## 1plwea2021001 ## Source details **Canonical URL:** [1plwea2021001](https://www.imf.org/-/media/files/publications/cr/2021/english/1plwea2021001.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2021/english/1plwea2021001.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2021/english/1plwea2021001.pdf.json) --- ### Recent developments and impact of the pandemic - Real GDP: contracted by 9.7 percent in FY2020 and contracted further by 17.1 percent in FY2021. - Construction: resilient, reflecting progress on large infrastructure projects (including the airport extension) and strong housing construction. - Tourism: border closures and suspension of commercial flights sharply curtailed tourist arrivals and tourism receipts; tourist arrivals fell by 92 percent in FY2021 (3,167 in FY2020; 24,708 in FY2021). - Inflation: edged up, driven by a rise in food and energy prices; consumer prices (period average) 2020/21 Est.: 1.2; 2021/22 Proj.: 3.0. - Employment: employment support measures prevented a notable deterioration in overall labor market conditions despite job losses in tourism-related sectors. - External: current account deficit widened significantly on the back of a sharp decline in tourism receipts; tourism receipts (million US$) 2019/20: 50.9; 2020/21 Est.: 3.9; 2021/22 Proj.: 31.3. ### Health, vaccination, and reopening - Vaccination: about 90 percent of the total population was fully vaccinated. - Reopening: Palau began to gradually reopen its borders with some safety measures; the travel bubble with Taiwan Province of China resumed in August 2021. ### Outlook and key macro projections - Real GDP growth (percent change): 2020/21 Est.: -17.1; 2021/22 Proj.: 9.4; 2022/23 Proj.: 18.3; 2023/24 Proj.: 2.9; 2024/25 Proj.: 2.9; 2025/26 Proj.: 2.7. - Nominal GDP (million US$): 2020/21 Est.: 216.2; 2021/22 Proj.: 242.7; 2022/23 Proj.: 294.9; 2023/24 Proj.: 305.5; 2024/25 Proj.: 316.7; 2025/26 Proj.: 327.7. - Tourist arrivals (number of visitors): 2020/21 Est.: 3,167; 2021/22 Proj.: 24,708; 2022/23 Proj.: 85,710; 2023/24 Proj.: 89,996; 2024/25 Proj.: 94,496; 2025/26 Proj.: 99,220. - Inflation drivers: inflation expected to pick up on the back of elevated international fuel prices; planned PGST in FY2023 will exert a one-off upward pressure on prices. - Fiscal and current account: large fiscal and current account deficits projected to narrow as tourism activities recover. - Risks: high uncertainty with downside risks including a protracted pandemic, a domestic outbreak, natural disasters, delayed Compact Agreement with the U.S., and OECD DAC graduation potentially reducing concessional financing and grants. ### Executive Board assessment and policy guidance - Directors welcomed the comprehensive policy response and noted recovery is underway, supported by high vaccination rates and gradual resumption of tourism. - Recommended maintaining support to the economy until recovery is broadly entrenched, while pursuing prudent medium-term policies to support macroeconomic stability and promote sustainable, greener, and inclusive growth. - Fiscal policy guidance: - Extend targeted fiscal support to still-affected households and firms; fiscal policy should remain the first line of defense if downside risks materialize. - Fiscal adjustment is needed to rebuild fiscal resilience and preserve debt sustainability. - Welcome approval of comprehensive tax reform to contribute to fiscal adjustment and improve tax system efficiency. - Additional revenue mobilization and expenditure rationalization are needed to accommodate higher climate spending and provide buffers against potentially lower grants and concessional financing. ### Policy response and immediate measures (CROSS Act and CARES) - CROSS Act stimulus package: $20 million (7.8 percent of GDP), mostly financed through concessional financing from the AsDB; components included unemployment benefits, temporary subsidies for utility bills, temporary job creation scheme for public works, and a lending scheme for the private sector. - U.S. CARES Act support: up to $19 million (7.4 percent of GDP) available to Palauan citizens. - Fiscal execution: by end-FY2020, about 26 percent of CROSS Act budgeted resources (2 percent of GDP) and around 71 percent of CARES Act support (5 percent of GDP) were disbursed. - Fiscal impact FY2020: non-grant revenues declined by 3.8 percentage points of GDP; fiscal balance moved from a surplus of 0.4 percent of GDP in FY2019 to a deficit of 10.9 percent of GDP in FY2020. - FY2021 fiscal support: fiscal support package expanded to 19.5 percent of GDP in FY2021; fiscal deficit projected to moderate to 12.6 percent of GDP in FY2022. - Estimated cumulative fiscal financing need: about 51 percent of GDP in FY2020-22; disbursed and planned AsDB financing of about US$100 million (42 percent of GDP) and bilateral donor financing of about US$20 million (8 percent of GDP) would cover most financing needs and help preserve government deposits around 7-9 percent of GDP. - Authorities’ plan: use the 2021 SDR allocation to enhance last-resort buffers. ### Fiscal projections, debt dynamics, and debt sustainability - Public finance (percent of GDP) highlights: - Central government revenue: 2020/21 Est.: 46.3; 2021/22 Proj.: 41.2; 2022/23 Proj.: 38.0. - Expenditure: 2020/21 Est.: 65.8; 2021/22 Proj.: 53.9; 2022/23 Proj.: 41.1. - Net lending (+)/borrowing (–): 2020/21 Est.: -19.5; 2021/22 Proj.: -12.6; 2022/23 Proj.: -3.2. - Public debt (percent of GDP): 2019/20: 62.1; 2020/21 Est.: 85.7; 2021/22 Proj.: 90.3; 2022/23 Proj.: 74.0; 2023/24 Proj.: 71.1; 2024/25 Proj.: 66.7; 2025/26 Proj.: 62.1. - Debt Sustainability Analysis (DSA) findings: - Baseline: public debt-to-GDP ratio projected to peak at 90 percent of GDP in FY2022, then decline to around 62 percent of GDP by FY2026 aided by concessional financing and favorable interest rate-growth differentials. - Stress scenarios: - GDP growth shock: debt-to-GDP would rise to nearly 100 percent in FY2022 and remain above 70 percent through FY2026. - Constant primary balance shock: debt-to-GDP would reach 146 percent in FY2026; gross financing needs would reach 62 percent of GDP in FY2026. - Contingent liabilities to SOEs shock: debt-to-GDP would rise to 83 percent in the medium term. - Gross financing needs: projected to reach 21.7 percent of GDP in FY2021 under baseline. - Composition: central government external debt 58.0 percent of GDP in FY2020; SOEs’ debt 9.7 percent of GDP in FY2020 (fully guaranteed). - AsDB disbursements FY2020-22: total US$100 million (US$15 million Pacific Disaster Resilience Program; US$20 million CPRO; US$10 million PPUC Reform Program; US$55 million RISES). - Favorable interest rates: AsDB loans with interest rates between 1.5 percent and 2 percent and grace period of 3 to 5 years. ### Near- and medium-term fiscal strategy and reform package - Near-term: - Extend fiscal relief measures until recovery is firmly entrenched; accelerate CROSS Act execution. - Improve governance safeguards for COVID-related spending (timely reporting, ex-post audits, publication of beneficial ownership of awarded contracts, use administrative data for beneficiary selection). - Avoid across-the-board spending cuts that could fragilize recovery; note planned FY2022 across-the-board 10 percent cut excluding CROSS Act, transfers to state governments, education, and social security. - Medium-term: - Rebuild fiscal resilience through gradual fiscal consolidation: proposed consolidation of 1 percent of GDP per year over 5 years (FY2024-FY2028) to help achieve a balanced budget, safeguard the CTF, strengthen long-term debt sustainability, and accommodate higher climate spending. - Fiscal adjustment scenario (Box 1): in addition to 1 percent net revenue from tax reform in FY2024, pursue fiscal adjustment of 1 percent of GDP per year over 4 years (FY2025-FY2028) to achieve a balanced budget while safeguarding the CTF; under this scenario public debt would decline to 30 percent of GDP by FY2040 and CTF balance stabilize at 93 percent of GDP by FY2040 with drawdowns reduced to US$8 million from FY2031. ### Tax reform and revenue measures - Main components of tax reform (expected entry into force January 2023): - Palau Goods and Services Tax (PGST): 10 percent on goods and services (excluding financial services). - Business Profits Tax (BPT): 12 percent applied to PGST-registered businesses and financial institutions. - Gross Revenue Tax (GRT): 4 percent for businesses with turnover exceeding $50,000 unless they opt in for BPT; turnover below $50,000 subject to $100 per annum business license fee. - Wages