = 1.2; 2019-23 = 0.8; 2024-39 = 0.6
  - CPI (y/y growth): 2017 = 0.1; 2018 = 1.5; 2019-23 = 1.9; 2024-37 = 2.0
  - Fiscal balance (percent of GDP): 2017 = 14.6; 2018 = 27.3; 2019-23 = 8.4 to -5.3 (table shows multiple periods); 2024-37 = 8.7 to -4.4 (source table lists periodized values)
  - Current account balance (percent of GDP): 2017 = 7.5; 2018 = 24.5; 2019-23 = 5.0 to -4.2; 2024-37 = 3.4 to -5.3
  - Sources: FSM authorities and IMF staff estimates and calculations.

### Policy implications and priorities implied by the analysis
- Fiscal policy
  - Lowering the risk of debt distress requires a fiscal adjustment and steadfast structural reforms to promote private sector growth.
  - Preparations for the expected fiscal cliff in FY2023 are critical; consider fiscal consolidation measures and efforts to broaden the domestic revenue base (current tax-to-GDP ratio around 13 percent).
- Data and statistical capacity
  - Prioritize timeliness improvements for national accounts, CPI, external sector statistics, and FSIs.
  - Rebase GDP (current base year FY2004) and compile expenditure approach to GDP to provide investment/savings indicators.
  - Implement SRFs for depository survey to improve international comparability.
  - Expand fiscal coverage to general government by including extrabudgetary units and social security funds; consider compiling public sector GFS.
- External sector and resilience
  - Enhance source data and estimation methods for re-exports of fuel, imports, travel credits/debits, personal transfers, interest payments, and investment liabilities to reduce large errors and omissions.
  - Strengthen strategies to build climate change resilience given high vulnerability to natural disasters.

*Source: 1fsmea2019001 - 2018. The Banking Board has also requested training for bank examiners, which PFTAC has planned (IMF staff report excerpts, as of July 8, 2019).*

### 4.      The FSM’s debt carrying capacity is assessed as weak. The country’s Composite Indicator (CI)

### 4.      The FSM’s debt carrying capacity is assessed as weak. The country’s Composite Indicator (CI)

### Composite Indicator (CI) assessment
- The CI index is 1.69, which indicates a weak debt-carrying capacity under the 2018 DSF framework.
- The CI remains the same as the last DSA.
- The CI is based on a weighted average of factors including real GDP growth, remittances, international reserves, world growth, and the Country Policy and Institutional Assessment (CPIA) score.
- The CI calculation uses 10-year averages of the variables, across 5 years of historical data and 5 years of projection, and the corresponding CPIA.
- The CI calculation is based on World Economic Outlook databases for April 2019 and October 2018.

CI calculation table (components preserved exactly as presented)
- CPIA: Coefficients (A) 0.385, 10-year average values (B) 2.745, CI Score components (A*B) = (C) 1.066, Contribution of components 63%
- Real growth rate (in percent): Coefficients (A) 2.719, 10-year average values (B) 1.179, CI Score components (C) 0.032, Contribution 0.032%
- Import coverage of reserves (in percent): Coefficients (A) 4.052, 10-year average values (B) 0.790, CI Score components (C) 0.032, Contribution 0.032%
- Import coverage of reserves^2 (in percent): Coefficients (A) -3.990, 10-year average values (B) 0.006, CI Score components (C) 0.000, Contribution 0.000%
- Remittances (in percent): Coefficients (A) 2.022, 10-year average values (B) 4.164, CI Score components (C) 0.085, Contribution 0.085%
- World economic growth (in percent): Coefficients (A) 13.520, 10-year average values (B) 0.359, CI Score components (C) 0.4829, Contribution 0.4829%
- CI Score: 1.69 (100%)
- CI rating: Weak

### Applicable DSA thresholds for FSM
- PV of external debt-to-GDP ratio: 30 percent
- PV of external debt-to-exports ratio: 140 percent
- External debt service-to-exports ratio: 10 percent
- External debt service-to-revenue ratio: 14 percent
- PV of public debt-to-GDP ratio (total public debt benchmark): 35 percent

