## cr1943

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### Recent developments and macroeconomic performance
- Real GDP contracted by 3.7 percent in FY2017, due to tourist arrivals dropping sharply by 17 percent.
- Construction activity remained subdued because of lower capital grants and a delay in the construction of a new luxury hotel.
- Inflation turned positive at 0.9 percent in FY2017 as fuel and food prices rose.
- The current account deficit increased substantially to 17.9 percent of GDP in FY2017, due to the downturn in tourism.
- The overall fiscal surplus (including grants and capital) rose to 4.8 percent of GDP in FY2017, with capital expenditure compressed at a low level due to low capital grant receipts.
- Public debt remains moderate and sustainable.
- Banking sector: loan to deposit ratio remained low at 12.2 percent in FY2017; credit to the private sector stood at 11.9 percent of GDP despite domestic credit increasing by 15.4 percent.

### Outlook and projections
- Growth projections:
  - FY2018: 0.4 percent.
  - FY2019: 2.0 percent.
  - FY2020: 2.5 percent.
  - Thereafter: gradually moderate to 2 percent as the one-off effect of increased hotel capacity dissipates.
- Inflation:
  - Projected to rise by 2.8 percent in FY2018 as commodity prices increase.
- Current account:
  - Projected to narrow to around 13 percent of GDP over the medium term with recovery in tourism and completion of major infrastructure projects.
- Fiscal position:
  - Projected to improve in the near-term as the overall fiscal balance is boosted temporarily after the disbursement of the Compact capital grants.
- Financing:
  - Deficits are expected to continue to be financed with capital grants and FDI inflows.

### Key risks to the outlook
- Downside risks are dominant:
  - Economic downturn due to lower than expected tourism arrivals would worsen the fiscal position and the external sector.
  - A shortfall of non-Compact capital grants would lead to lower infrastructure investment and lower economic growth.
  - Vulnerability to natural disasters and climate change could cause output losses and damage to infrastructure and other capital.
  - Weaker than expected global growth in the U.S. and China, a sharp tightening of global financial conditions, and further U.S. dollar appreciation could adversely affect tourism receipts.
- Policy instrument constraints:
  - Given the lack of monetary and exchange rate policy instruments, Palau would need to rely on fiscal and structural policies should these risks materialize.

### Executive Board and Directors’ assessment (policy guidance)
- Directors agreed with staff appraisal and welcomed signs of gradual recovery in tourism and construction.
- Medium-term challenges noted:
  - Expiration of the Compact grants in FY2024.
  - Revenue volatility stemming from limited economic diversification.
  - Vulnerabilities to climate change and natural disasters.
- Emphasized priorities:
  - Continued sound macroeconomic policies to ensure long-term fiscal sustainability, safeguard financial stability, reduce vulnerabilities to external shocks, and promote sustainable and resilient growth.
- Fiscal framework and fiscal adjustment:
  - Develop a medium-term fiscal framework that can accommodate high revenue volatility and manage fiscal risks; employ a net worth approach to provide the desired path for the current fiscal balance consistent with medium-term fiscal objectives.
  - Need for additional fiscal adjustment over the medium term to ensure sustained increases in public investment for resilient growth.
  - Adjustment should rely on revenue-enhancing tax reform, complemented by strengthening public financial management, including in public investment.
  - Welcome authorities’ plan to implement a comprehensive tax reform, including the introduction of the VAT.
  - Encourage continued efforts to lower subsidies to state-owned enterprises.
- Tourism and growth resilience:
  - Welcome efforts to implement a comprehensive tourism strategy to support sustainable and resilient economic growth; greater geographical diversification of source countries could enhance resilience.
  - Encourage improving the investment climate, adopting a streamlined foreign investment regime, addressing infrastructure bottlenecks, and tackling brain drain from youth emigration.
- Financial sector policies:
  - Banking system sound but lends too little domestically; advise relaxing the interest rate ceiling for commercial loans to better reflect riskiness and help small companies prepare business plans and financial statements.
  - Welcome plans to broaden financial supervision to nonbank financial institutions to preserve financial stability.
  - Recommend a cautious approach to cryptocurrencies given associated financial risks and encourage steps to address deficiencies in the AML/CFT framework.

### U.S. Compact assistance and Compact Trust Fund (CTF) treatment
- Before ratification, Palau received current grants of US$13.1 million and withdrew US$5 million from the CTF annually in 2010–17.
- Following ratification in late 2017, remaining funds under the new agreement are to be disbursed in a lump sum fashion:
  - US$65 million to be added to the CTF,
  - US$34 million for capital improvement projects,
  - US$25 million for current assistance in FY2018–19.
- CTF assumption and implication:
  - The CTF is now expected to maintain its nominal balance indefinitely, with the assumption of the same average nominal rate of return as before, as the additional contribution boosted the existing fund balance.
  - Given the higher balance, the expected investment return will now be high enough to cover the withdrawal of US$15 million a year.

### Recent fiscal outcomes and short-term projections with Compact disbursements
- Overall fiscal surplus reached 4.8 percent of GDP in FY2017.
- Overall fiscal balance (including grants and capital expenditure) has been in surplus since 2011.
- FY2017 specifics:
  - Capital expenditure compressed at 2.9 percent of GDP, compared to 5.5 percent of GDP in FY2016.
  - Domestic revenue rose by about 2 percent of GDP.
- Short-term projections with Compact disbursements:
  - Overall fiscal balance projected to increase to 8.8 percent of GDP in FY2019 with the lump sum Compact grants payment.
  - On the revenue side, capital grants from the U.S. Compact are estimated to rise by 9.2 percent of GDP in FY2019.
  - Capital investment financed by grants is projected to rise to 5 to 6 percent of GDP during 2019–21 before declining to 3.8 percent of GDP over the medium-term.
  - Tax revenue projection: projected to increase by 2 percent of GDP from 2018 owing to higher receipts from the Pristine Paradise Environmental Fee (PPEF).
  - Current expenditure:
    - Expected to rise by 2 percent of GDP because of higher transfers to state governments, the Civil Service Pension Fund (CSPF) and other entities as PPEF receipts are earmarked for redistribution.
    - Current expenditure excluding the PPEF redistribution projected to remain stable at around 32 percent of GDP in FY2018–19.

### Medium-term baseline, CTF dynamics, and staff recommendations
- Baseline overall fiscal balance: projected to remain at about 3 percent of GDP in FY2024.
- Capital spending assumption: around 4 percent of GDP in FY2022–24 financed by capital grants.
- Current grants: now at US$13 million per year, projected to decline to zero by FY2020.
- Offset via CTF withdrawals: permitted annual CTF withdrawals increase from the current US$5 million to US$15 million over the same period.
- CTF balance projection: about 80 percent of GDP by the end of FY2024.
- Staff recommendations: medium-term fiscal framework
  - Move toward a medium-term fiscal framework and strategy based on a net worth approach to:
    - Stabilize government net worth in the long run.
    - Guide necessary fiscal adjustment as the real value of the CTF declines.
    - Use the current fiscal balance (domestic revenue minus current expenditure) as the policy variable to ensure the government’s intertemporal budget constraint.
  - Objectives include medium-term fiscal sustainability, maintaining buffers and capital investment, accommodating revenue volatility and exceptional expenditure related to natural disasters.

### Staff reform scenario and fiscal adjustments
- Baseline current fiscal balance path:
  - Current fiscal deficit in FY2018 projected to widen to 6.0 percent of GDP in FY2018 and then gradually narrow to 5.0 percent in the medium-term.
- Staff argued for fiscal adjustments of 4.7 percent of GDP to create room for higher public investment.
- Under staff’s reform scenario:
  - Capital spending can be sustained at 7.5 percent of GDP from FY2023.
  - Resulting GDP growth raised to 3 percent in the medium-term and a higher government net worth than in the baseline.
- Reform scenario breakdown (FY2019–23):
  - Total Needed Adj. 4.7 percent of GDP.
  - Revenue increase under reform scenario: 3.4 percent of GDP.
  - Expenditure cut under reform scenario: 1.4 percent of GDP.
  - Assumption: Inc. VAT at about 12.5% implemented (note: assumes tax reform implemented in October 2020).
  - Tax reform with VAT estimated to increase revenue by 3 percent of GDP by 2023; revenue increase expected under the baseline is 0.4 percent of GDP.

### Tax and structural reform recommendations
- Comprehensive tax reform package under consideration would:
  - Introduce a Value-Added taxes (VAT) in place of the gross revenue tax (GRT),
  - Introduce a net profits tax,
  - Reform/reduce wages and salary tax rates for low income earners,
  - Repeal the GRT, general import tax, and hotel and vessel cabin tax.
- Expected fiscal contribution:
  - Increase in tax revenue from reform could contribute about two-thirds of the required adjustment if the VAT tax rate is set at about 12.5 percent.
  - Without tax reform, adjustment would rely more on expenditure cuts, associated with relatively lower economic growth.
- Additional tax reform details (Appendix VI):
  - Tax reform estimated to increase tax revenue by 2.4–4 percent of GDP by FY2024 depending on VAT rate (10–15 percent under consideration).
  - Staff suggest 12.5 percent VAT in the reform scenario to help meet the 3 percent of GDP revenue target from tax reform (given 1 percent from PPUC subsidy cuts).
  - Proposed VAT registration threshold: US$100,000.
  - Proposed corporate rate example: 10 percent corporate rate; current GRT rate is 4 percent.