and salaries tax adjustments: marginal rate reduced from 12 percent to 10 percent for incomes $8,000–$40,000; tax refunds for Palauan citizens with annual income below $15,000; marginal rate for incomes below $8,000 raised from 6 percent to 8 percent. - Social assistance: informal sector with revenue below $15,000 to receive 4 percent of total revenue up to $600; Palauans receiving SSF or CSPF benefits with total income < $15,000 entitled to 4 percent up to $600 yearly. - Carbon tax: existing fuel tax converted to carbon tax at 2c per gallon (options to raise to above 15c per gallon or up to 30c per gallon discussed). - Land transaction proceeds fee: 4 percent on proceeds of leases or land transfers. - Taxes on hotel rooms and vessel cabins: changed to $10 or 10 percent whichever is higher. - Expected revenue impact: - Tax reform could yield estimated net revenue gain of about 1 percent of GDP and cover the first year of the 5-year fiscal adjustment. - Additional revenue options: raise carbon tax above 15 cents per gallon; raise BPT from 12 percent to at least 15 percent; streamline PGST exemptions; improvements to tax administration and IT modernization expected to generate 0.2 percent of GDP per year. ### Public sector reform and containment of fiscal risks - CSPF (Civil Service Pension Fund): - Rising payments of unfunded benefits require drawdown of investments and will lead to negative net position in near term. - Recommended reforms: increase retirement age; hikes in contribution rates for employers and employees; shift from defined-benefit to defined-contribution scheme. - PPUC (Palau Public Utilities Corporation): - Operating losses, particularly for water and wastewater. - Accelerate reforms to adopt and maintain full cost recovery tariffs for fuel, power, water and wastewater (with AsDB support). - SSF (Social Security Fund): - Strengthen governance and better align contributions with benefits. - State governments: - Enhance fiscal management capacity to better align expenditures with available resources. - Estimated savings and fiscal adjustment options (percent of GDP): - Approved tax reform 1.0 - Additional tax measures 4.0 - Raise carbon tax up to 30 cents per gallon 1.5 - Streamlining exemptions under the PGST 1.0 - Improvements to tax administration with new IT system 1.0 - Raise BPT rate to at least 15 percent 0.5 - Expenditure measures 1.5 - Streamline subsidies to PPUC 1.0 - Streamline subsidies and transfers to other public entities 0.5 - Total measures 6.5 - Note: estimates assume 0.2 percent of GDP per year revenue gain from improved tax administration. ### Financial sector findings and reforms - Banking system: sound overall; commercial banks have ample liquidity. - Credit conditions: - Bank lending declined by 4.8 percent in FY2020 (y/y); lending further shrunk in 2021Q1. - Loan-to-GDP ratio around 12 percent in FY2020; deposits-to-GDP over 120 percent. - Loans to businesses 16 percent of total loans in FY2020; loans to households 84 percent of total commercial bank loans. - Size of individual loans end-FY2020: 23.8 thousand USD per borrower. - Non-performing loans: ratio increased from pre-crisis average of 0.7 percent to 1.7 percent in 2021Q1; NDBP NPL 4.7 percent as of September 2020. - Structural constraints: - Interest rate ceilings: corporate loans capped at prime plus 4 percentage points (7.25 percent since May 2020); individual loans capped at 18 percent by law, effective rate 10.8 percent in FY2020. - Information asymmetry and land ownership limits constrain collateral use. - NDBP not licensed to take deposits nor under FIC supervision. - Policy recommendations: - Accelerate financial sector reforms to support financial deepening and SMEs’ capacity to absorb credit. - Strengthen risk-based supervision, including for non-bank financial institutions and DNFBPs; prioritize improving the AML/CFT framework. - Streamline processes for foreign investment, improve business environment, enhance human capital. - Allow NDBP to take deposits by placing it under FIC supervision; extend targeted lending schemes and credit guarantees with banks sharing part of the risk; avoid relaxation of loan classification and provisioning rules. ### Climate change challenges, costs, and policy actions - Climate hazards and impacts: - Projected temperature increases: annual average air temperature will rise by 0.7-1.6 °F by 2030 and by 1.3-2.5 °F by 2050 (medium-emissions scenario, relative to 1986–2005). - Sea level rise, higher air and sea temperatures, potential increase in tropical cyclone intensity, coral reef heat exposure, and erosion of low-lying coastal land. - Economic impact estimates: - Authorities estimate negative economic impact from climate change in the range of 4 to 20 percent of GDP annually. - World Bank estimate: additional costs for coastal protection and adaptation about 4 percent of GDP per year. - 2015 authority estimate: climate change-related cost at $500 million (about 194 percent of 2020 GDP), including relocation of major hospital. - PCRAFI (2011): expected annual loss due to tropical cyclones and earthquakes 2.7 million USD (about 1 percent of 2019 GDP); 50 percent chance over next 50 years of losses exceeding 30 million USD (11 percent of 2019 GDP); 10 percent chance of catastrophic losses exceeding 247 million USD (88 percent of 2019 GDP). - Adaptation financing and implementation: - Five-year Climate Change Action Plan estimated total cost US$500 million for FY2016–FY2020; only US$22.8 million available until 2018. - OECD climate-related development finance 2015–2019: about US$38 million (21–26 million for adaptation). - Green Climate Fund grant in 2020 part of multi-country project to enhance climate resilience information. - Renewal of Compact Agreement beyond 2024 could boost climate efforts. - Mitigation and energy: - Current share of renewable energy production: 8 percent. - Targets (2016 INDC by 2025): reduce energy sector emissions by 22 percent relative to 2005; generate 45 percent of energy from renewables; increase energy efficiency by 35 percent. - With AsDB support, policy-based loan in 2020 to improve PPUC financial viability and facilitate entry of private renewable energy producers. - Policy implication: - Timely implementation of Palau’s climate change adaptation and mitigation strategy and tapping climate risk financing are critical; limited access to funding is a major impediment. ### Data, statistics, and capacity building needs - Statistics: broadly adequate for surveillance but improvements needed. - Need development of quarterly statistics for BOP, real, and fiscal sectors. - Broaden fiscal coverage to general government and improve public sector debt statistics. - Expand monetary statistics to include NDBP and other financial corporations. - Implement e-GDDS in early 2022 with IMF Statistics Department support. - Capacity building requests: - Continued technical assistance for tax reform regulations, compilation of comprehensive fiscal accounts, and capacity building for Financial and Economic Intelligence Services (FEIS). ### Key statistics and selected indicators (as presented) - Nominal GDP for FY2020: US$258 million. - Population (2019): 17,457. - GDP per capita for FY2020: US$14,784. - Quota: SDR 3.1 million. - Selected time series highlights (exact values preserved): - Nominal GDP (million US$): 2016/17: 285.3; 2017/18: 284.7; 2018/19: 274.2; 2019/20: 257.7; 2020/21 Est.: 216.2; 2021/22 Proj.: 242.7; 2022/23 Proj.: 294.9; 2023/24 Proj.: 305.5; 2024/25 Proj.: 316.7; 2025/26 Proj.: 327.7. - Real GDP growth (percent change): 2016/17: -3.3; 2017/18: -0.1; 2018/19: -1.9; 2019/20: -9.7; 2020/21 Est.: -17.1; 2021/22 Proj.: 9.4; 2022/23 Proj.: 18.3; 2023/24 Proj.: 2.9; 2024/25 Proj.: 2.9; 2025/26 Proj.: 2.7. - Tourist arrivals (number of visitors): 2016/17: 122,103; 2017/18: 115,997; 2018/19: 89,726; 2019/20: 41,674; 2020/21 Est.: 3,167; 2021/22 Proj.: 24,708; 2022/23 Proj.: 85,710; 2023/24 Proj.: 89,996; 2024/25 Proj.: 94,496; 2025/26 Proj.: 99,220. - Expenditure per Tourist Arrival (US$): 2016/17: 976; 2017/18: 984; 2018/19: 1,061; 2019/20: 1,257; 2020/21 Est.: 1,273; 2021/22 Proj.: 1,312; 2022/23 Proj.: 1,361; 2023/24 Proj.: 1,384; 2024/25 Proj.: 1,408; 2025/26 Proj.: 1,432. - Tourism receipts (million US$): 2016/17: 113.0; 2017/18: 104.8; 2018/19: 91.9; 2019/20: 50.9; 2020/21 Est.: 3.9; 2021/22 Proj.: 31.3; 2022/23 Proj.: 112.8; 2023/24 Proj.: 120.5; 2024/25 Proj.: 128.8; 2025/26 Proj.: 137.6. - Current account balance including grants (million US$): 2016/17: -55.3; 2017/18: -44.4; 2018/19: -85.3; 2019/20: -124.4; 