### Natural disaster stress test (customized)
- A tailored stress test for a natural disaster shock is added given severity and frequency of natural disasters in the FSM.
- Natural disaster scenario assumptions:
  - A one-off shock of 10 percentage points to the debt-GDP ratio in FY2019 is assumed.
  - Real GDP growth is lowered by 5.0 percentage points in the year of the shock.
  - Exports growth is lowered by 3.5 percentage points in the year of the shock.
- Contingent liability shocks use default DSF parameters.
- Exchange rate depreciation scenario is not considered because the U.S. dollar is the FSM’s legal tender.

### External debt sustainability (A)
- Baseline projections:
  - External debt-to-GDP ratio rises from 12 percent in FY2023 to 30 percent in FY2029 and 57 percent in FY2039.
  - The PV of external debt-to-GDP ratio breaches its threshold in FY2033.
  - Ratios of PV of external debt to exports and debt service ratios to revenue and exports remain below their thresholds throughout the projection period.
- Comparison with previous DSA:
  - Previous DSA projected external debt-to-GDP ratio to reach 24 percent in FY2027 and 49 percent in FY2037.
  - Current projections show a worse external debt path, reflecting a worsening of the long-run fiscal position compared to the previous DSA.
- Stress test results:
  - Natural disaster shock: PV of external debt-to-GDP ratio rises to 41 percent in FY2029 and 83 percent in FY2039, breaching the threshold in FY2027 (six years earlier than baseline breach).
  - A shock in the fiscal primary balance among standardized tests results in the highest PV of external debt-to-GDP ratio over the 10-year horizon, breaching the threshold in FY2028.

### Public sector debt sustainability (B)
- Public debt dynamics:
  - Public debt-to-GDP ratio projected to rise from 12 percent in FY2023 to 43 percent in FY2029 and 67 percent in FY2039.
  - Public debt rises faster than external debt due to a gradually rising share of domestic debt in government financing.
  - The PV of public debt-to-GDP ratio breaches the threshold in FY2030.
- Comparison with previous DSA:
  - Previous DSA projected public debt-to-GDP ratio to reach 24 percent in FY2027 and 49 percent in FY2037.
  - Current public debt path worsened compared to the previous DSA.
- Stress test results:
  - Natural disasters and a worsening fiscal position increase vulnerability of public debt dynamics.
  - A negative growth shock can lead to higher fiscal deficits as percent of GDP, sharply increasing the PV of public debt-to-GDP ratio to 115 percent in FY2039.

### Risk rating and vulnerabilities
- Mechanical DSA ratings:
  - Mechanical external and overall debt-distress ratings are moderate because no DSA threshold is breached within the standard 10-year horizon.
- Extended horizon and final judgement:
  - Following DSA guideline, the horizon for FSM is extended to 20 years due to the fiscal cliff in FY2024 and sizable fiscal deficits thereafter.
  - With one out of four external debt thresholds and the threshold for total public debt breached by end-FY2039, the FSM’s external and overall debt distress risk ratings are judged to be high.
- Drivers of high-risk judgement:
  - Fiscal cliff in FY2024 and sizable deficits thereafter.
  - Vulnerability to natural disasters and worsening fiscal position as shown by stress tests.
- Policy implications highlighted:
  - Need to implement fiscal adjustments.
  - Need to develop a strategy for climate change resilience.
  - Need to improve capacity for debt management.

### Consideration of trust and sinking funds
- DSA conducted on a gross debt basis and does not net out financial assets such as:
  - Compact Trust Fund: 156 percent of GDP in FY2017
  - FSM Trust Fund: 32 percent of GDP
  - Sinking fund for public debt: about 6 percent of GDP
- Reasons these funds do not alter the high risk rating:
  - Compact Trust Fund: drawdowns prohibited prior to FY2024 and limited to investment returns after FY2024 under the Compact Agreement.
  - FSM Trust Fund Act (amended in 2019 by Public Law No. 20–185): no funds can be withdrawn from the fund before FY2030.
  - Sinking fund size is only slightly larger than the annual fiscal deficit projected post-FY2024 and would not affect the thrust of the analyses.