### Public financial management (PFM), PPUC, and CSPF reforms
- PFM strengthening and expenditure efficiency:
  - Eliminating subsidies to the Palau Public Utilities Corporation (PPUC) over the next 5 years would yield a cumulative saving of 1 percent of GDP.
  - Better PFM would improve efficiency in public investment and help manage PPP-related contingent liabilities.
  - A formal Public Expenditure and Financial Accountability (PEFA) assessment would help update and identify areas for the PFM roadmap (self-assessment in 2013).
- Quasi-fiscal risks and reform steps:
  - CSPF: part of PPEF revenue allocated to CSPF starting 2018; fund liabilities expected to exceed assets in the medium term absent additional pension reform; actuarial study under way.
  - PPUC: government provided subsidies of about 1 percent of GDP last year; PPUC expected to increase tariffs to operate on a full-cost recovery basis per AsDB loan terms; authorities considering long-term plan to introduce solar energy sources to limit exposure to rising fuel prices.
- Staff analysis: public debt remains sustainable under the baseline.

### Authorities’ views and policy intentions
- Authorities concurred with developing a medium-term fiscal framework and efforts to strengthen PFM and adopt an MTFS.
- MTFS to include multi-year budgeting, planning, and a new performance reporting framework for expenditure.
- Authorities plan to raise additional revenue given expiration of Compact assistance and to finance capital investment via bilateral grants and facilities such as the Green Climate Fund; intend to use PPPs for capital projects (national airport expansion, solar power to PPUC).
- Tax reform status: tax reform bill sent to Congress in September 2018, awaiting enactment; a tax bill was last considered in FY2014 but not approved.
- Specific tax reform measures authorities discussed: introduction of ‘Palau Goods and Service Tax (PGST)’ replacing the GRT and increase in net income tax rate for financial institutions and all PGST-registered businesses.
- Fiscal buffer (General Fund Reserve, GFR):
  - GFR established in FY2014 to provide funds in national emergencies.
  - GFR stands at about 5 percent of GDP in FY2018.
  - Authorities aim to increase GFR above 10 percent of GDP; intention was taken into account in the baseline scenario (GFR not treated separately from government deposits).
- Long-term aspiration: convert the CTF into a permanent fund; recent injection of U.S. compact grants boosted CTF balance but will only maintain a nominal value of the CTF; additional funds needed to avoid a declining real value if converted into a permanent fund.

### Making potential growth more resilient — tourism and labor
- Tourism strategy:
  - Strengthen growth potential by implementing a comprehensive tourism strategy and addressing infrastructure gaps.
  - Focus on greater diversification of source markets and moving toward high-end tourism, building on the pristine environment.
  - High-end tourism strategy: shift from higher volume of arrivals to increasing revenue per arrival while keeping growth of tourist arrivals in check; measures include tax breaks for prospective five-star hotels, increasing capacity of foreign investment board and marketing budget of Palau Visitors Authority.
- Population and labor:
  - Total population including migrants declined by 11 percent since 2005 mainly because of youth emigration.
  - Palau relies heavily on foreign labor mainly from the Philippines (about twenty-seven percent of the population).
  - President submitted a bill to increase the minimum wage to Guam levels over the next 10 years; staff warned increasing minimum wages could be counterproductive and suggested alternative approaches to retain young workers:
    - Structural reforms to improve entrepreneurial opportunities,
    - Provision of healthcare and primary schooling,
    - Vocational training in the tourism-related industry.
- Energy target and projects:
  - President target: 45 percent energy supply from renewable energy by 2020.
  - Palau recently signed an agreement with a French contractor to build a solar panel grid.

### Climate resilience and disaster preparedness
- Authorities are internalizing risks to growth and costs for ex-post response by building fiscal buffers and securing contingent financial assistance.
- Palau secured contingent financial assistance from the AsDB in 2018, which will be available over the next three years.
- Over the medium-term, greater assistance from multilateral climate change schemes is needed to cope with substantial adaptation cost to prepare for natural disasters and climate change.
- Staff recommendations:
  - Continue progress in climate resilience projects to strengthen early disaster warning system.
  - Improve coastal protection and planning.
  - Promote renewable energy.

### Impact, exposure, and financing needs (Appendix I)
- About 40 percent of Palau’s land area consists of low elevation atolls.
- Expected sea-level rise is estimated to be 0.38–0.72 meters during 2010–50 and 0.84-1.62 meters by 2100 (AsDB, 2013).
- AsDB (2013) estimates the cost of climate change in the Pacific region as a whole to be 2.2-3.5 percent of annual GDP by 2050.
- PCRAFI estimates average annual loss from disasters for Palau of US$2.7 million.
- Severe drought financing needs: US$3.2 million (1.1 percent of GDP) for water acquisition and distribution.
- Expected financing needs for the next three years: about US$8.1 million (PCRAFI’s estimate US$2.7 million × 3 years).
- Cost of the 5-year action plan (FY2016–20) estimated to be around US$500 million.
- In 2018, Palau secured policy-based contingent financial assistance for natural disasters from AsDB up to US$15 million over the next three years.
- General Fund Reserve (GFR): US$1.65 million emergency funding for severe drought was drawn from the GFR in 2016.

### Investment climate and foreign direct investment (FDI)
- Improving the investment climate is a priority to attract more foreign investment and foster private sector development.
- Key actions recommended:
  - Adopt a new foreign investment regime with less restrictions and requirements.
  - Create a one-stop shop for potential investors.
  - Address infrastructure bottlenecks to attract more FDI.
  - Improve regulatory framework and land-use planning to facilitate infrastructure development.
- World Bank Doing Business Indicators (2017) show room for improvement; Palau lags Pacific Island peers especially in:
  - Getting electricity
  - Protecting minority investors
  - Resolving insolvency
- Authorities’ view:
  - Recent Responsible Tourism Act and increased authority of the Foreign Investment Board aim to promote private sector development.
  - Authorities emphasized brain drain constraints and were optimistic that a higher minimum wage could retain emigrants and attract returnees.

### Preserving financial stability and facilitating credit extension
- Banking system strengths and weaknesses:
  - Commercial banks have ample liquidity, a low non-performing loans ratio, and stable returns on assets.
  - Private credit amounts to only 12 percent of GDP, substantially lower than other Pacific island countries.
  - Banks have invested excess liquidity in the U.S.; foreign banks continue to lend little domestically despite rapid rise in deposits.
- Interest rate caps under the usury law:
  - Interest rate on lending to individuals is capped at 18 percent per annum.
  - Interest rate on lending to corporations is capped at “the prime rate on corporate loans at large U.S. Money Center Banks+4 percentage points”—which stands at 9 percent as of August 2018.
- Other impediments to credit extension:
  - Small market size
  - Lack of secured lending for real estate
  - SMEs’ limited capacity in preparing business plans and financial statements
- Staff recommendations:
  - Relax interest rate ceiling for corporate loans.
  - Facilitate strengthening the National Development Bank of Palau (NDBP)’s lending capacity by becoming a deposit-taking institution.
- Legislative and operational notes:
  - Legislation to permit the NDBP to take deposits has been passed and now it has been under regulatory inspections for being granted for a license by the FIC.
  - NDBP lending is expected to fill part of the financing gap for SMEs once it starts taking deposits.

### Financial sector developments and AML/CFT
- Financial Institutions Commission (FIC) progress:
  - Broadening financial regulation and supervision to non-bank institutions.
  - Improving AML/CFT regime with TA from IMF/PFTAC and U.S. FDIC.
  - Made progress in conducting bank examinations, strengthening data collection and reporting, and publishing quarterly data.
  - Prepared legislation to bring credit unions under FIC supervision; bill under consideration by Congress.
- AML/CFT assessment:
  - Palau underwent an APG assessment published in September 2018; findings identified several deficiencies that could place Palau under closer scrutiny of the FATF.
  - Authorities plan to address AML/CFT deficiencies identified by APG.
- Cryptocurrencies:
  - Foreign private investors have approached authorities to operate cryptocurrencies; substantial uncertainty and no related legislation exist.
  - FIC has not granted a bank license to cryptocurrency operators.
  - Staff cautioned that cryptocurrencies pose significant financial integrity, consumer protection, and cybersecurity risks.
  - Staff urged full implementation of FATF recommendations (including the revised Recommendation 15 regarding new technologies) and a cautious approach to cryptocurrency-related plans.

### External sector assessment
- Staff assessment:
  - External position assessed to be moderately weaker than underlying fundamentals and desirable policy settings.
  - Current account deficit widened due to decline in tourism receipts; substantial uncertainty exists due to recent BOP data revisions.
  - Anticipated reduction of U.S. Compact grants will lead to a large structural change in external financing in FY2025.
  - Current account deficit increased to 17.9 percent of GDP in FY2017 due to tourism downturn.
  - Deficit projected to come down to around 13 percent of GDP over the medium-term.
  - Deficit expected to continue to be financed mostly with capital grants and FDI inflows.
  - Government’s U.S. dollar deposits (equivalent of foreign reserves in a dollarized economy) remain appropriate at 3.8 months of government spending.

### Debt sustainability, risks, and scenarios
- Public debt expected to remain sustainable despite AsDB loans of about US$53 million disbursed starting FY2016.
- Baseline projection: public debt-to-GDP ratio declines to 25.6 percent of GDP by FY2023 from 34.5 percent in FY2018.
- Public-sector debt DSA (selected baseline figures, nominal gross public debt in percent of GDP): 42.3, 32.0, 33.8, 34.5, 33.6, 32.7, 30.3, 27.5, 25.6 (projections shown for 2016–2023).
- Key risks:
  - GDP growth shocks (e.g., severe tourism downturn) and natural disasters could raise public debt substantially (example: a 5.2 percentage point decline in real GDP growth during FY2019–20 would raise public debt-to-GDP to 46.4 percent in FY2020).
  - Contingent liabilities from SOEs and CSPF: SOE sector external debt equivalent to about 10 percent of GDP; CSPF unsustainable—potential fiscal cost roughly two percent of GDP over the medium term if liabilities materialize.
- Scenarios:
  - Baseline Scenario: long-run capital spending set at 3.8 percent of GDP; government net worth stabilizes at 83.5 percent of GDP.
  - Reform Scenario: capital spending returns to historical trend of 7.5 percent of GDP by FY2024; required overall fiscal adjustment of 4.7 percent of GDP; with reform government net worth stabilizes at 86.2 percent of GDP.
  - Stress tests: constant primary balance and contingent liability shocks evaluated; contingent liability and growth shocks materially increase debt ratios.