2020/21 Est.: -120.8; 2021/22 Proj.: -109.6; 2022/23 Proj.: -68.7; 2023/24 Proj.: -61.8; 2024/25 Proj.: -63.0; 2025/26 Proj.: -61.3. - International Investment Position (million US$): 2016/17: -136.1; 2017/18: -105.0; 2018/19: -176.8; 2019/20: -256.3; 2020/21 Est.: -364.2; 2021/22 Proj.: -438.5; 2022/23 Proj.: -470.3; 2023/24 Proj.: -494.4; 2024/25 Proj.: -520.5; 2025/26 Proj.: -544.4. - External debt (million US$): 2016/17: 85.9; 2017/18: 91.8; 2018/19: 91.4; 2019/20: 150.1; 2020/21 Est.: 183.4; 2021/22 Proj.: 217.9; 2022/23 Proj.: 214.8; 2023/24 Proj.: 210.8; 2024/25 Proj.: 203.2; 2025/26 Proj.: 194.8. ### Priority policy recommendations (summary) - Near-term: - Extend targeted fiscal and financial support until recovery is firmly entrenched; accelerate CROSS Act execution. - Enhance governance safeguards and reporting for COVID-related spending; conduct ex-post audits and publish beneficial ownership of contracts. - Use targeted spending measures as first line of defense if downside risks materialize. - Medium-term: - Rebuild fiscal resilience via gradual fiscal consolidation (1 percent of GDP per year over 5 years or alternative 4-year adjustment as described) and implement comprehensive tax reform. - Mobilize additional revenue (PGST implementation, BPT adjustments, higher carbon tax, improved tax administration) and rationalize expenditures (streamline subsidies, PPUC reforms). - Strengthen debt management capacity, consider a separate debt management unit, and expand debt compilation to general government. - Structural and financial reforms: - Accelerate financial sector reforms to support credit growth and SME financing; bring NDBP under FIC supervision to allow deposit-taking. - Strengthen AML/CFT framework and risk-based supervision; modernize business registry and beneficial ownership disclosures. - Improve investment climate, streamline foreign investment processes, upgrade climate-resilient infrastructure, and invest in human capital to diversify away from tourism. - Climate resilience: - Timely implement climate adaptation and mitigation strategy; tap climate risk financing and maintain access to concessional climate funds (e.g., Green Climate Fund). - Plan for adaptation costs estimated at a minimum of 4 percent of GDP per year. *Source: IMF staff report chapter "6. A comprehensive policy response" (Content unit: 1plwea2021001).* ### 17.1 percent in FY2021. In contrast to the tourism sector, construction activities were resilient, ### 1plwea2021001 - 17.1 percent in FY2021. In contrast to the tourism sector, construction activities were resilient, ### Recent developments and impact of the pandemic - Real GDP contracted by 9.7 percent in FY2020 and contracted further by 17.1 percent in FY2021. - Construction activities were resilient, reflecting progress on large infrastructure projects (including the airport extension) and strong housing construction. - Tourism sector: border closures and suspension of commercial flights sharply curtailed tourist arrivals and tourism receipts. - Inflation edged up, driven by a rise in food and energy prices. - Employment support measures prevented a notable deterioration in overall labor market conditions despite job losses in tourism-related sectors. - The current account deficit widened significantly on the back of a sharp decline in tourism receipts. ### Health and reopening - About 90 percent of the total population was fully vaccinated. - Palau began to gradually reopen its borders with some safety measures. ### Outlook and key projections - Real GDP is projected to rebound by 9.4 percent in FY2022 alongside a gradual recovery in tourist arrivals. - Tourist arrivals are expected to remain below pre-pandemic levels through FY2023. - Inflation is expected to pick up on the back of elevated international fuel prices. - Large fiscal and current account deficits are projected to narrow as tourism activities recover. - The outlook is subject to high uncertainty and risks are tilted to the downside, including from a protracted pandemic, a domestic outbreak, and natural disasters. - Palau’s graduation from the OECD’s list of countries eligible for official development assistance could lead to lower concessional financing, in particular grants. ### Executive Board assessment and policy guidance - Executive Directors welcomed the comprehensive policy response that helped limit health and economic impacts and noted that recovery is underway, supported by high vaccination rates and gradual resumption of tourism. - Directors recommended maintaining support to the economy until recovery is broadly entrenched, while emphasizing the need for prudent medium-term policies to support macroeconomic stability and promote sustainable, greener, and inclusive growth. - Fiscal policy: - Extend measures providing targeted fiscal support to still-affected households and firms; fiscal policy should remain the first line of defense if downside risks materialize. - Fiscal risks over the medium-term have increased substantially; fiscal adjustment is needed to rebuild fiscal resilience and preserve debt sustainability. - Welcome approval of comprehensive tax reform to contribute to fiscal adjustment and improve tax system efficiency. - Additional revenue mobilization and expenditure rationalization are needed to accommodate higher climate spending, improve the external position, and provide buffers against potentially lower grants and concessional financing. - Financial sector and structural reforms: - Accelerate financial sector reforms to support financial deepening and enhance SMEs’ capacity to absorb credit. - Strengthen risk-based supervision, including for non-bank financial institutions, and prioritize improving the AML/CFT framework. - Streamline processes for foreign investment, improve the business environment, and enhance human capital to encourage private investment within and outside tourism. - Climate resilience: - Timely implementation of Palau’s climate change adaptation and mitigation strategy is essential, including tapping into climate risk financing to enhance economic resilience. - Capacity building to enhance macroeconomic management was encouraged. ### Key statistics and selected indicators (as presented) - Nominal GDP for FY2020: US$258 million. - Population (2019): 17,457. - GDP per capita for FY2020: US$14,784. - Quota: SDR 3.1 million. Selected time series (2016/17–2025/26; where Est. = 2020/21 Est., Proj. = 2021/22 onward projections): - Nominal GDP (million US$): 2016/17: 285.3; 2017/18: 284.7; 2018/19: 274.2; 2019/20: 257.7; 2020/21 Est.: 216.2; 2021/22 Proj.: 242.7; 2022/23 Proj.: 294.9; 2023/24 Proj.: 305.5; 2024/25 Proj.: 316.7; 2025/26 Proj.: 327.7. - Real GDP growth (percent change): 2016/17: -3.3; 2017/18: -0.1; 2018/19: -1.9; 2019/20: -9.7; 2020/21 Est.: -17.1; 2021/22 Proj.: 9.4; 2022/23 Proj.: 18.3; 2023/24 Proj.: 2.9; 2024/25 Proj.: 2.9; 2025/26 Proj.: 2.7. - GDP deflator (percent change): 2016/17: -1.1; 2017/18: -0.1; 2018/19: -1.8; 2019/20: 4.1; 2020/21 Est.: 1.2; 2021/22 Proj.: 2.5; 2022/23 Proj.: 2.8; 2023/24 Proj.: 0.7; 2024/25 Proj.: 0.7; 2025/26 Proj.: 0.8. - Consumer prices (percent change; period average): 2016/17: 0.9; 2017/18: 2.0; 2018/19: 0.6; 2019/20: 0.7; 2020/21 Est.: 1.2; 2021/22 Proj.: 3.0; 2022/23 Proj.: 2.8; 2023/24 Proj.: 0.7; 2024/25 Proj.: 0.7; 2025/26 Proj.: 0.8. - Tourist arrivals (number of visitors): 2016/17: 122,103; 2017/18: 115,997; 2018/19: 89,726; 2019/20: 41,674; 2020/21 Est.: 3,167; 2021/22 Proj.: 24,708; 2022/23 Proj.: 85,710; 2023/24 Proj.: 89,996; 2024/25 Proj.: 94,496; 2025/26 Proj.: 99,220. - Expenditure per Tourist Arrival (US$): 2016/17: 976; 2017/18: 984; 2018/19: 1,061; 2019/20: 1,257; 2020/21 Est.: 1,273; 2021/22 Proj.: 1,312; 2022/23 Proj.: 1,361; 2023/24 Proj.: 1,384; 2024/25 Proj.: 1,408; 2025/26 Proj.: 1,432. Public finance (In percent of GDP): - Central government revenue: 2016/17: 40.3; 2017/18: 44.5; 2018/19: 44.5; 2019/20: 47.4; 2020/21 Est.: 46.3; 2021/22 Proj.: 41.2; 2022/23 Proj.: 38.0; 2023/24 Proj.: 39.0; 2024/25 Proj.: 38.6; 2025/26 Proj.: 38.9. - Taxes and other revenue: 2016/17: 27.2; 2017/18: 27.2; 2018/19: 27.8; 2019/20: 24.0; 2020/21 Est.: 22.1; 2021/22 Proj.: 20.3; 2022/23 Proj.: 22.9; 2023/24 Proj.: 24.3; 2024/25 Proj.: 24.8; 2025/26 Proj.: 25.4. - Grants: 2016/17: 13.1; 2017/18: 17.3; 2018/19: 16.7; 2019/20: 23.4; 2020/21 Est.: 24.2; 2021/22 Proj.: 21.0; 2022/23 Proj.: 15.1; 2023/24 Proj.: 14.7; 2024/25 Proj.: 13.8; 2025/26 Proj.: 13.6. - Expenditure: 2016/17: 35.5; 2017/18: 38.2; 2018/19: 44.1; 2019/20: 58.3; 2020/21 Est.: 65.8; 2021/22 Proj.: 53.9; 2022/23 Proj.: 