*Source: 1fsmea2019001 - 4.      The FSM’s debt carrying capacity is assessed as weak. The country’s Composite Indicator (CI).*

### 11.      The authorities agreed that the FSM remains at high risk of debt distress. They supported

### 1fsmea2019001 - 11.      The authorities agreed that the FSM remains at high risk of debt distress. They supported

### Executive summary and policy stance
- The authorities agreed that the Federated States of Micronesia (FSM) remains at high risk of debt distress.
- They supported staff’s judgement to use a 20-year forecast horizon, which incorporates the FSM’s country-specific prospect that U.S. Compact grants are expected to expire in FY2023 under the Compact Agreement.
- They agreed that a gradual fiscal adjustment through FY2023, aimed at coping with the fiscal cliff while preserving the budget space for critical development spending, would be warranted and reduce the debt distress risk.

### Baseline projections — external debt and key macro assumptions (selected)
- External debt (nominal) 2018–2039 (in percent of GDP, selected years):
  - 2018: 20.3
  - 2019: 18.5
  - 2020: 16.5
  - 2021: 14.9
  - 2022: 13.3
  - 2023: 11.9
  - 2024: 14.4
  - 2029: 30.4
  - 2039: 18.8
- Change in external debt (annual, selected): -1.9; -1.8; -2.0; -1.6; -1.6; -1.5; 2.5; 3.6; 1.0
- Identified net debt-creating flows (selected): -25.0; -15.9; -2.7; -2.5; -2.4; -2.1; 4.2; 4.1; 3.9; 4.1; -0.1
- Non-interest current account deficit (selected): -25.0; -16.4; -2.7; -2.8; -2.6; -2.4; 4.0; 3.7; 3.0; 4.2; -0.3
- Exports (percent of GDP, selected): 2018: 30.4; 2019: 30.7; 2020: 30.9; 2021: 31.1; 2022: 31.2; 2023: 31.3; 2024–2029: 31.3
- Imports (percent of GDP, selected): 2018: 74.9; 2019: 75.9; 2020: 74.9; 2021: 74.8; 2022: 72.8; 2023: 72.7; 2024: 72.1; 2029: 70.8
- Net current transfers (negative = inflow) (percent of GDP, selected): -56.3; -48.4; -34.4; -34.1; -32.1; -31.9; -13.9; -14.3; -15.0; -37.9; -24.1
  - of which: official (selected): -30.4; -30.7; -29.0; -28.4; -26.1; -25.5; -7.4
- Net FDI (negative = inflow): 0.1 (constant across listed years)
- Endogenous debt dynamics (selected): 0.0; 0.4; -0.1; 0.3; 0.2; 0.2; 0.2; 0.4; 0.9
  - Contribution from nominal interest rate (selected): 0.5; 0.7; 0.1; 0.4; 0.3; 0.3; 0.2; 0.5; 1.2
  - Contribution from real GDP growth (selected): -0.3; -0.3; -0.1; -0.1; -0.1; -0.1; -0.1; -0.2; -0.3
- Residual (selected): 23.1; 14.1; 0.7; 0.9; 0.8; 0.6; -1.7; -0.5; -3.0; -5.0; 1.0
  - of which: exceptional financing: 0.0 (across listed years)

### Key sustainability indicators (external)
- PV of PPG external debt-to-GDP ratio (selected): 16.4; 14.8; 13.6; 12.4; 11.2; 10.0; 11.1; 20.6; 41.3
- PV of PPG external debt-to-exports ratio (selected): 54.1; 48.3; 44.0; 39.8; 35.8; 32.0; 35.5; 65.8; 132.1
- PPG debt service-to-exports ratio (selected): 5.8; 6.6; 5.1; 5.0; 4.7; 4.6; 4.4; 4.5; 7.7
- PPG debt service-to-revenue ratio (selected): 3.0; 4.1; 4.4; 4.4; 4.3; 4.2; 3.0; 3.2; 5.8
- Gross external financing need (Million of U.S. dollars, selected): -86.2; -54.5; -4.2; -4.8; -4.5; -3.8; 23.5; 25.6; 35.0