### Banking sector soundness and structure (selected indicators)
- Deposit Money Banks total assets (million US$): 2010/11 113.6; 2011/12 135.7; 2012/13 140.4; 2013/14 175.9; 2014/15 231.8; 2015/16 281.7; 2016/17 290.9.
- Deposits (million US$): 2010/11 105.4; 2011/12 130.9; 2012/13 136.0; 2013/14 171.2; 2014/15 225.8; 2015/16 275.3; 2016/17 283.8.
- Loan/deposit ratio (in percent, series): 24.5; 19.6; 20.6; 17.3; 12.8; 10.9; 12.2.
- Nonperforming loans to total gross loans (percent): 2014 3.2; 2015 2.1; 2016 0.8; 2017 0.6; 2018 0.7.
- Return on assets (percent): 2014 1.4; 2015 1.4; 2016 1.5; 2017 1.6; 2018 1.9.
- Liquid assets to total assets (liquid asset ratio, percent): 2014 81.4; 2015 85.8; 2016 87.4; 2017 86.0; 2018 86.5.

### Domestic credit constraints and policy measures
- Structural impediments:
  - lack of secured lending for real estate,
  - small businesses’ limited capacity to prepare financial statements,
  - lending caps on the interest rate.
- Interest rate ceilings and observed ceilings:
  - Individual loan ceiling: 18%
  - Corporate loan ceiling: 7.25% (note: elsewhere corporate cap described as “prime +4” equating to 9 percent as of August 2018).
- Role of NDBP:
  - NDBP to fill financing gap for SMEs once licensed to take deposits; legislation passed but licensing pending regulatory inspections.
- SME support:
  - Technical assistance for SMEs to prepare business plans and financial statements.
  - Improve secured lending frameworks.

### Tourism sector composition and performance
- Tourist arrivals (selected):
  - FY2013: 168,764
  - FY2016: 146,629
  - FY2017: 122,050
  - FY2018 (est.): 115,964
  - FY2019 (proj.): 118,283
- Expenditure per Tourist Arrival (US$):
  - FY2013: 875
  - FY2016: 937
  - FY2017: 1,003
  - FY2018 (est.): 1,074
  - FY2019 (proj.): 1,152
- Tourism concentration:
  - Tourism sector accounts for 86 percent of total exports in 2016.
  - Export concentration index rose from 0.65 in 2006 to 0.81 in 2016.
- Source market change (2010 → 2018): China increased to 43% in 2018 from 1% in 2010; Japan declined to 21% from 35%.

### Labor market and minimum wage
- Current wage rate in Palau: US$3.50 an hour.
- Proposed path: increase to US$8.50 by 50 cents annually over the next ten years.
- Staff caution:
  - Large minimum wage increases can adversely affect competitiveness and fiscal costs for state governments.
  - Minimum wage is not an effective tool to reverse emigration; alternatives recommended include structural reforms, diaspora engagement, and better data collection on emigration.

### Selected key statistics (staff estimates and projections)
- Nominal GDP for FY2017: US$290 million
- Population (2015): 17,661
- GDP per capita for FY2015: US$17,139
- Consumer prices (percent change; period average):
  - FY2016: -1.0
  - FY2017: 0.9
  - FY2018 (proj.): 2.8
- Current account balance (including grants, percent of GDP):
  - FY2016: -10.5
  - FY2017: -17.9
  - FY2018 (proj.): -17.3
  - FY2019 (proj.): -16.0
- Current account balance (excluding grants, percent of GDP):
  - FY2017: -32.4
  - FY2018 (proj.): -31.6
  - FY2019 (proj.): -30.7
- Central government:
  - Overall fiscal surplus (including grants and capital) in FY2017: 4.8 percent of GDP
  - Current fiscal balance (excluding grants) FY2017: -5.4 percent of GDP
  - Grants in FY2017: 13.1 percent of GDP

*Source: IMF staff report (Republic of Palau, Article IV Consultation, staff estimates and projections).*

### 3.7 percent in FY2017, due to tourist arrivals dropping sharply by 17 percent. Construction

### cr1943 - 3.7 percent in FY2017, due to tourist arrivals dropping sharply by 17 percent. Construction

### Recent developments and macroeconomic performance
- Real GDP contracted by 3.7 percent in FY2017, due to tourist arrivals dropping sharply by 17 percent.
- Construction activity remained subdued because of lower capital grants and a delay in the construction of a new luxury hotel.
- Inflation turned positive at 0.9 percent in FY2017 as fuel and food prices rose.
- The current account deficit increased substantially to 17.9 percent of GDP in FY2017, due to the downturn in tourism.
- The overall fiscal surplus (including grants and capital) rose to 4.8 percent of GDP in FY2017, with capital expenditure compressed at a low level due to low capital grant receipts.
- Public debt remains moderate and sustainable.
- Banking sector: loan to deposit ratio remained low at 12.2 percent in FY2017; credit to the private sector stood at 11.9 percent of GDP despite domestic credit increasing by 15.4 percent.

### Outlook and projections
- Growth projections:
  - FY2018: 0.4 percent.
  - FY2019: 2.0 percent.
  - FY2020: 2.5 percent.
  - Thereafter: gradually moderate to 2 percent as the one-off effect of increased hotel capacity dissipates.
- Inflation:
  - Projected to rise by 2.8 percent in FY2018 as commodity prices increase.
- Current account:
  - Projected to narrow to around 13 percent of GDP over the medium term with recovery in tourism and completion of major infrastructure projects.
- Fiscal position:
  - Projected to improve in the near-term as the overall fiscal balance is boosted temporarily after the disbursement of the Compact capital grants.
- Financing:
  - Deficits are expected to continue to be financed with capital grants and FDI inflows.

### Key risks to the outlook
- Downside risks are dominant:
  - Economic downturn due to lower than expected tourism arrivals would worsen the fiscal position and the external sector.
  - A shortfall of non-Compact capital grants would lead to lower infrastructure investment and lower economic growth.
  - Vulnerability to natural disasters and climate change could cause output losses and damage to infrastructure and other capital.
  - Weaker than expected global growth in the U.S. and China, a sharp tightening of global financial conditions, and further U.S. dollar appreciation could adversely affect tourism receipts.
- Policy instrument constraints:
  - Given the lack of monetary and exchange rate policy instruments, Palau would need to rely on fiscal and structural policies should these risks materialize.

### Executive Board and Directors’ assessment (policy guidance)
- Directors agreed with staff appraisal and welcomed signs of gradual recovery in tourism and construction.
- Medium-term challenges noted:
  - Expiration of the Compact grants in FY2024.
  - Revenue volatility stemming from limited economic diversification.
  - Vulnerabilities to climate change and natural disasters.
- Emphasized priorities:
  - Continued sound macroeconomic policies to ensure long-term fiscal sustainability, safeguard financial stability, reduce vulnerabilities to external shocks, and promote sustainable and resilient growth.
- Fiscal framework and fiscal adjustment:
  - Develop a medium-term fiscal framework that can accommodate high revenue volatility and manage fiscal risks; employ a net worth approach to provide the desired path for the current fiscal balance consistent with medium-term fiscal objectives.
  - Need for additional fiscal adjustment over the medium term to ensure sustained increases in public investment for resilient growth.
  - Adjustment should rely on revenue-enhancing tax reform, complemented by strengthening public financial management, including in public investment.
  - Welcome authorities’ plan to implement a comprehensive tax reform, including the introduction of the VAT.
  - Encourage continued efforts to lower subsidies to state-owned enterprises.
- Tourism and growth resilience:
  - Welcome efforts to implement a comprehensive tourism strategy to support sustainable and resilient economic growth; greater geographical diversification of source countries could enhance resilience.
  - Encourage improving the investment climate, adopting a streamlined foreign investment regime, addressing infrastructure bottlenecks, and tackling brain drain from youth emigration.
- Financial sector policies:
  - Banking system sound but lends too little domestically; advise relaxing the interest rate ceiling for commercial loans to better reflect riskiness and help small companies prepare business plans and financial statements.
  - Welcome plans to broaden financial supervision to nonbank financial institutions to preserve financial stability.
  - Recommend a cautious approach to cryptocurrencies given associated financial risks and encourage steps to address deficiencies in the AML/CFT framework.

### Selected key statistics (from staff estimates and projections)
- Nominal GDP for FY2017: US$290 million
- Population (2015): 17,661
- GDP per capita for FY2015: US$17,139
- Tourist arrivals:
  - FY2013: 168,764
  - FY2016: 146,629
  - FY2017: 122,050
  - FY2018 (est.): 115,964
  - FY2019 (proj.): 118,283
- Expenditure per Tourist Arrival (US$):
  - FY2013: 875
  - FY2016: 937
  - FY2017: 1,003
  - FY2018 (est.): 1,074
  - FY2019 (proj.): 1,152
- Consumer prices (percent change; period average):
  - FY2016: -1.0
  - FY2017: 0.9
  - FY2018 (proj.): 2.8
- Current account balance (including grants, percent of GDP):
  - FY2016: -10.5
  - FY2017: -17.9
  - FY2018 (proj.): -17.3
  - FY2019 (proj.): -16.0
- Current account balance (excluding grants, percent of GDP):
  - FY2017: -32.4
  - FY2018 (proj.): -31.6
  - FY2019 (proj.): -30.7
- Central government:
  - Overall fiscal surplus (including grants and capital) in FY2017: 4.8 percent of GDP
  - Current fiscal balance (excluding grants) FY2017: -5.4 percent of GDP
  - Grants in FY2017: 13.1 percent of GDP

*Source: IMF staff report (Republic of Palau, Article IV Consultation, staff estimates and projections).*

### 10.      Palau has continued to receive substantial U.S. financial assistance despite the delay in

### 10.      Palau has continued to receive substantial U.S. financial assistance despite the delay in the ratification of the new Compact Agreement

### U.S. Compact assistance and CTF treatment
- Before ratification, Palau received current grants of US$13.1 million and withdrew US$5 million from the CTF annually in 2010–17.
- Following ratification in late 2017, remaining funds under the new agreement are to be disbursed in a lump sum fashion:
  - US$65 million to be added to the CTF,
  - US$34 million for capital improvement projects,
  - US$25 million for current assistance in FY2018–19.
- CTF assumption and implication:
  - The CTF is now expected to maintain its nominal balance indefinitely, with the assumption of the same average nominal rate of return as before, as the additional contribution boosted the existing fund balance.
  - Given the higher balance, the expected investment return will now be high enough to cover the withdrawal of US$15 million a year.