41.1; 2023/24 Proj.: 39.4; 2024/25 Proj.: 38.4; 2025/26 Proj.: 37.1. - Expense: 2016/17: 32.5; 2017/18: 35.9; 2018/19: 39.6; 2019/20: 52.3; 2020/21 Est.: 61.3; 2021/22 Proj.: 48.9; 2022/23 Proj.: 36.7; 2023/24 Proj.: 35.3; 2024/25 Proj.: 34.1; 2025/26 Proj.: 32.3. - Net acquisition of nonfinancial assets: 2016/17: 3.0; 2017/18: 2.3; 2018/19: 4.5; 2019/20: 6.1; 2020/21 Est.: 4.5; 2021/22 Proj.: 5.0; 2022/23 Proj.: 4.4; 2023/24 Proj.: 4.2; 2024/25 Proj.: 4.3; 2025/26 Proj.: 4.8. - Current fiscal balance (excluding grants) 2/: 2016/17: -5.3; 2017/18: -8.8; 2018/19: -11.8; 2019/20: -28.3; 2020/21 Est.: -39.2; 2021/22 Proj.: -28.6; 2022/23 Proj.: -13.8; 2023/24 Proj.: -11.0; 2024/25 Proj.: -9.2; 2025/26 Proj.: -6.9. - Current fiscal balance (including current grants) 3/: 2016/17: 5.6; 2017/18: 6.6; 2018/19: -1.0; 2019/20: -11.8; 2020/21 Est.: -20.1; 2021/22 Proj.: -12.1; 2022/23 Proj.: -2.6; 2023/24 Proj.: 0.0; 2024/25 Proj.: 1.6; 2025/26 Proj.: 3.7. - Net lending (+)/borrowing (–): 2016/17: 4.8; 2017/18: 6.3; 2018/19: 0.4; 2019/20: -10.9; 2020/21 Est.: -19.5; 2021/22 Proj.: -12.6; 2022/23 Proj.: -3.2; 2023/24 Proj.: -0.5; 2024/25 Proj.: 0.2; 2025/26 Proj.: 1.9. - General government debt (percent of GDP): 2016/17: 34.4; 2017/18: 37.0; 2018/19: 38.6; 2019/20: 62.1; 2020/21 Est.: 85.7; 2021/22 Proj.: 90.3; 2022/23 Proj.: 74.0; 2023/24 Proj.: 71.1; 2024/25 Proj.: 66.7; 2025/26 Proj.: 62.1. Balance of payments and external sector: - Trade balance (million US$): 2016/17: -138.9; 2017/18: -136.5; 2018/19: -142.9; 2019/20: -147.8; 2020/21 Est.: -117.0; 2021/22 Proj.: -128.1; 2022/23 Proj.: -150.9; 2023/24 Proj.: -145.5; 2024/25 Proj.: -153.9; 2025/26 Proj.: -160.4. - Exports (f.o.b., million US$): 2016/17: 14.6; 2017/18: 15.5; 2018/19: 13.4; 2019/20: 6.1; 2020/21 Est.: 8.7; 2021/22 Proj.: 10.1; 2022/23 Proj.: 13.9; 2023/24 Proj.: 14.1; 2024/25 Proj.: 14.3; 2025/26 Proj.: 14.6. - Imports (f.o.b., million US$): 2016/17: 153.5; 2017/18: 151.9; 2018/19: 156.4; 2019/20: 153.8; 2020/21 Est.: 125.7; 2021/22 Proj.: 138.2; 2022/23 Proj.: 164.8; 2023/24 Proj.: 159.6; 2024/25 Proj.: 168.3; 2025/26 Proj.: 175.0. - Tourism receipts (million US$): 2016/17: 113.0; 2017/18: 104.8; 2018/19: 91.9; 2019/20: 50.9; 2020/21 Est.: 3.9; 2021/22 Proj.: 31.3; 2022/23 Proj.: 112.8; 2023/24 Proj.: 120.5; 2024/25 Proj.: 128.8; 2025/26 Proj.: 137.6. - Current account balance including grants (million US$): 2016/17: -55.3; 2017/18: -44.4; 2018/19: -85.3; 2019/20: -124.4; 2020/21 Est.: -120.8; 2021/22 Proj.: -109.6; 2022/23 Proj.: -68.7; 2023/24 Proj.: -61.8; 2024/25 Proj.: -63.0; 2025/26 Proj.: -61.3. - Current account balance excluding grants (million US$): 2016/17: -93.4; 2017/18: -94.3; 2018/19: -120.6; 2019/20: -154.9; 2020/21 Est.: -152.8; 2021/22 Proj.: -136.3; 2022/23 Proj.: -99.0; 2023/24 Proj.: -92.5; 2024/25 Proj.: -94.4; 2025/26 Proj.: -93.5. International investment position and external debt: - International Investment Position (million US$): 2016/17: -136.1; 2017/18: -105.0; 2018/19: -176.8; 2019/20: -256.3; 2020/21 Est.: -364.2; 2021/22 Proj.: -438.5; 2022/23 Proj.: -470.3; 2023/24 Proj.: -494.4; 2024/25 Proj.: -520.5; 2025/26 Proj.: -544.4. - Assets (million US$): 2016/17: 629.0; 2017/18: 715.2; 2018/19: 688.9; 2019/20: 736.9; 2020/21 Est.: 721.7; 2021/22 Proj.: 734.6; 2022/23 Proj.: 763.5; 2023/24 Proj.: 801.4; 2024/25 Proj.: 836.1; 2025/26 Proj.: 874.6. - Liabilities (million US$): 2016/17: 765.1; 2017/18: 820.2; 2018/19: 865.7; 2019/20: 993.2; 2020/21 Est.: 1,085.9; 2021/22 Proj.: 1,173.0; 2022/23 Proj.: 1,233.7; 2023/24 Proj.: 1,295.8; 2024/25 Proj.: 1,356.5; 2025/26 Proj.: 1,419.0. - External debt (million US$): 2016/17: 85.9; 2017/18: 91.8; 2018/19: 91.4; 2019/20: 150.1; 2020/21 Est.: 183.4; 2021/22 Proj.: 217.9; 2022/23 Proj.: 214.8; 2023/24 Proj.: 210.8; 2024/25 Proj.: 203.2; 2025/26 Proj.: 194.8. - Current account balance (percent of GDP) including grants: 2016/17: -19.4; 2017/18: -15.6; 2018/19: -31.1; 2019/20: -48.3; 2020/21 Est.: -55.9; 2021/22 Proj.: -45.2; 2022/23 Proj.: -23.3; 2023/24 Proj.: -20.2; 2024/25 Proj.: -19.9; 2025/26 Proj.: -18.7. - Current account balance (percent of GDP) excluding grants: 2016/17: -32.7; 2017/18: -33.1; 2018/19: -44.0; 2019/20: -60.1; 2020/21 Est.: -70.7; 2021/22 Proj.: -56.2; 2022/23 Proj.: -33.6; 2023/24 Proj.: -30.3; 2024/25 Proj.: -29.8; 2025/26 Proj.: -28.5. - International Investment Position (percent of GDP): 2016/17: -47.7; 2017/18: -36.9; 2018/19: -64.5; 2019/20: -99.4; 2020/21 Est.: -168.4; 2021/22 Proj.: -180.7; 2022/23 Proj.: -159.5; 2023/24 Proj.: -161.8; 2024/25 Proj.: -164.3; 2025/26 Proj.: -166.1. - External debt (percent of GDP): 2016/17: 30.1; 2017/18: 32.2; 2018/19: 33.3; 2019/20: 58.2; 2020/21 Est.: 84.8; 2021/22 Proj.: 89.8; 2022/23 Proj.: 72.8; 2023/24 Proj.: 69.0; 2024/25 Proj.: 64.2; 2025/26 Proj.: 59.4. ### Policy recommendations (summary) - Near-term: extend policy support until recovery is firmly entrenched, while improving efficiency of COVID-related spending. - Medium-term: rebuild fiscal resilience through gradual fiscal consolidation once recovery is underway and reform the public sector to contain rising fiscal risks; lower public debt; improve external position; accommodate higher climate spending; provide buffers against potentially lower grants and concessional financing. - Structural and financial sector reforms: accelerate reforms to lift medium-term growth, invest in climate-resilient infrastructure, and diversify within and outside tourism. *REPUBLIC OF PALAU STAFF REPORT FOR THE 2021 ARTICLE IV CONSULTATION* ### 6. A comprehensive policy response ### 6. A comprehensive policy response ### Policy response and immediate measures - Authorities implemented measures to strengthen healthcare and mitigate economic and social hardship, including domestic testing capability and quarantine facilities. - A stimulus package of $20 million (7.8 percent of GDP) was implemented under the Coronavirus One Stop Shop Relief Act (CROSS Act), mostly financed through concessional financing from the AsDB. - CROSS Act components included: unemployment benefits, temporary subsidies for utility bills, a temporary job creation scheme for public works, and a lending scheme for the private sector. - Citizens of Palau received unemployment benefits under the U.S. Coronavirus Aid, Relief, and Economic Security Act (CARES Act), with up to $19 million (7.4 percent of GDP) available. - Tourist arrivals dropped by 53 percent in FY2020, partially offset by a 26 percent increase year-on-year between October 2019 and January 2020. ### Fiscal impact and financing - Government non-grant revenues declined by 3.8 percentage points of GDP in FY2020. - By end-FY2020, about 26 percent of the budgeted resources under the CROSS Act (2 percent of GDP) and around 71 percent of support under the U.S. CARES Act (5 percent of GDP) were disbursed. - Non-crisis related spending (social benefits payments, subsidies to SOEs, transfers to the Civil Service Pension Fund and the Social Security Fund) increased by about 6 percent of GDP. - As support under the CARES Act was covered by corresponding grants, the fiscal balance moved from a surplus of 0.4 percent of GDP in FY2019 to a deficit of 10.9 percent of GDP in FY2020. - Disbursements of large external loans in FY2020, particularly by the AsDB, boosted government deposits. - The fiscal support package expanded to 19.5 percent of GDP in FY2021; the fiscal deficit is projected to moderate to 12.6 percent of GDP in FY2022. - Estimated cumulative fiscal financing need of about 51 percent of GDP in FY2020-22. - Disbursed and planned AsDB financing of about US$100 million (42 percent of GDP) and bilateral donor financing of about US$20 million (8 percent of GDP) would cover most financing needs and help preserve government deposits around 7-9 percent of GDP. - Authorities’ plan to use the 2021 SDR allocation to enhance last-resort buffers is appropriate. ### Banking system and credit conditions - Banking system is sound overall; commercial banks have ample liquidity. - Ratio of non-performing loans to total loans increased from the pre-crisis average of 0.7 percent to 1.7 percent in 2021Q1. - Bank lending declined by 4.8 percent in FY2020 (year-on-year), reflecting increased risk aversion and lower loan demand. ### External position and vulnerabilities - External Sustainability model indicates a current account (CA) gap of -19.7 percent of GDP in FY2020; point estimate uncertainty suggests the CA gap is likely in the range of -5 to -20 percent in FY2020. - CA deficit expected to narrow in the medium term as tourism resumes, but remain