### Key macroeconomic assumptions (selected)
- Real GDP growth (percent): 1.2; 1.4; 0.8; 0.7; 0.6; 0.6; 0.6; 0.6; 0.8; 0.7
- GDP deflator in US dollar terms (change in percent): 1.2; 1.0; 2.0; 2.0; 2.0; 2.0; 2.0; 2.0; 2.8; 1.9
- Effective interest rate (percent) (selected): 2.4; 3.6; 0.3; 2.4; 2.1; 2.2; 2.1; 2.0; 2.2; 2.6; 2.0
- Growth of exports of G&S (US dollar terms, percent, selected): 3.1; 3.5; 3.4; 3.4; 2.9; 2.9; 2.6; 2.6; 2.6; 6.8; 2.9
- Growth of imports of G&S (US dollar terms, percent, selected): 4.1; 3.8; 1.4; 2.6; -0.1; 2.5; 1.8; 2.5; 2.5; 2.2; 2.2
- Grant element of new public sector borrowing (in percent): 35.5; 37.2; 38.2 (presented in projection years)
- Government revenues (excluding grants, percent of GDP, selected): 58.2; 48.9; 35.7; 35.2; 34.7; 34.3; 45.1; 43.7; 41.5; 32.3; 41.4
- Aid flows (Million of US dollars, selected): 142.0; 147.6; 143.7; 144.7; 136.3; 137.4; 62.3; 69.5; 87.0
- Grant-equivalent financing (percent of GDP, projection note): 13.8; 13.9; 13.4; 13.8
- Grant-equivalent financing (percent of external financing, projection note): 86.0; 80.5; 85.5; 83.2
- Nominal GDP (Million of US dollars, selected): 372; 381; 391; 402; 413; 423; 434; 494; 640
- Nominal dollar GDP growth (selected): 2.5; 2.4; 2.7; 2.8; 2.6; 2.6; 2.6; 2.6; 3.6; 2.6

### Public sector debt (baseline) — selected metrics
- Public sector debt (percent of GDP, selected): 2018: 20.3; 2019: 18.5; 2020: 16.5; 2021: 14.9; 2022: 13.3; 2023: 11.9; 2024: 16.2; 2029: 43.2; 2039: 22.7
  - of which: external debt mirrors external DSA figures (e.g., 2018: 20.3)
- Change in public sector debt (selected): -1.9; -1.8; -2.0; -1.6; -1.6; -1.5; 4.4; 6.1; 1.2
- Identified debt-creating flows (selected): -27.6; -19.0; -7.3; -6.7; -5.7; -4.7; 4.4; 6.1; 4.4; -8.2; -1.1
- Primary deficit (selected): -27.6; -19.2; -6.9; -6.6; -5.6; -4.7; 4.4; 5.8; 4.0; -7.9; -1.1
- Revenue and grants (percent of GDP, selected): 96.4; 87.6; 72.4; 71.2; 67.8; 66.7; 57.1; 55.8; 53.5; 70.3; 64.0
  - of which: grants (percent of GDP, selected): 38.2; 38.8; 36.7; 36.0; 33.0; 32.5; 12.0; 12.0; 12.0
- Primary (noninterest) expenditure (percent of GDP, selected): 68.8; 68.4; 65.5; 64.6; 62.1; 62.1; 61.5; 61.5; 57.5; 62.4; 62.9
- Automatic debt dynamics (selected): 0.0; 0.2; -0.4; -0.1; -0.1; -0.1; -0.1; 0.4; 0.3
- Residual (selected): 25.7; 17.3; 5.3; 5.1; 4.2; 3.3; 0.0; 0.0; -3.1; 7.3; 3.2