### Recent fiscal outcomes
- Overall fiscal surplus reached 4.8 percent of GDP in FY2017.
- Overall fiscal balance (including grants and capital expenditure) has been in surplus since 2011.
- FY2017 specifics:
  - Capital expenditure compressed at 2.9 percent of GDP, compared to 5.5 percent of GDP in FY2016.
  - Domestic revenue rose by about 2 percent of GDP.
- Composition note: lower capital grant receipts were a key factor reducing capital expenditure in FY2017.

### Short-term projections with Compact disbursements
- Overall fiscal balance projected to increase to 8.8 percent of GDP in FY2019 with the lump sum Compact grants payment.
- On the revenue side, capital grants from the U.S. Compact are estimated to rise by 9.2 percent of GDP in FY2019.
- Capital investment financed by grants is projected to rise to 5 to 6 percent of GDP during 2019–21 before declining to 3.8 percent of GDP over the medium-term.
- Tax revenue projection: projected to increase by 2 percent of GDP from 2018 owing to higher receipts from the Pristine Paradise Environmental Fee (PPEF).
- Current expenditure:
  - Expected to rise by 2 percent of GDP because of higher transfers to state governments, the Civil Service Pension Fund (CSPF) and other entities as PPEF receipts are earmarked for redistribution.
  - Current expenditure excluding the PPEF redistribution projected to remain stable at around 32 percent of GDP in FY2018–19.

### Medium-term baseline and CTF dynamics
- Baseline overall fiscal balance: projected to remain at about 3 percent of GDP in FY2024.
- Capital spending assumption: around 4 percent of GDP in FY2022–24 financed by capital grants.
- Current grants: now at US$13 million per year, projected to decline to zero by FY2020.
- Offset via CTF withdrawals: permitted annual CTF withdrawals increase from the current US$5 million to US$15 million over the same period.
- CTF balance projection: about 80 percent of GDP by the end of FY2024.

### Staff recommendations: medium-term fiscal framework
- Move toward a medium-term fiscal framework and strategy based on a net worth approach to:
  - Stabilize government net worth in the long run.
  - Guide necessary fiscal adjustment as the real value of the CTF declines.
  - Use the current fiscal balance (domestic revenue minus current expenditure) as the policy variable to ensure the government’s intertemporal budget constraint.
- Objectives include medium-term fiscal sustainability, maintaining buffers and capital investment, accommodating revenue volatility and exceptional expenditure related to natural disasters.

### Staff reform scenario and fiscal adjustments
- Baseline current fiscal balance path:
  - Current fiscal deficit in FY2018 projected to widen to 6.0 percent of GDP in FY2018 and then gradually narrow to 5.0 percent in the medium-term.
- Staff argued for fiscal adjustments of 4.7 percent of GDP to create room for higher public investment.
- Under staff’s reform scenario:
  - Capital spending can be sustained at 7.5 percent of GDP from FY2023.
  - Resulting GDP growth raised to 3 percent in the medium-term and a higher government net worth than in the baseline.
- Reform scenario breakdown (FY2019–23):
  - Total Needed Adj. 4.7 percent of GDP.
  - Revenue increase under reform scenario: 3.4 percent of GDP.
  - Expenditure cut under reform scenario: 1.4 percent of GDP.
  - Assumption: Inc. VAT at about 12.5% implemented (note: assumes tax reform implemented in October 2020).
  - Tax reform with VAT estimated to increase revenue by 3 percent of GDP by 2023; revenue increase expected under the baseline is 0.4 percent of GDP.

### Tax and structural reform recommendations
- Comprehensive tax reform package under consideration would:
  - Introduce a Value-Added taxes (VAT) in place of the gross revenue tax (GRT),
  - Introduce a net profits tax,
  - Reform/reduce wages and salary tax rates for low income earners,
  - Repeal the GRT, general import tax, and hotel and vessel cabin tax.
- Expected fiscal contribution:
  - Increase in tax revenue from reform could contribute about two-thirds of the required adjustment if the VAT tax rate is set at about 12.5 percent.
  - Without tax reform, adjustment would rely more on expenditure cuts, associated with relatively lower economic growth.

### Public financial management, PPUC, and CSPF reforms
- PFM strengthening and expenditure efficiency:
  - Eliminating subsidies to the Palau Public Utilities Corporation (PPUC) over the next 5 years would yield a cumulative saving of 1 percent of GDP.
  - Better PFM would improve efficiency in public investment and help manage PPP-related contingent liabilities.
  - A formal Public Expenditure and Financial Accountability (PEFA) assessment would help update and identify areas for the PFM roadmap (self-assessment in 2013).
- Quasi-fiscal risks and reform steps:
  - CSPF: part of PPEF revenue allocated to CSPF starting 2018; fund liabilities expected to exceed assets in the medium term absent additional pension reform; actuarial study under way.
  - PPUC: government provided subsidies of about 1 percent of GDP last year; PPUC expected to increase tariffs to operate on a full-cost recovery basis per AsDB loan terms; authorities considering long-term plan to introduce solar energy sources to limit exposure to rising fuel prices.
- Staff analysis: public debt remains sustainable under the baseline.

### Authorities’ views and policy intentions
- Authorities concurred with developing a medium-term fiscal framework and efforts to strengthen PFM and adopt an MTFS.
- MTFS to include multi-year budgeting, planning, and a new performance reporting framework for expenditure.
- Authorities plan to raise additional revenue given expiration of Compact assistance and to finance capital investment via bilateral grants and facilities such as the Green Climate Fund; intend to use PPPs for capital projects (national airport expansion, solar power to PPUC).
- Tax reform status: tax reform bill sent to Congress in September 2018, awaiting enactment; a tax bill was last considered in FY2014 but not approved.
- Specific tax reform measures authorities discussed: introduction of ‘Palau Goods and Service Tax (PGST)’ replacing the GRT and increase in net income tax rate for financial institutions and all PGST-registered businesses.
- Fiscal buffer (General Fund Reserve, GFR):
  - GFR established in FY2014 to provide funds in national emergencies.
  - GFR stands at about 5 percent of GDP in FY2018.
  - Authorities aim to increase GFR above 10 percent of GDP; intention was taken into account in the baseline scenario (GFR not treated separately from government deposits).
- Long-term aspiration: convert the CTF into a permanent fund; recent injection of U.S. compact grants boosted CTF balance but will only maintain a nominal value of the CTF; additional funds needed to avoid a declining real value if converted into a permanent fund.

### Making potential growth more resilient — tourism and labor
- Tourism strategy:
  - Strengthen growth potential by implementing a comprehensive tourism strategy and addressing infrastructure gaps.
  - Focus on greater diversification of source markets and moving toward high-end tourism, building on the pristine environment.
  - High-end tourism strategy: shift from higher volume of arrivals to increasing revenue per arrival while keeping growth of tourist arrivals in check; measures include tax breaks for prospective five-star hotels, increasing capacity of foreign investment board and marketing budget of Palau Visitors Authority.
- Population and labor:
  - Total population including migrants declined by 11 percent since 2005 mainly because of youth emigration.
  - Palau relies heavily on foreign labor mainly from the Philippines (about twenty-seven percent of the population).
  - President submitted a bill to increase the minimum wage to Guam levels over the next 10 years; staff warned increasing minimum wages could be counterproductive and suggested alternative approaches to retain young workers:
    - Structural reforms to improve entrepreneurial opportunities,
    - Provision of healthcare and primary schooling,
    - Vocational training in the tourism-related industry.
- Energy target and projects:
  - President target: 45 percent energy supply from renewable energy by 2020.
  - Palau recently signed an agreement with a French contractor to build a solar panel grid.

*Source: IMF staff report excerpt (Republic of Palau).*

### 24.      Building resilience to climate change and natural disasters is critical to Palau’s

### Building resilience to climate change and natural disasters is critical to Palau’s

### Climate resilience and disaster preparedness
- Authorities are internalizing risks to growth and costs for ex-post response by building fiscal buffers and securing contingent financial assistance.
- Palau secured contingent financial assistance from the AsDB in 2018, which will be available over the next three years.
- Over the medium-term, greater assistance from multilateral climate change schemes is needed to cope with substantial adaptation cost to prepare for natural disasters and climate change.
- Staff recommendations:
  - Continue progress in climate resilience projects to strengthen early disaster warning system.
  - Improve coastal protection and planning.
  - Promote renewable energy.

### Investment climate and foreign direct investment (FDI)
- Improving the investment climate is a priority to attract more foreign investment and foster private sector development.
- Key actions recommended:
  - Adopt a new foreign investment regime with less restrictions and requirements.
  - Create a one-stop shop for potential investors.
  - Address infrastructure bottlenecks to attract more FDI.
  - Improve regulatory framework and land-use planning to facilitate infrastructure development.
- World Bank Doing Business Indicators (2017) show room for improvement; Palau lags Pacific Island peers especially in:
  - Getting electricity
  - Protecting minority investors
  - Resolving insolvency
- Authorities’ view:
  - Recent Responsible Tourism Act and increased authority of the Foreign Investment Board aim to promote private sector development.
  - Authorities emphasized brain drain constraints and were optimistic that a higher minimum wage could retain emigrants and attract returnees, though they regarded higher unemployment or loss of competitiveness as less likely outcomes than staff assessed.