elevated. - Risks of external financing distress are low given banks’ large foreign assets and continued access to long-term concessional loans and grants. - Government’s U.S. dollar deposits, the equivalent of foreign reserves in a dollarized economy, are appropriate at 5 months of government spending. - Palau faces structural vulnerabilities: remoteness, high dependence on volatile tourist arrivals, relatively high debt burden, exposure to climate change and natural disasters, and implications from graduation from the OECD DAC list. ### Outlook and macro projections - Real GDP contracted further by 17.1 percent (year-on-year) in FY2021, with an estimated 92 percent drop in tourist arrivals. - About 90 percent of the total population fully vaccinated; borders gradually reopened and the travel bubble with Taiwan Province of China resumed in August 2021. - Under a gradual reopening scenario with tourist arrivals reaching FY2019 levels in FY2024: - Real GDP projected to rebound by 9.4 percent in FY2022 and 18.3 percent in FY2023. - Over the medium-term, output expected to remain on a lower trajectory due to economic scarring in tourism. - Inflation projected to pick up from 1.2 percent in FY2021 to 3 percent in FY2022, driven by elevated international commodity prices; the planned PGST in FY2023 will exert a one-off upward pressure on prices. - Main downside risks: protracted COVID-19 pandemic and domestic outbreak, delayed Compact Agreement with the U.S., reduced concessional financing following OECD DAC graduation, higher-than-expected inflation, and more frequent/severe natural disasters. - Upside potential: rapid global vaccine distribution could expedite tourism resumption; ratification of a new Compact Agreement could boost grant revenues, though timing and terms are uncertain. ### Authorities’ views - Authorities broadly agreed with staff assessment of outlook and risks, expecting recovery from FY2022 but tourism-related activity to remain below pre-pandemic levels through FY2023. - Construction momentum expected to be sustained near-term due to foreign-financed projects such as the airport extension. - Authorities emphasized Palau’s vulnerability and fragility despite high-income status and noted potential impacts from OECD DAC graduation on grants and concessional financing. - Authorities concurred that the rise in imports of pharmaceutical products during the pandemic is transitory and agreed that the CA deficit should narrow over the medium-term. - Authorities support fiscal reforms (comprehensive tax reform and rationalization of public expenditure) to improve fiscal position and reduce the CA deficit. ### Policy recommendations and priorities - Overall approach: secure a robust recovery and manage risks with targeted fiscal and financial policies, contingency planning, and a medium-term fiscal consolidation. - Baseline: extend targeted fiscal and financial policies, accelerate execution of the CROSS Act, and maintain support until recovery is firmly entrenched. - Downside scenario: targeted spending measures to reach affected entities as first line of defense, with attention to debt sustainability; contingency plans for social assistance to protect the most vulnerable; priority to rebuild fiscal resilience over the medium-term. A. Near-term fiscal policy response - Extend fiscal relief measures until recovery is firmly entrenched; accelerate CROSS Act execution to extend targeted support to affected households and firms as envisaged in the FY2022 budget. - While spending is projected to fall from 19.5 percent of GDP in FY2021 to a 12.6 percent deficit in FY2022, a planned across-the-board 10 percent cut in spending (other than CROSS Act support and transfers to state governments, education, and social security) could fragilize nascent momentum. - Enhance governance safeguards to improve efficiency of COVID-related spending: - Timely reporting and integration of COVID-related spending in the budget cycle. - Conduct and publication of planned ex-post audits. - Publication of beneficial ownership information of awarded contracts. - Use of administrative data (e.g., tax returns) to support beneficiary selection and reduce processing times. - Improve targeting using indicators of corporate financial health (recovery in operating revenues or profits) and maintain communication with the business community. B. Rebuilding fiscal resilience over the medium-term - Fiscal risks have increased; public debt projected to peak at 90 percent of GDP in FY2022 and gradually decline to 62 percent of GDP by FY2026, supported by concessional financing and favorable interest rate-growth differentials. - A gradual fiscal consolidation is critical to lower public debt, reduce fiscal risks, increase climate-related spending, and provide buffers against potentially lower grants/concessional financing due to OECD DAC graduation. - Proposed consolidation: a gradual fiscal adjustment of 1 percent of GDP per year over 5 years (FY2024-FY2028) to help achieve a balanced budget, safeguard the CTF, strengthen long-term debt sustainability, and accommodate higher climate spending. - Authorities should maintain fiscal prudence and timely unwind emergency measures once the health crisis is over; consider improving targeting of relief measures and tapering unemployment benefits as recovery proceeds. C. Revenue mobilization and expenditure rationalization - Revenue measures: - Comprehensive tax reform approved; expected to enter into force in January 2023. Key elements include: - Introduction of a 10 percent PGST. - Introduction of a 12 percent business profits tax. - A redefined 4 percent land transaction proceeds fee. - Tax reform could yield an estimated net revenue gain of about 1 percent of GDP and cover the first year of the 5-year fiscal adjustment. - Effective implementation requires elaboration and approval of corresponding regulations, with support from PFTAC, including safeguards to prevent abuse of PGST refunds. - Modernization of the tax IT system is critical. - Additional revenue options if needed: - Raise the carbon tax from 2 cents per gallon to above the initially proposed rate of 15 cents per gallon. - Raise the business profits tax rate from 12 percent to at least 15 percent to align with the agreed global minimum corporate tax rate. - Streamline exemptions under the PGST. - Expenditure measures: - Streamline subsidies to the Palau Public Utilities Corporation (PPUC) and transfers to other public entities and state governments while enhancing efficiency. - Strengthen public financial management (PFM), including the public investment management framework and consider a formal PEFA assessment. - Advance the planned Fiscal Responsibility and Debt Management Act with regulations that include well-defined escape clauses to reduce procyclicality and a framework to better monitor and manage external debt. - CTF considerations: - CTF expected to provide annual contributions of US$15 million to the budget starting in FY2019; increasing annual withdrawals above US$15 million could endanger the fund’s long-term sustainability. *Source: IMF staff report chapter "6. A comprehensive policy response" (Content unit: 1plwea2021001).* ### 22. Swift public sector reform is critical to contain fiscal risks. Transfers to the Civil Service ### Swift public sector reform is critical to contain fiscal risks. Transfers to the Civil Service Pension Fund (CSPF), the PPUC, the Social Security Fund (SSF), and state governments have significantly increased in the past few years, reflecting these entities’ increasingly difficult financial situations. ### Fiscal pressures and reform priorities - Rising payments of unfunded benefits to CSPF pensioners are requiring a drawdown of investments and will lead to a negative net position of the Fund in the near term. - Recommended CSPF reforms: - Increase of retirement age. - Hikes in contribution rates for employers and employees. - Shift from a defined-benefit to a defined-contribution scheme. - A swift implementation of a comprehensive set of reforms is critical for the sustainability of the CSPF. - PPUC issues and required measures: - Operating losses, particularly for water and wastewater. - Build on support from the AsDB to accelerate reforms to adopt and maintain full cost recovery tariffs for both fuel and power, and water and wastewater. - SSF reform: - Strengthen the Fund’s governance and better align contributions with benefits to secure SSF’s financial stability and contain fiscal risks. - Enhance state governments’ fiscal management capacity to better align expenditures with