### Public sector sustainability indicators
- PV of public debt-to-GDP ratio (selected): 16.4; 14.8; 13.6; 12.4; 11.2; 10.0; 12.9; 33.4; 51.1
- PV of public debt-to-revenue and grants ratio (selected): 17.1; 16.9; 18.8; 17.4; 16.5; 15.0; 22.6; 59.8; 95.5
- Debt service-to-revenue and grants ratio (selected): 1.8; 2.3; 2.2; 2.2; 2.2; 2.1; 2.4; 14.3; 11.7
- Gross financing need (selected): -25.8; -17.2; -5.3; -5.1; -4.1; -3.2; 5.8; 13.8; 10.3

### Stress tests, scenarios, and sensitivity analysis — key outcomes
- Stress tests and tailored tests indicate vulnerability to natural disasters and combined contingent liabilities, with "most extreme shock" labels:
  - External PPG indicators: most extreme shock identified for certain indicators include Natural Disasters and Non-debt flows (varies by indicator).
  - Public debt indicators: natural disaster shocks and combined contingent liabilities produce large increases in PV of debt and debt-service ratios in several projection years.
- Sensitivity tables (selected breaches and results):
  - PV of debt-to-GDP ratio (baseline and alternative scenarios): baseline values 15; 14; 12; 11; 10; 11; 12; 14; 16; 18; 21; 41 (2019–2039 sequence in Table 3 header)
  - Bound and tailored tests show values that in many cases breach policy thresholds (bold values in original tables indicate breaches).
- Tailored tests (public DSA) show that natural disaster and combined contingent liability shocks can raise public debt substantially (examples from Table 4):
  - Under "Natural disaster" tailored test: public debt rises to values such as 32; 38; 45; 52; 61; 70; 107 (selected projection years).

### Drivers of debt dynamics (Figure summary)
- Major recent contributors to debt changes include:
  - Primary deficits and current account deficits as principal debt-creating flows.
  - Residuals (unexpected changes) have been sizable in some historical vintages.
  - Real GDP growth, real interest rates, price and exchange rate changes, and changes in PPG debt all interact to determine debt trajectories.

### Policy implications and recommended fiscal strategy
- Maintain the planned gradual fiscal adjustment through FY2023 to manage the expected expiration of U.S. Compact grants in FY2023 and to reduce debt distress risk.
- Preserve budget space for critical development spending while implementing fiscal consolidation to cope with the fiscal cliff.
- Monitor key vulnerabilities highlighted by stress tests, notably natural disaster risk and contingent liabilities, and prepare contingent financing plans.

*Source: https://www.imf.org/-/media/files/publications/cr/2019/1fsmea2019001.pdf*

### 1990. The size of 3-year adjustment from program inception is found on the horizontal axis; the

### Statement by Nigel Ray, Executive Director for the Federated States of Micronesia and Sali David, Advisor to the Executive Director — August 28, 2019

### Background
- The Federated States of Micronesia (FSM) is a small island country spread out over the western Pacific Ocean with more than 600 islands, covering an area roughly the width of Australia.
- It has a population of just over 100,000.
- Four autonomous states make up the FSM – Pohnpei, Kosrae, Chuuk and Yap – each with its own distinct language and ethnic identity.
- A key challenge is the forthcoming expiry of annual grants from the United States (US) – equivalent to more than 20 percent of GDP – made under the Compact of Free Association.
- After 2023, most grants will be replaced by distributions from a Compact Trust Fund (CTF) being built up from US contributions; current contribution and expected investment return paths mean distributions are unlikely to compensate for the loss of grants while also maintaining the CTF’s real value.
- The FSM also has its own trust fund, the FSM Trust Fund (FSMTF), as an additional revenue source to enhance fiscal self-reliance.
- A government committee and an Action Plan 2023 have been established to prepare for the expiry of the grants and some US support services; the Action Plan includes increasing revenue mobilization, building fiscal buffers and developing the private sector.
- President David W. Panuelo was elected in May 2019 and aims to continue driving a reform agenda.
- The FSM is the first Pacific island country to have an IMF-World Bank Climate Change Policy Assessment (CCPA), conducted alongside the Article IV consultation.
- The FSM authorities broadly agree with staff’s recommendations and appreciate IMF technical assistance and training.