### Preserving financial stability and facilitating credit extension
- Banking system strengths and weaknesses:
  - Commercial banks have ample liquidity, a low non-performing loans ratio, and stable returns on assets.
  - Private credit amounts to only 12 percent of GDP, substantially lower than other Pacific island countries.
  - Banks have invested excess liquidity in the U.S.; foreign banks continue to lend little domestically despite rapid rise in deposits.
- Interest rate caps under the usury law:
  - Interest rate on lending to individuals is capped at 18 percent per annum.
  - Interest rate on lending to corporations is capped at “the prime rate on corporate loans at large U.S. Money Center Banks+4 percentage points”—which stands at 9 percent as of August 2018.
- Other impediments to credit extension:
  - Small market size
  - Lack of secured lending for real estate
  - SMEs’ limited capacity in preparing business plans and financial statements
- Staff recommendations:
  - Relax interest rate ceiling for corporate loans.
  - Facilitate strengthening the National Development Bank of Palau (NDBP)’s lending capacity by becoming a deposit-taking institution.
- Legislative and operational notes:
  - Legislation to permit the NDBP to take deposits has been passed and now it has been under regulatory inspections for being granted for a license by the FIC.
  - NDBP lending is expected to fill part of the financing gap for SMEs once it starts taking deposits.
- Authorities’ view:
  - Agreed banks remain sound and credit needs to rise.
  - Not convinced interest rate ceiling on commercial loans is a key obstacle to credit growth.
  - Agreed NDBP could play a role in extending domestic credit but needs to strengthen financial positions and satisfy regulatory requirements first.

### Financial sector developments and AML/CFT
- Financial Institutions Commission (FIC) progress:
  - Broadening financial regulation and supervision to non-bank institutions.
  - Improving AML/CFT regime with TA from IMF/PFTAC and U.S. FDIC.
  - Made progress in conducting bank examinations, strengthening data collection and reporting, and publishing quarterly data.
  - Prepared legislation to bring credit unions under FIC supervision; bill under consideration by Congress.
- AML/CFT assessment:
  - Palau underwent an APG assessment published in September 2018; findings identified several deficiencies that could place Palau under closer scrutiny of the FATF.
  - Authorities plan to address AML/CFT deficiencies identified by APG.
- Cryptocurrencies:
  - Foreign private investors have approached authorities to operate cryptocurrencies; substantial uncertainty and no related legislation exist.
  - FIC has not granted a bank license to cryptocurrency operators.
  - Staff cautioned that cryptocurrencies pose significant financial integrity, consumer protection, and cybersecurity risks.
  - Staff urged full implementation of FATF recommendations (including the revised Recommendation 15 regarding new technologies) and a cautious approach to cryptocurrency-related plans to avoid pressure on Palau’s banking relationships with foreign banks.
- Authorities’ view:
  - Expect financial supervision to cover credit unions once legislation is passed.
  - Emphasized need for cooperation and exchange of information with foreign jurisdictions to address foreign-originated money laundering risks.
  - Urged IMF assistance on regulation for cryptocurrency and blockchain technology.

### External sector assessment
- Staff assessment:
  - External position assessed to be moderately weaker than underlying fundamentals and desirable policy settings.
  - Current account deficit widened due to decline in tourism receipts; substantial uncertainty exists due to recent BOP data revisions.
  - Anticipated reduction of U.S. Compact grants will lead to a large structural change in external financing in FY2025.
  - Current account deficit increased to 17.9 percent of GDP in FY2017 due to tourism downturn.
  - Deficit projected to come down to around 13 percent of GDP over the medium-term.
  - Deficit expected to continue to be financed mostly with capital grants and FDI inflows.
  - Government’s U.S. dollar deposits (equivalent of foreign reserves in a dollarized economy) remain appropriate at 3.8 months of government spending.
- Authorities’ view:
  - Agreed with staff assessment; noted fiscal consolidation, construction recovery, and tourism recovery would help reduce current account deficit.
  - Acknowledged ongoing TA on BOP statistics that could lead to downward revision in historical current account deficits.

### Statistics and surveillance
- Palau’s statistics are broadly adequate for surveillance due to TA from IMF PFTAC and Graduate School USA.
- Staff advice:
  - Further improvements to BOP statistics.
  - Inclusion of statistics on non-bank financial institutions in monetary statistics to help surveillance of financial activities.

### Staff appraisal — outlook, risks, and policy priorities
- Growth and outlook:
  - Economic growth expected to recover over the medium term, led by rebound in tourism and construction financed by recent disbursement of the Compact grant for capital projects.
  - Growth projected to increase to 2.5 percent in FY2020 on the back of tourism rebound and continuing construction activity.
  - Inflation expected to remain low with stable commodity prices and low U.S. inflation.
  - Current account deficit expected to decline as fiscal consolidation continues.
  - External sector position assessed as moderately weaker than underlying fundamentals.
- Downside risks:
  - Slower growth due to lower than expected tourist arrivals from failure to implement a tourism strategy.
  - Vulnerability to natural disasters.
  - Weaker global growth and sharp tightening of global financial conditions with further U.S. dollar appreciation.
- Fiscal framework and reforms:
  - Develop a medium-term fiscal framework using the net worth approach to provide desired path for current fiscal balance and support sustainability when Compact grants expire in FY2024.
  - Revenue-enhancing tax reform to create room for higher capital investment and strengthen fiscal buffers.
    - Comprehensive tax reform should include introduction of a VAT and lower subsidies to SOEs, requiring reforming the CSPF and restructuring the PPUC.
    - Higher revenue from tax reform can provide fiscal space for higher public investment, contributing to higher potential growth.
  - Strengthen public financial management to efficiently develop and maintain infrastructure assets while maintaining fiscal discipline and reducing fiscal risks from investment projects.
- Sectoral and labor recommendations:
  - Implement a comprehensive high-end tourism strategy expeditiously; encourage greater geographical diversification of source countries.
  - Youth emigration constraint: increasing the minimum wage to Guam levels could lead to higher unemployment and encourage foreign labor inflows; staff advise structural reforms instead:
    - Improve entrepreneurial opportunities.
    - Strengthen healthcare provision.
    - Enhance primary schooling and vocational training in the tourism industry.
- Financial sector reforms:
  - Relax interest rate ceiling for commercial loans to help credit extension.
  - Help SMEs prepare business plans and financial statements.
  - Implement FIC supervision extension to credit unions and address AML/CFT deficiencies in a timely manner.
  - Adopt a cautious approach to cryptocurrencies given financial integrity risks, particularly in the absence of AML/CFT measures for virtual assets.

*Source: cr1943 - 24.*

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

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

### Real sector: developments and volatility
- Real GDP and growth
  - Nominal GDP for FY2017: US$290 million
  - Real GDP growth (selected years, percent change): FY2015 0.5; FY2016 -3.7; FY2017 0.4; FY2018 2.0; FY2019 2.5
- Growth volatility
  - Palau has experienced high growth volatility relative to peers in the Pacific (Volatility of GDP Growth, 2001-2017: ordered by standard deviation)
- Inflation
  - Consumer prices (period average, selected years): FY2015 -1.0; FY2016 0.9; FY2017 2.8; FY2018 2.4; FY2019 2.0
  - Headline inflation has become positive on the back of rising food prices.
- Financial intermediation
  - Credit to private sector (in percent of GDP, selected): 12.4; 12.0; 9.8; 9.8; 11.9 (series in Tables)
  - Domestic credit markets remain highly underdeveloped, with banks lending little despite sizable asset positions.

### Tourism sector: composition, revenue, and fiscal impact
- Source market composition (change 2010 → 2018)
  - 2010: Japan 35%, South Korea 17%, Taiwan, Province of China 27%, China 1%, USA/Canada 9%, Europe 5%, Others 6%
  - 2018: Japan 21%, South Korea 11%, Taiwan, Province of China 10%, China 43%, USA/Canada 7%, Europe 4%, Others 4%
- Tourism receipts and expenditure per visitor
  - Expenditure per Tourist Arrival (US$): FY2010 1,006; FY2011 1,016; FY2012 875; FY2013 937; FY2014 1,003; FY2015 1,074; FY2016 1,152; FY2017 1,236
  - Revenue per visitor arrival and per visitor night (index shown FY2010–FY2017) — revenue per tourist declined during the FY15 boom and has gradually reversed.
- Hotel performance
  - Growth in visitor nights by hotel grade (FY2010–17): ‘second tier’ hotels grew most; occupancy rates in high-end hotels remained stable, other types more volatile.
- Fiscal impact
  - The recent downturn has reduced tourism related taxes at both the federal and state-level.