available resources and reduce central government transfers. ### Estimated total savings and fiscal adjustment options (Palau: Options of Measures to Support Fiscal Adjustment during FY2024-28) - These reforms could generate annual savings of up to 1.5 percent of GDP. - Estimated total saving (in percent of GDP): - Approved tax reform 1.0 - Additional tax measures 4.0 - Raise carbon tax gradually, up to 30 cents per gallon 1.5 - Streamlining exemptions under the PGST 1.0 - Improvements to tax administration with new IT system 1.0 - Raise business profits tax rate, to at least 15 percent 0.5 - Expenditure measures 1.5 - Streamline subsidies to PPUC 1.0 - Streamline subsidies and transfers to other public entities 0.5 - Total measures 6.5 - Note: The estimates assume a revenue gain of 0.2 percent of GDP per year due to improvements in tax administration. A potentially higher PGST rate in the long-term, if initial revenue mobilization and expenditure rationalization efforts fall short of covering the needed fiscal consolidation, is not included. ### Authorities’ views on fiscal policy and reforms - Authorities agreed with staff’s near-term fiscal policy advice. - FY2022 budget measures: - Provisions to extend the CROSS Act to provide targeted support to still affected households and firms. - A 10-percent cut in spending by government branches aimed at reducing extraneous spending while maintaining crucial public services. - A supplementary monthly social security benefit of $100, financed by the central government, expected in FY2022. - Authorities concurred fiscal risks had increased substantially and reform-based fiscal adjustment was needed in the medium-term. - Views on tax reform: - Comprehensive tax reform will modernize the tax system, improve efficiency and fairness, and generate additional fiscal revenues. - Transition from the Gross Revenue Tax to the Palau Goods and Services Tax (PGST), a VAT system, expected to encourage entry of new and small businesses and promote foreign investment, particularly in high-value tourism. - Fiscal Responsibility and Debt Management Act: - Planned Act under consideration in Congress would cement Palau’s track record of fiscal prudence and establish guiding principles for the budget process, PFM, debt management, and fiscal risk management. ### Financial sector policies to support credit and preserve stability - Credit constraints and structural impediments: - Loan-to-GDP ratio was around 12 percent in FY2020. - Bank lending is highly concentrated in small loans to individuals; lending to businesses constrained by lack of reliable financial information for firms and SMEs’ limited capacity. - Interest rate ceiling on commercial loans noted as a structural issue (Appendix IX). - Policy options to support distressed but viable businesses: - Extension of lending schemes and credit guarantee programs with emergency relief measures, with banks bearing part of the risk. - Avoid relaxation of loan classifications and provisioning rules. - Support SMEs to prepare business plans and financial statements. - Strengthen National Development Bank of Palau’s (NDBP) lending capacity by effectively allowing it to take deposits through a license of the Financial Institutions Commission (FIC). - AML/CFT measures: - Moratorium on crypto-asset and crypto-currency activities is adequate. - Strengthen Know-Your-Customer practices and transparency of financial transaction reporting by enacting DNFBPs transaction reporting requirements of August 2021. - Modernize business registry and beneficial ownership disclosures by corporations. - Strengthen risk-based AML/CFT supervision for financial institutions and designate AML/CFT supervisors for non-bank financial institutions and DNFBPs (real estate agents, lawyers). ### Climate resilience, economic diversification, and infrastructure needs - Growth strategy and diversification: - Opportunity to revisit growth model given potential long-lasting reduction in tourism. - Pursue greater diversification of source markets and move toward high-value and eco-tourism. - Policy package: streamline foreign investment processes, improve regulatory framework and land-use planning, upgrade climate-resilient infrastructure, enhance human capital. - Develop domestic agri-food supply chain to support eco-tourism and boost value-added from agriculture and manufacturing. - Climate adaptation costs and priorities: - Palau is set to face substantial costs for coastal protection and other climate adaptation needs, estimated at a minimum of 4 percent of GDP per year. - 2015 authority estimate: climate change-related cost at $500 million (about 194 percent of 2020 GDP), including relocation of the major hospital due to rising sea levels. - Planned reform of the PPUC would improve its financial sustainability and facilitate entry of private renewable energy producers. - Importance of maintaining access to concessional climate financing (e.g., Green Climate Fund). - Authorities emphasized urgency of infrastructure investments, with most imminent project being relocation of the national hospital. ### Statistics, data, and capacity building - Statistics adequacy and improvements: - Palau’s statistics are broadly adequate for surveillance thanks to PFTAC and Graduate School USA TA. - Need development of quarterly statistics for BOP, real, and fiscal sectors. - Broaden coverage of fiscal data to general government level and improve public sector debt statistics. - Strengthen capacity of state governments and other units to provide timely and adequate financial statements. - Expand coverage of monetary statistics to include NDBP and other financial corporations. - Palau expected to implement the enhanced General Data Dissemination System (e-GDDS) in early 2022, with IMF Statistics Department support. - Authorities’ request: - Continued TA to develop regulations supporting tax reform implementation, compilation of comprehensive fiscal accounts, and capacity building for newly created Financial and Economic Intelligence Services (FEIS). ### Staff appraisal and policy recommendations - Pandemic response and outlook: - Authorities’ comprehensive economic policy response cushioned the COVID-19 impact. - With about 90 percent of the total population fully vaccinated, Palau has started to reopen borders and is projected to gradually rebound in FY2022. - Near-term outlook subject to elevated uncertainty; risks tilted to the downside (pandemic, higher inflation, shortfall of non-Compact grants, natural disasters). - Fiscal risks and debt sustainability: - Fiscal risks have increased substantially; public debt has surged but remains sustainable due to large share of concessional financing, particularly from the AsDB. - Near-term policy stance: - Pandemic relief measures should be extended until recovery is firmly entrenched. - Accelerate execution of the CROSS Act to provide targeted support as envisaged in FY2022 budget. - If downside risks materialize, use targeted spending measures as first line of defense with due consideration to debt sustainability. - Medium-term fiscal adjustment: - A fiscal adjustment is needed to rebuild fiscal resilience. - Staff assesses that a fiscal adjustment of 1 percent of GDP per year over 5 years will help lower public debt ratios, preserve the CTF, accommodate higher spending to address climate change, provide buffers against potentially lower grants and concessional financing, and improve the external position. - Revenue and tax reform recommendations: - Welcome approval of comprehensive tax reform; potential revenue gains estimated at about 1 percent of GDP. - Options to raise additional revenue include: - Raising the carbon tax in line with Palau’s commitments to address climate change. - Increasing the business profit tax rate to at least the 15 percent agreed minimum global corporate tax rate. - Streamlining PGST exemptions. *Source: IMF staff report excerpt for Palau (chapter 22).