### Fiscal policy
- The FSM will face a fiscal cliff after 2023, with the overall balance projected to turn from a surplus of around 5 percent of GDP in 2023 to a deficit of 4-5 percent of GDP in 2024.
- Authorities broadly agree with staff’s recommendation for a gradual fiscal adjustment leading up to 2023 to preserve budget space for priority spending such as education and health.
- Planned revenue and tax measures under consideration or implementation:
  - Continue to enhance tax compliance.
  - Consider growth-friendly tax policy reforms, such as introducing a value added tax and selected excises on tobacco, alcohol and fuel.
  - Rationalize tax expenditures and strengthen tax administration through the roll-out of a new IT system.
- Ongoing PFM reforms with the World Bank and European Union aim to streamline and rationalize nonessential expenditure and ensure space for spending on climate change resilience.
- The authorities are committed to continuing to build up the FSMTF by saving revenue windfalls into it; FSMTF funds have grown from about $13 million in 2014 to around $230 million in 2019.
- New laws enacted in 2019 earmark 50 percent of corporate tax receipts and 20 percent of fishing license fees as contributions to the FSMTF.
- Current rules would allow the FSM to take only investment returns out of the CTF, which could produce large revenue volatility after 2023; authorities seek a review of CTF distribution rules.
- Authorities do not agree with staff’s recommendation to use the FSMTF as a stabilizer, preferring to continue building it up for the long term.
- Fiscal deficits post-2023 would place external debt on an upward trajectory, leaving the FSM at a high risk of debt distress.
- Authorities support staff’s consideration of the debt trajectory over a 20-year horizon in the DSA and intend to continue maximizing grant financing and not take on any new loans up to 2023.

### Financial sector
- Supervision of the FSM’s financial sector would be significantly transformed by any reduction in US FDIC oversight after 2023.
- Authorities agree with staff recommendations to:
  - Strengthen the FSM Banking Board’s capacity for banking supervision.
  - Update the banking laws.
  - Maintain correspondent banking relationships.
  - Develop prudential regulations.
- Authorities have been active on international tax transparency issues given that a number of investment companies are based in the FSM.
- An assessment by the EU and OECD Global Forum on Transparency and Exchange of Information for Tax Purposes two years ago found the FSM to be largely compliant.

### Private sector development
- Authorities agree that improving the business and investment climate and facilitating access to credit are critical for private sector development.
- Structural challenges include remoteness, limited natural resources and sparse population.
- Ongoing reform efforts and priority sectors include fisheries, information and communication technologies, maritime transportation, energy and niche tourism.
- Reforms include judicial reforms for business dispute resolution and coordination with the four State governments on land registries.
- A bill to amend the Foreign Investment Act is before Congress, aimed at streamlining FDI laws and creating a single national window for FDI.

### Climate change and resilience
- The FSM has many low-lying islands at risk from natural disasters, compounded by rising sea levels and temperature change.
- The CCPA found generally good planning in place and potential financing to address climate change impacts from the $200 million backlog of unspent compact infrastructure funds.
- Some infrastructure gaps remain, due to the need to find suitable donor projects and limited absorptive capacity.
- CCPA recommendations include:
  - Developing an overarching National Adaptation Plan fully integrated with sectoral and subnational strategies.
  - Creating a comprehensive strategy for building resilience to natural disasters, particularly for early warning, disaster response and risk financing.
- These measures are important given the expected loss of access to direct funding from US federal agencies for natural disaster response and reconstruction after 2023.
- Authorities will reflect on CCPA findings and recommendations.
- Full implementation of the FSM’s energy master plan should enable the country to meet its Naturally Determined Contributions under the Paris Agreement.
- Authorities acknowledge adaptation planning is lacking and will continue seeking financing and technical assistance; they request climate finance institutions to streamline requirements for small states with limited capacity to access funding.

*Statement by Nigel Ray, Executive Director for the Federated States of Micronesia and Sali David, Advisor to the Executive Director — August 28, 2019*

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/1fsmea2019001.pdf_