### External sector: balances, exchange rates, and debt
- Current account and trade
  - Current account balance (including grants, percent of GDP, selected): FY2015 -51.9; FY2016 -51.4; FY2017 -49.7; FY2018 -51.2
  - Exports of services and imports of goods: export decline from FY16 with decline in tourist arrivals; imports maintained weak growth.
  - The current account deficit has been larger than other PICs and the gap widened due to a decline in service exports and capital grants.
- Exchange rate
  - Palau: Nominal effective exchange rate (NEER) and Real effective exchange rate (REER) indexed to 2005=100 show a mild depreciation since 2016.
- External debt and financing
  - External debt increased sharply during FY16-17, mainly due to disbursements of AsDB loans.
  - Public external debt (percent of GDP, selected): 26.3; 29.6; 30.8; 32.7; 33.2 (series in Tables)
  - External debt (in percent of exports of goods and services, projection): FY2015 51.3; FY2016 60.6; FY2017 64.4; FY2018 65.6; FY2019 64.0; FY2020 59.6; FY2021 55.2; FY2022 50.5; FY2023 46.1

### Fiscal sector: revenue, spending, and medium-term scenarios
- Key fiscal aggregates (Central Government, percent of GDP, selected)
  - Taxes and other revenue: FY2015 24.8; FY2016 26.6; FY2017 28.0; FY2018 28.1; FY2019 28.1; FY2020 28.1
  - Grants: FY2015 16.2; FY2016 13.1; FY2017 12.0; FY2018 21.2; FY2019 13.0; FY2020 12.5
  - Expense: FY2015 32.0; FY2016 32.0; FY2017 34.0; FY2018 33.9; FY2019 33.8; FY2020 33.7
  - Net acquisition of nonfinancial assets (percent of GDP, selected): FY2015 5.5; FY2016 2.9; FY2017 1.8; FY2018 6.6; FY2019 5.5; FY2020 5.1
- Fiscal balances
  - Current balance (excluding grants, percent of GDP): FY2015 -7.2; FY2016 -5.4; FY2017 -6.0; FY2018 -5.8; FY2019 -5.7; FY2020 -5.5
  - Current balance (including current grants, percent of GDP): FY2015 2.7; FY2016 5.6; FY2017 4.6; FY2018 5.5; FY2019 3.4; FY2020 3.3
  - Net lending (+)/borrowing (–) (percent of GDP, selected): FY2015 3.5; FY2016 4.8; FY2017 4.3; FY2018 8.8; FY2019 1.8; FY2020 1.8
- Government assets and deposits
  - Compact Trust Fund (CTF) balance (million US$): FY2015 189.6; FY2016 199.2; FY2017 183.9; FY2018 196.8; FY2019 219.8; FY2020 226.5
  - Government cash and deposits (million US$ and percent of GDP): FY2015 6.2; FY2016 9.6; FY2017 23.4; FY2018 28.6; FY2019 32.7; FY2020 49.9 (In percent of GDP: 2.8; 3.9; 8.0; 9.4; 11.3; 16.8)
- Public spending composition
  - Wage bill as share of revenue and expenditure: Palau spends far more than peers on wages.
- Investment needs and outlook
  - To restore investment and guarantee sustainability, a large fiscal investment is needed.
  - Government currency and deposits are projected to continue to accumulate at a reduced pace after FY19 under the baseline.

### Medium-term projections and Staff's reform scenario
- Baseline projections (Real sector and public finance, selected)
  - Real GDP growth (percent change): 2018/19 2.0; 2019/20 2.5; 2020/21 2.2; 2021/22 2.0; 2022/23 2.0; 2023/24 2.0
  - Consumer prices (period average): 2018/19 2.4; projection 2019/20 2.0; 2020/21 2.0; 2021/22 2.0; 2022/23 2.0; 2023/24 2.0
  - Current account balance (including grants, percent of GDP, projection): 2018/19 -16.0; 2019/20 -15.8; 2020/21 -15.4; 2021/22 -13.6; 2022/23 -12.7; 2023/24 -11.8
- Staff's reform scenario (assumptions and outcomes)
  - Assumption: the current fiscal deficit is reduced by 1.1 percent of GDP each year during FY2019-24 to 1.9 percent of GDP in FY2025 by raising taxes and cutting current expenditure; additional savings are used to increase public investment to 7.5 percent of GDP by FY2024.
  - Real GDP growth under reform scenario (percent change): 2019/20 2.5; 2020/21 2.2; 2021/22 2.8; 2022/23 3.0; 2023/24 3.0
  - Current account balance (including grants, percent of GDP) under reform scenario: 2019/20 -15.2; 2020/21 -15.0; 2021/22 -13.2; 2022/23 -12.2; 2023/24 -11.2
  - Fiscal improvements relative to baseline: by 2021/22 current balance (excluding grants) improves by 1.5 percentage points of GDP; net lending/borrrowing improves by 0.4–0.5 percentage points in later years.
- Fiscal space usage
  - For the exercise, it is assumed Palau uses additional fiscal space to fund capital investment directly.

### Banking sector soundness and structure
- Bank assets and deposits (selected)
  - Deposit Money Banks total assets (million US$): 2010/11 113.6; 2011/12 135.7; 2012/13 140.4; 2013/14 175.9; 2014/15 231.8; 2015/16 281.7; 2016/17 290.9
  - Deposits (million US$): 2010/11 105.4; 2011/12 130.9; 2012/13 136.0; 2013/14 171.2; 2014/15 225.8; 2015/16 275.3; 2016/17 283.8
  - Loan/deposit ratio (in percent, series): 24.5; 19.6; 20.6; 17.3; 12.8; 10.9; 12.2
- Financial soundness indicators (2014–2018)
  - Nonperforming loans to total gross loans (percent): 2014 3.2; 2015 2.1; 2016 0.8; 2017 0.6; 2018 0.7
  - Return on assets (percent): 2014 1.4; 2015 1.4; 2016 1.5; 2017 1.6; 2018 1.9
  - Liquid assets to total assets (liquid asset ratio, percent): 2014 81.4; 2015 85.8; 2016 87.4; 2017 86.0; 2018 86.5

*Source: Palau authorities; and Fund staff estimates and projections.*

### Appendix I. Enhancing Resilience to Climate Change

### Appendix I. Enhancing Resilience to Climate Change

### Impact and exposure
- About 40 percent of Palau’s land area consists of low elevation atolls.
- Expected sea-level rise is estimated to be 0.38–0.72 meters during 2010–50 and 0.84-1.62 meters by 2100 (AsDB, 2013).
- The expected cost of climate change in Palau would be substantial given Palau’s high dependence on tourism and fisheries.
- AsDB (2013) estimates the cost of climate change in the Pacific region as a whole to be 2.2-3.5 percent of annual GDP by 2050, with significant sectoral impacts on agriculture, fisheries, tourism, environment protection and health.

### Historical probability of natural disasters
- The Emergency Events Database (EM-DAT) indicates Palau had been hit by natural disasters only once since 1980.
- Based on EM-DAT, Lee, Zhang and Nguyen (2018) suggest Palau’s low likelihood of severe natural disaster means no medium-term baseline projection adjustment is necessary for expected severe natural disasters.

### Expected losses and financing needs
- PCRAFI estimates average annual loss from disasters for Palau of US$2.7 million.
- Severe drought associated with El Niño led to water shortages; the government’s estimated financing needs were US$3.2 million (1.1 percent of GDP), mainly for water acquisition and distribution.
- The expected financing needs for the next three years would be about US$8.1 million (i.e., PCRAFI’s estimate on average annual loss from natural disasters US$2.7 million × 3 years).

### Authorities’ adaptation strategy and financing
- Palau’s adaptation strategy and action plan are embedded in the “Palau Climate Change Policy: For Climate and Disaster Resilient Low Emissions Development” with aims to:
  - enhance adaptation and resilience;
  - manage disasters and minimize disaster risk; and
  - mitigate global climate change by working towards low emission development.
- Cost of the 5-year action plan (FY2016–20) is estimated to be around US$500 million.
- The authorities plan to finance implementation from multilateral and bilateral donors, and the national budget.
- In 2018, Palau secured policy-based contingent financial assistance for natural disasters from AsDB up to US$15 million over the next three years.
- The General Fund Reserve (GFR) can be used for emergency funding; US$1.65 million emergency funding for severe drought was drawn from the GFR in 2016 (Republic of Palau Public Law No. 9-59. 2016. Extreme Drought Emergency Funding Act).

### Fiscal and reserve context relevant to disaster response
- Government U.S. dollar deposits effectively serve as reserves in a fully dollarized economy.
- The liquid asset ratio in the banking sector is 86 percent.
- Central government deposits were 11.3 percent of GDP in FY2017, corresponding to 3.8 months of government spending and 1.8 months of imports.
- A rule of thumb minimum size of fiscal reserves is one month of government spending.

### Staff-supported measures and policy recommendations
- Near-term priorities:
  - Internalize risks to growth and ex-post response costs by building domestic fiscal buffers and securing external buffers.
- Staff supported and encouraged continuing climate resilience projects to:
  - strengthen the early disaster warning system;
  - improve coastal protection and planning; and
  - promote renewable energy.
- Medium-term priorities:
  - Given substantial adaptation costs, increasing financial assistance from multilateral climate change schemes should be a priority.
- Contingent planning recommended:
  - Maintain reserve buffers and expand contingent financing plans with development partners.
  - Strengthen infrastructure including coastal protection and planning.
  - In the event of disasters, draw on contingent funding to rebuild infrastructure and provide social safety nets to the affected.

*Source: Appendix I. Enhancing Resilience to Climate Change.*

### 5. Sharp

### 5. Sharp

### Global financial conditions risk (short term)
- Risk: tightening of global financial conditions (short term).
- Probability assessment: High.
- Shock driver: Faster increases of the US interest rate leading to stronger U.S. dollar.
- Impact on Palau: An appreciation of the U.S. dollar would worsen Palau’s external position due to a loss of competitiveness in the tourism sector.
- Policy recommendation: Continue with structural reforms to implement high-end tourism strategy by boosting non-price competitiveness to retain tourist arrivals.