* ### 40. Swift public sector reform to rationalize subsidies and transfers to public entities ### 1plwea2021001 - 40. Swift public sector reform to rationalize subsidies and transfers to public entities ### Public sector reform and fiscal consolidation - Swift public sector reform to rationalize subsidies and transfers to public entities should contribute to the fiscal adjustment. - Rapid implementation of a comprehensive set of reforms, including an increase of retirement age and hikes in contribution rates, is critical for the near-term sustainability of the CSPF. - Building on support from the AsDB, the authorities should accelerate the PPUC’s reform to adopt and maintain full cost recovery tariffs. - Strengthening the SSF’s governance and enhancing state governments’ fiscal management capacity would help better align these entities’ expenditures with available resources. - It is recommended that the next Article IV consultation be held on the current 24-month cycle. ### Financial sector reforms - Financial sector reforms should be accelerated to support credit growth and improve AML/CFT. - Temporary measures to support the recovery (credit guarantees, and debt moratoria) should be extended and targeted to viable and still impacted firms. - The NDBP should be placed under the supervision of the FIC to effectively allow the bank to take deposits, thereby strengthening its lending capacity. - Enhancing SMEs capacity to prepare business plans and relaxing the interest rate ceiling on commercial loans could help boost the structurally low credit creation. - Risk-based supervision should be strengthened, including by designating specific AML/CFT supervisors for non-bank financial institutions and DNFBPs. ### Growth, diversification, and human capital - Steadfast implementation of priority reforms should continue to support sustained growth post-pandemic. - Palau should pursue greater diversification of source markets and move toward high-value and eco-tourism. - Streamlining processes for foreign investment, improving the regulatory framework and land-use planning, and enhancing human capital would encourage private investment within and outside tourism, better integrate tourism with other sectors of the economy, and create quality job opportunities. ### Climate resilience - Strengthening resilience to climate change is essential for Palau’s sustainable development. - Timely implementation of Palau’s climate change adaptation and mitigation strategy, including by tapping into climate risk financing, is critical to enhance economic resilience against rising threats from climate change that could pose disproportionately large damages to Palau’s small economy. ### Capacity building and data/administration - Pursuing capacity building efforts will enhance macroeconomic management. - With technical assistance support from the Fund and PFTAC, the authorities should develop regulations that will support a timely implementation of the approved tax reform and improve data quality to support surveillance, particularly in the fiscal, external, and financial sectors. ### Box 1 — Palau: Medium-Term Fiscal Adjustment Scenario - Baseline scenario: - The fiscal balance is projected to reach a surplus of 0.2 percent of GDP in FY2025, before declining to a deficit in FY2033. - Public debt to GDP is expected to fall from a peak of 90 percent to 41 percent in FY2040. - The CTF’s balance is expected to erode to 76 percent of GDP by FY2040 with drawdowns of US$15 million annually. - Fiscal adjustment scenario: - Objective: achieve a balanced budget while safeguarding the CTF for future generations, increasing spending to address climate change, and providing buffers against potentially lower grants and concessional financing due to Palau’s graduation from the OECD’s list of countries eligible for official development assistance. - In addition to the revenue gain from the tax reform in FY2024, the government pursues a fiscal adjustment of 1 percent of GDP per year over the 4 consecutive years (FY2025-FY2028). - The fiscal adjustment is achieved through higher domestic revenue mobilization and expenditure rationalization. - Savings from the last two years of the fiscal adjustment (2 percent of GDP) are expected to cover half of the estimated spending needs to address climate change. - The adjustment leads to marginal dampening effects on growth in the near term. - Under the scenario, the government would use parts of its primary surplus to repay existing debt from FY2030 and reduce drawdowns from the CTF by about half to US$8 million from FY2031. - Outcomes: stabilize the CTF balance at 93 percent of GDP and public debt would decline to 30 percent of GDP by FY2040. - Footnotes (as presented): - "The fiscal adjustment for 4 years (4 percent of GDP) will complement the net gains from the tax reform (1 percent of GDP) in FY 2024 for a total fiscal adjustment of 5 per cent of GDP over 5 years (FY 2024-FY 2028). The fiscal adjustment could be more ambitious and extended through FY2030 if needed, for instance if the graduation from the OECD’s list leads to a larger than expected reduction in grants and concessional financing." - "The baseline incorporates part of ongoing and planned climate adaption and resilience projects (at least 1 per cent of GDP)." ### Key statistics and projections (selected exact figures from the chapter) - Nominal GDP for FY2020: US$258 million - Population (2019): 17,457 - GDP per capita for FY2020: US$14,784 - Tourist arrivals: - FY2020: 3,167 visitors - FY2021: 24,708 visitors - Real GDP growth (percent change): - FY2020 (2020/21): -17.1 - FY2021 (2021/22): 9.4 - Consumer prices (percent change; period average) for FY2020: 1.2 - Current fiscal balance (including current grants) projected to be a surplus of 0.2 percent of GDP in FY2025 (baseline projection to FY2025 leading into deficit by FY2033 as noted above). - Public debt: - Peak of 90 percent of GDP (date as described in text) - Projected to fall to 41 percent of GDP in FY2040 under baseline - Projected to decline to 30 percent of GDP in FY2040 under fiscal adjustment scenario - Compact Trust Fund (CTF) balance: - Expected to erode to 76 percent of GDP by FY2040 under baseline with drawdowns of US$15 million annually - Stabilized at 93 percent of GDP by FY2040 under fiscal adjustment scenario with drawdowns reduced to US$8 million from FY2031 *Source: 1plwea2021001 - 40. Swift public sector reform to rationalize subsidies and transfers to public entities (IMF).* ### Appendix I. Palau’s Climate Change Challenges ### Appendix I. Palau’s Climate Change Challenges ### A. Impact of Climate Change on Palau - Climate change poses an existential threat to Palau. - Projected temperature increases (Australian Bureau of Meteorology and Commonwealth Scientific and Industrial Research Organization (2014), relative to 1986–2005, medium‑emissions scenario): - Annual average air temperature will rise by 0.7-1.6 °F by 2030. - Annual average air temperature will rise by 1.3-2.5 °F by 2050. - Observed and projected climate hazards and impacts: - Sea water level and air temperature have been on the rise and trends are expected to continue. - Climate change could increase the intensity of tropical cyclones. - Gradual sea level rise will erode low-lying coastal land critical for economic and agricultural activities. - Higher air temperature could increase cases of heat stroke and lower labor productivity. - Warmer seawater will expose coral reef to excess heat, potentially undermining Palau’s attractiveness for diving and beach tourism. - Estimated negative economic impact: - Authorities estimate the negative economic impact from climate change to be in the range of 4 to 20 percent of GDP annually, including through adverse effects to agricultural and fish produce, and a decline in tourism revenue. - Disaster risk financing context (PCRAFI, 2011): - Expected annual loss due to tropical cyclones and earthquakes for Palau is 2.7 million USD (about 1 percent of 2019 GDP). - Over the next 50 years, Palau has a 50 percent chance of incurring losses exceeding 30 million USD (11 percent of 2019 GDP). - Over the next 50 years, Palau has a 10 percent chance of experiencing catastrophic losses exceeding 247 million USD (88 percent of 2019 GDP). ### B. Palau’s Climate Change Policies and Implementation - Strategic decisions shaping Palau’s climate strategy (mid-2010s): - 2015: Adoption of “Palau Climate Change Policy” with three objectives: - (i) enhance adaptation and resilience, - (ii) manage disasters and minimize disaster risk, - (iii) mitigate global climate change by working towards low emission development. - 2016: Ratification of the UNFCCC Paris Agreement. - In its Intended Nationally Determined Contribution, Palau introduced three indicative targets by 2025: - (i) reduce energy sector emissions by 22 percent relative to the 2005 levels, - (ii) generate 45 percent of its energy from renewable sources, - (iii) increase energy efficiency by 35 percent. - 2016: Alignment of tourism strategy with climate objectives via “the Palau Responsible Tourism Policy Framework,” prioritizing protection of the pristine environment and targeting niche markets rather than mass-tourism. - Adaptation implementation and