*The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path. “Low” indicates a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent.*

### Medium-term to long-term fiscal sustainability (Appendix V)
- Context:
  - Palau relies on declining and potentially volatile external financing.
  - Without a change in fiscal stance, Palau would need to maintain public investment at a low 3.8 percent of GDP to sustain a current fiscal deficit at 5.0 percent of GDP after FY2024.
  - Staff recommended reducing the current fiscal deficit to 1.2 percent of GDP by FY2023 to create space for increasing public investment to 7.5 percent of GDP.
- Compact of Free Association provisions:
  - Direct assistance up to FY24 and a Compact Trust Fund (CTF) with maximum permitted withdrawals fixed at US$15 million; real value erodes over time.
  - Non-Compact grants have fallen from 17.2 percent of GDP in FY10 to 8.1 percent of GDP in FY17.
- Fiscal and investment trends:
  - Capital expenditure fell to 2.9 percent of GDP in FY2017 and is expected to fall to 1.8 percent in FY2018.
  - Historical average of capital spending ratio is about 7.5 percent for FY2000–17.
- Fiscal framework recommendation:
  - Adopt a medium-term framework based on the government net worth approach to stabilize government net worth while preserving appropriate capital investment.
  - Assuming expected nominal rate of return on the CTF, government net worth will decline over the medium term unless overall fiscal surpluses are generated.
- Scenarios analyzed:
  - Baseline Scenario:
    - Long-run level of capital spending set at 3.8 percent of GDP to avoid compromising fiscal sustainability.
    - Government net worth stabilizes at 83.5 percent of GDP.
  - Reform Scenario:
    - Capital spending returns to historical trend of 7.5 percent of GDP by FY2024.
    - Required overall fiscal adjustment: 4.7 percent of GDP to reach a fiscal balance of -1.2 percent.
    - Adjustment composition: 4 percent from new policy measures, tax reform and expenditure cuts; remainder from improvements to financial management.
    - Tax reform estimated to raise additional revenue of 2.4 – 4.0 percent of GDP by FY2024, depending on VAT rates.
    - Possible expenditure measures: phasing out subsidies to the Palau Public Utility Company (PPUC) in line with AsDB loan terms.
    - With reform, government net worth would stabilize at 86.2 percent of GDP in the medium term.
- Fiscal risks:
  - SOE sector external debt equivalent to about 10 percent of GDP; could become contingent liabilities.
  - Civil Service Pension Fund (CSPF) is unsustainable; a collapse would likely shift pension liabilities to the government.
  - Immediate risks (unfunded CSPF liabilities and AsDB-guaranteed PPUC loan) could entail a fiscal cost of roughly two percent of GDP over the medium term, increasing required adjustment.

### Fiscal balances and illustrative projections
- Without fiscal adjustment: capital investment limited to 3.8 percent of GDP to sustain fiscal position; insufficient for development goals.
- Reform sequencing: fiscal adjustment preceding additional investment yields an overall balance somewhat higher between FY2019–23; cumulatively raises an additional 3.3 percent of GDP, assumed stored as additional deposits, raising net worth relative to baseline.

### Tax reform (Appendix VI)
- Objective: mobilize revenue to compensate for reduced grant receipts and fishing revenue by introducing a modern, efficient tax system.
- Main pillars:
  - Introduction of VAT (Palau Goods and Services Tax, ‘PGST’).
  - Expansion of Net Income Tax (NIT) and reforms to other fees and existing taxes.
- Distributional design:
  - Much of the burden intended to fall on tourists; tourists account for about seven times as the number of residents.
  - Offset measures for low-income earners to counter one-off price increases at VAT introduction.
- Revenue estimates:
  - Tax reform estimated to increase tax revenue by 2.4–4 percent of GDP by FY2024.
  - Revenue range depends on VAT rate chosen (10–15 percent under consideration).
  - Staff suggest 12.5 percent VAT in the reform scenario to help meet the 3 percent of GDP revenue target from tax reform (given 1 percent from PPUC subsidy cuts).
- Rationale for rate:
  - A VAT rate below 10 percent would fail to raise sufficient revenue.
  - VAT rate above 12.5 percent is consistent with fiscal adjustment required for medium-term sustainability.
- Complementary tax changes:
  - Expand NIT to taxpayers above the VAT threshold (VAT registration threshold proposed at US$100,000).
  - Current GRT rate is 4 percent; proposed 10 percent corporate rate still competitive vis-à-vis PICs average of 25.7 percent.
  - Wages and salary taxes can be reduced for low-income earners; add tax tier to increase progressivity.
- Ancillary benefits:
  - VAT promotes detailed account keeping for medium and large enterprises.
  - Dual-entry GST record keeping expected to increase tax and regulatory compliance and reduce ‘front businesses’.
- Cross-country evidence:
  - Cook Islands and Fiji showed limited negative impact of VAT introduction on tourist arrivals and tourism sector outcomes.

- VAT in Pacific Island Countries, 2018 (as presented):
  - Cook Islands: 15 (12.5), threshold NZ$40,000 ($28,360), introduced 1997.
  - Fiji: 9 (15, 12.5, 10), threshold F$100,000 ($49,042), introduced 1992.
  - Kiribati: 12.5, threshold A$100,000 ($78,073), introduced 2014.
  - Niue: 12.5, threshold NZ$75,000 ($53,174), introduced 2009.
  - PNG: 10, threshold K250,000 ($77,711), introduced 1999.
  - Samoa: 15 (10), threshold SAT$130,000 ($51,802), introduced 1994.
  - Tonga: 15, threshold TOP100,000 ($45,663), introduced 2005.
  - Tuvalu: 7, threshold $A100,000 ($78,073), introduced 2009.
  - Vanuatu: 15 (12.5), threshold VT4,000,000 ($36,593), introduced 1998.

### Debt sustainability analysis (Appendix VII)
- Overview:
  - Public debt expected to remain sustainable despite AsDB loans of about US$53 million disbursed starting FY2016.
  - Baseline projection: public debt-to-GDP ratio declines to 25.6 percent of GDP by FY2023 from 34.5 percent in FY2018.
- Composition of public debt (FY2017):
  - Central government external debt: 19.9 percent of GDP.
  - Government domestic accounts payable/domestic arrears: 4.2 percent of GDP.
  - SOEs’ debt (fully guaranteed by government): 9.8 percent of GDP.
- Key assumptions:
  - Palau has no access to private foreign capital markets; external debt is from international organizations for specific projects.
  - Baseline assumes central government and SOEs do not take new external loans during FY2018–23.
- Projection drivers:
  - Decline in public debt-to-GDP driven by scheduled debt repayment for major project loans and amortization of past loans.
  - Primary surpluses and growth-interest rate differential in FY2020–23 larger than required to pay scheduled debt service; surpluses used to repay domestic arrears and build government deposits.
- Stress scenarios:
  - Constant primary balance scenario: does not lead to large deviations from baseline public debt and gross financing needs.
  - GDP growth shock scenario: a decline in real GDP growth by 5.2 percentage points during FY2019–20 (one standard deviation of GDP growth past 10 years) would lead public debt-to-GDP to jump to 46.4 percent of GDP in FY2020 and remain around 40 percent by FY2023.
- Notes:
  - Public debt in the DSA is larger than in some tables because it covers both central government and SOEs.

*Republic of Palau — IMF staff report chapter content (cr1943 - 5. Sharp).*

### 5.      This result highlights that GDP growth shocks and associated fiscal costs—which may

### 5.      This result highlights that GDP growth shocks and associated fiscal costs—which may

### Debt sustainability risks
- Major risks to public-sector debt sustainability:
  - GDP growth shocks and associated fiscal costs resulting from:
    - high volatility of the tourism sector
    - large natural disasters
  - Potential increase in government expenditure from several sources (the contingent liability shock)
- Footnote evidence:
  - Lee et al. (2018): extreme natural disasters may cause "0.4~5.6 percentage point decline in GDP growth and 0.9~4.1 percentage point decline in fiscal balance-to-GDP ratio (IMF Working Paper, 18/108)."
  - The contingent liability scenario considers potential increases in government expenditure from:
    - failure of repayment on on-lent funds by Palau Public Utilities Corporation (PPUC) and Palau National Communications Corporation (PNCC)
    - potential government support to the Civil Service Pension Fund (CSPF) obligations (assumed as 2 percent of GDP per year in total)
  - Potential liabilities from public-private partnership projects (e.g., PPP for airport renovation and expansion) were not included due to lack of information.

### Public Sector Debt Sustainability Analysis (DSA) — Baseline Scenario (selected statistics)
- As of September 06, 2018 (projections shown for 2016–2023)
- Nominal gross public debt (in percent of GDP): 42.3, 32.0, 33.8, 34.5, 33.6, 32.7, 30.3, 27.5, 25.6
- Of which: guarantees (in percent of GDP): 20.2, 10.6, 9.8, 8.5, 8.2, 7.8, 7.5, 7.2, 6.9
- Public gross financing needs (in percent of GDP): 0.1, -2.8, -4.0, -3.9, -6.7, 1.1, 2.1, -0.1, -1.4
- Real GDP growth (in percent): 1.4, 0.5, -3.7, 0.4, 2.0, 2.5, 2.2, 2.0, 2.0
- Inflation (GDP deflator, in percent): 3.8, 3.2, -1.0, 1.9, 2.3, 2.0, 2.0, 2.0, 2.0
- Nominal GDP growth (in percent): 5.3, 3.7, -4.7, 2.3, 4.4, 4.5, 4.2, 4.0, 4.0
- Effective interest rate (in percent): 1.2, 1.2, 2.0, 2.0, 1.8, 1.9, 1.9, 2.1, 2.2
- Change in gross public sector debt (in percent of GDP, 2016–2023): -1.4, 4.8, 1.8, 0.6, -0.8, -1.0, -2.3, -2.8, -1.9 (cumulative -8.2)
- Identified debt-creating flows (in percent of GDP, 2016–2023): -1.5, -2.6, -1.7, -0.5, -1.9, -0.8, -2.2, -2.7, -1.8 (cumulative -9.8)
  - Primary deficit (in percent of GDP): -0.9, -3.7, -5.3, -4.7, -9.2, -2.3, -2.3, -3.8, -3.8 (cumulative -26.2)
  - Primary (noninterest) revenue and grants (in percent of GDP): 43.6, 41.0, 39.8, 40.0, 49.3, 41.2, 40.7, 40.5, 40.4 (cumulative 52.2)
  - Primary (noninterest) expenditure (in percent of GDP): 42.7, 37.3, 34.5, 35.3, 40.0, 38.9, 38.4, 36.8, 36.6 (cumulative 26.0)
  - Automatic debt dynamics (in percent of GDP): -1.4, -0.7, 2.2, -0.1, -0.8, -0.8, -0.7, -0.6, -0.5 (cumulative -3.6)
  - Other identified debt-creating flows (in percent of GDP): 0.8, 1.7, 1.4, 4.3, 8.2, 2.4, 0.9, 1.7, 2.5 (cumulative 19.9)
- Residual, including asset changes (in percent of GDP, 2016–2023): 0.1, 7.4, 3.5, 1.1, 1.1, -0.1, -0.1, -0.1, -0.2 (cumulative 1.6)
- Debt-stabilizing scenario assumption: key variables remain at the level of the last projection year.

### Public DSA — Alternative Scenarios (underlying assumptions)
- Baseline assumptions (2018–2023, in percent unless indicated):
  - Real GDP growth: 0.4, 2.0, 2.5, 2.2, 2.0, 2.0
  - Inflation: 1.9, 2.3, 2.0, 2.0, 2.0, 2.0
  - Primary Balance: 4.7, 9.2, 2.3, 2.3, 3.8, 3.8
  - Effective interest rate: 2.0, 1.8, 1.9, 1.9, 2.1, 2.2
- Historical scenario assumptions:
  - Real GDP growth: 0.4, 0.8, 0.8, 0.8, 0.8, 0.8
  - Primary Balance: 4.7, 1.9, 1.9, 1.9, 1.9, 1.9
  - Effective interest rate: 2.0, 1.8, 0.9, 0.8, 0.9, 0.8
- Constant Primary Balance Scenario:
  - Primary Balance constant at 4.7 (2018–2023)
- Real GDP Growth Shock:
  - Real GDP growth path: 0.4, -3.2, -2.7, 2.2, 2.0, 2.0
  - Primary Balance path: 4.7, 6.5, -3.1, 2.3, 3.8, 3.8
  - Effective interest rate path: 2.0, 1.8, 1.8, 1.9, 1.5, 1.6
- Contingent Liability shock:
  - Primary Balance path shown with a notable deviation (e.g., 7.2 in one year), reflecting assumed contingent liabilities to SOEs

### Tourism and diversification — key findings
- Importance of diversification:
  - Export diversification reduces growth volatility in LIDCs and small states.
- Palau export composition:
  - Tourism sector accounts for 86 percent of total export in 2016 (increase from 83 percent in 2012).
  - Other services (e.g., transportation and telecommunication) account for about 10 percent of total exports in 2016.
  - Goods account for 4 percent of total exports in 2016.
  - Palau is the most tourism-concentrated country among small states.
- Export concentration index:
  - Palau’s service export concentration index increased from 0.65 in 2006 to 0.81 in 2016.
  - Palau’s concentration index is almost twice as high as the average of other Pacific and Caribbean small states.
  - Positive linkage between concentration index and growth volatility: more concentrated countries experience higher volatility in growth.
- Diversification within tourism:
  - Tourism in small states tends to be undiversified; example figures:
    - Caribbean economies receive on average 44 percent of arrivals from the United States.
    - Samoa, Fiji, and Vanuatu received 52 percent of arrivals from Australia and New Zealand.
  - Palau’s tourism diversification is in line with other small states, but given Palau’s stronger reliance on tourism, broader tourism demand base is needed.
- Empirical results on volatility:
  - In the regression, "an increase by one percentage point increase in the concentration index leads to an increase of 4 percentage point in standard deviation of GDP."
  - Interaction term indicates the impact is lessened in countries with greater tourism dependence.
  - Higher average revenue per tourist arrival does not exhibit higher output volatility; targeting high-end tourism alone may not reduce volatility unless accompanied by geographical diversification.
- Policy implication:
  - Need for Palau to further build fiscal buffers to counter-cyclicality caused by tourism dependence and to undertake structural reforms to enhance potential growth and increase resilience.

### Financial sector reforms — key findings
- Banking structure and credit provision:
  - Banking system: three foreign-owned U.S. FDIC-insured banks (holding 91 percent of loans and 99 percent of deposits as of December 2017), two non-FDIC-insured banks (operating savings accounts only), and the National Development Bank of Palau (NDBP).
  - Bank credit-to-GDP ratio is substantially lower than other Pacific island countries (PICs).
  - NDBP legislation (December 2014) allows NDBP to take deposits, but licensing requires meeting commercial bank regulatory requirements.
- Trends in lending and deposits (FY2010–FY2017):
  - Bank loan declined from 14.3 percent of GDP to 10.4 percent during FY2010–16 before rebounding to 12.5 percent in FY2017.
  - Deposit-to-GDP ratio increased from 51.3 percent to 98.1 percent during FY2010–17.
  - Resulted in a steady decline in loan-to-deposit ratio.
  - Commercial lending accounts for 17.8 percent of total loans in FY2017; consumer lending has been at least 80 percent of total loans except FY2011.
  - Deposits composition FY2010–FY2017: non-financial corporations accounted for 40–50 percent of total deposits; deposits from individuals declined by around 20 percentage points since FY2010; government deposits increased by similar amounts.
- Interest rate ceilings and lending incentives:
  - Usury law caps interest rate on lending to individuals at 18 percent per annum.
  - Interest rate on lending to corporations capped at “the prime rate on corporate loans at large U.S. Money Center Banks+4 percentage points”—which stands at 9 percent as of August 2018.
  - Corporate loan caps are expected to bind given comparable U.S. small business loan rates ranged from 8 percent to 40 percent in October 2015.
  - Consequence: foreign-owned banks prefer investing in less risky, more secured offshore markets (e.g., U.S. and Guam) rather than domestic lending.
  - Large spread between lending and deposit rates similar to most Pacific island countries.

*Source: IMF staff.*

### 4.      Facilitating domestic credit provision is a key to private sector development. As

### 4.      Facilitating domestic credit provision is a key to private sector development. As

### Domestic credit constraints and recommended measures
- Structural impediments to mobilizing domestic credit identified include:
  - lack of secured lending for real estate,
  - small business’ limited capacity to prepare financial statements,
  - lending caps on the interest rate.
- Authorities can facilitate domestic credit provision by:
  - relaxing the interest rate ceiling for corporate loans to better reflect cost and riskiness,
  - helping small and medium-sized enterprises (SMEs) prepare business plans and financial statements.

### Interest rate ceilings, spreads, and bank interest rate context
- Individual loan ceiling: 18%
- Corporate loan ceiling: 7.25%
- Observed bank interest rate range in the chart: 7.5%, 8.25%, 9% (years FY2010–FY2017 shown for Deposit, Mortgage loan, Consumer loan, Corporate loan)
- Large interest rate spreads in PICs mainly result from high cost and high risk of credit potentially arising from small scale, vulnerability to shocks, and geographic dispersion in the region (IMF Working Paper, 15/96).

### Role and capacity of the National Development Bank of Palau (NDBP)
- NDBP’s role can be strengthened to fill the financing gap for SMEs by:
  - obtaining a license for taking deposits to secure more stable funding sources,
  - building capacity to meet regulatory requirements,
  - improving its system for loan approval and monitoring to safeguard potential risks for depositors.
- The NDBP remains outside the FIC’s supervision; Financial Soundness Indicators do not include NDBP data.

### SME support and broader supply-side measures
- SME-focused actions recommended:
  - technical assistance for SMEs to prepare business plans and financial statements,
  - targeted capacity building so SMEs can better access bank credit.
- Complementary reforms include improving secured lending frameworks (noted lack of secured lending for real estate).

### Labor market and minimum wage (Appendix X: Labor Market and Minimum Wages)
- Context:
  - Current wage rate in Palau: US$3.50 an hour.
  - Proposed path: increase to US$8.50 by 50 cents annually over the next ten years.
- Key findings and considerations:
  1. The proposed increase in the minimum rate is sizable for an extended period of time. Large minimum wage increases can adversely affect Palau’s competitiveness and add significant fiscal costs for state governments whose average wage is significantly below the proposed minimum.
  2. Migration is not driven purely by wage differentials but also by social and cultural factors, educational opportunities, healthcare, and the relative diversity of economic opportunities in the host country (IMF 2015).
  3. Setting wages above the equilibrium wage rate can generate unemployment and could exacerbate outward migration (example cited: Puerto Rico, Castillo-Freeman & Freeman, 1992).
  4. The increase in minimum wage is likely to have a limited impact on Palauan U.S. residents’ migration patterns:
     - Median civilian salary of Palauans living in the mainland United States: US$22,098.
     - This translates into an hourly wage of US$12.06 per hour, based on average U.S. working patterns.
     - Even with an increase to US$8.50, Palauans in the U.S. would still be better off in the U.S. wage-wise.
  5. Alternative approaches to stem outward migration and increase benefits from migration include:
     - ensuring limited barriers for migrants seeking to return to Palau (particularly regarding taxation of repatriated earnings),
     - undertaking structural reforms to improve ease of doing business to create entrepreneurial opportunities and encourage diaspora return,
     - taking advantage of modern communications to build active diaspora networks,
     - improving data collection on emigration (e.g., surveying outbound air passengers).
  6. Conclusion on minimum wage policy:
     - The minimum wage is not an effective tool for migration policy and should be set to balance goals of labor market efficiency and poverty reduction.
     - There are potentially large costs for both private and public sectors of rapidly increasing the minimum wage and limited evidence that low wages are a driver of emigration or that the proposed increase would be sufficient to alter migration decisions.

_International Monetary Fund — Republic of Palau: excerpts from Staff Report and Appendix X (as provided)._

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_Source: https://www.imf.org/-/media/files/publications/cr/2019/cr1943.pdf_