financing constraints: - The Five-year Climate Change Action Plan (part of Palau Climate Change Policy) identified priority adaptation projects, including relocation of the national hospital and establishment of emergency shelters. - Estimated total cost of the 5-year Climate Change Action Plan (public and private sectors combined) was 500 million USD for FY2016–FY2020. - Palau’s first Voluntary National Review of the SDGs (“Pathway to 2030” (2019)) stated that only 22.8 million USD was made available until 2018. - The cost estimate is currently under revision by the new administration. - Long-term adaptation needs and financing gaps: - World Bank estimate: additional costs for coastal protection and other adaptation projects during 2020’s to be about 4 percent of GDP per year for Palau. - OECD’s External Development Finance Statistics (2015–2019): climate-related development finance for Palau was about 38 million USD, of which financing for adaptation was between 21 to 26 million USD. - This is equivalent to 4 to 5 million USD per year (1.5 to 1.9 percent of 2019 GDP), covering about half of the World Bank’s estimated annual adaptation costs. - The grant from the Green Climate Fund in 2020 (part of a multi-country project to enhance climate information and knowledge services for resilience) is a welcome step. - Renewal of the Compact Agreement with the United States beyond 2024 could provide further boost to climate efforts. - Implementation implication: - Limited access to funding for climate adaptation is a major impediment; it will be important to renew efforts to secure financing for adaptation projects from diversified sources, both domestically and internationally. ### C. Mitigation: Energy Mix and Renewable Opportunities - Emissions context: - Total emissions from Palau are negligible on a global scale, but CO2 emissions per capita for Palau are high compared to other Pacific island and small countries—likely reflecting large inflows of visitors who contribute to emissions but are not included in the population denominator. - Greenhouse gas emissions per capita have been on the rise in Palau despite a continuous decline in inbound visitors. - Energy generation mix and renewable energy potential: - Current share of renewable energy production in Palau is 8 percent. - Authorities could strengthen efforts to increase renewable energy, notably solar energy. - Recent and planned policy and financing actions: - With support from the Asian Development Bank (AsDB), authorities plan to provide affordable financing to low-income and female households for promoting energy-efficient housing and roof-top solar electricity generation. - Authorities secured a policy-based loan from the AsDB in 2020 to improve the financial viability of the PPUC, which could facilitate the entry of private renewable energy producers. - Policy implication: - Reinvigorating mitigation efforts by promoting renewable energy production would improve the energy mix and strengthen synergy between climate change objectives and the tourism strategy. *Source: Appendix I. Palau’s Climate Change Challenges* ### 3. Imminent risks of external financing distress, however, are still low, given the ### 1plwea2021001 - 3. Imminent risks of external financing distress, however, are still low, given the ### External financing risks and current account - Imminent risks of external financing distress are still low, given the structure of external financing. - Assumptions underpinning low immediate risk: - Continuous access to long-term, concessional loans from multilateral organizations. - Availability of grant financing from the U.S. - Large foreign assets in the banking sector (about 111 percent of GDP in 2020) mitigate external financing risks. - Medium-term concerns: - Protracted external imbalances could pose a financing challenge over the medium term. - The level of the current account (CA) deficit pre-COVID was already elevated; additional efforts are needed to further reduce it. - Reinvigorated structural reforms suggested to improve the current account balance: - (i) increasing renewable energy production to cut fuel imports; - (ii) developing domestic agri-food supply chain to reduce food imports. - Fiscal policy option: - An ambitious fiscal adjustment strategy (for instance 1 percent of GDP per year for 5 years) could help improve the external position while providing room to increase public investments in climate-resilient infrastructure. ### Exchange rate and competitiveness - Institutional arrangement: - Palau has no central bank and uses U.S. dollar as its legal tender. - Therefore, Palau’s real effective exchange rate (REER) broadly follows that of the U.S. Dollar. - Competitiveness considerations: - Tourism costs in Palau are broadly similar to other Pacific destinations (e.g., Samoa and Vanuatu); exchange rate developments could influence tourists’ destination decisions. - The REER moderately depreciated in the second half of 2020, in line with movement of U.S. dollar. ### Reserves and liquidity buffers - Government deposits: - Government’s U.S. dollar deposits effectively serve as reserves and as the main instrument to absorb short-term liquidity shocks. - Government deposits increased in FY2020 to 23.6 percent of GDP, covering more than 3 months of imports. - Current level of government deposits corresponds to 5 months of government spending, which is higher than the standard yardstick of one month of government spending used for an appropriate fiscal buffer. - Liquidity need assessment: - The need for a liquidity buffer to repay short-term external debt is limited for Palau, thanks to access to long-term concessional financing from bilateral or multilateral official creditors. ### Risk Assessment Matrix — selected risks, likelihoods, impacts, and policy responses - Natural disasters and climate change (short and medium term) - Relative likelihood: Low/Medium - Expected impacts if realized: High - Recommended policy responses: - Maintain reserve buffers and expand contingent financing plans with development partners. - Strengthen infrastructure including coastal protection and planning. - Uncontrolled Covid-19 local outbreak (short term) - Relative likelihood: Low - Expected impacts if realized: High - Recommended policy responses: - Secure financing sources or draw down government deposits to prop up healthcare capacity and provide support to firms/households. - Graduation from the OECD’s DAC list - Relative likelihood: High (Palau is expected to graduate in 2022) - Expected impacts if realized: Medium - Recommended policy responses: - Fiscal adjustment to provide buffer against potential shortfall of concessional financing, particularly grants. - Delay in extending the Compact agreement (medium term) - Relative likelihood: Low (Compact Agreement scheduled to expire in 2024; authorities negotiating extension) - Expected impacts if realized: High - Recommended policy responses: - Secure alternative financing sources to continue infrastructure investment and ensure debt sustainability. - Growing NPL (medium term) - Relative likelihood: Medium - Expected impacts if realized: Medium - Recommended policy responses: - Strengthen monitoring of banks’ asset quality and implement capital injection if necessary. - Resurgence of the Covid-19 pandemic (short term) - Relative likelihood: Medium - Expected impacts if realized: High - Recommended policy responses: - Diversify source countries of tourists; undertake counter-cyclical fiscal policy to mitigate adverse economic impact. - Rising commodity prices (short term) - Relative likelihood: Medium - Expected impacts if realized: Medium - Recommended policy responses: - Support vulnerable households; accelerate renewable energy adoption and increase domestic food production. - Permanent decline in global tourism (medium term) - Relative likelihood: Medium/High - Expected impacts if realized: Medium/High - Recommended policy responses: - Pursue low-volume, high-value tourism strategy with focus on eco-tourism. - Promote economic diversification through comprehensive policies to improve the investment climate, enhance investment in human capital, and upgrade climate-resilient infrastructure. ### Debt Sustainability Analysis — key findings and scenarios - Overall assessment: - While Palau’s public debt remains sustainable, a sharp deterioration of the fiscal position due to the pandemic has significantly increased debt sustainability risks. - Historical and projected debt dynamics: - Public debt-to-GDP ratio increased from 38.6 percent of GDP in FY2019 to 62.1 percent in FY2020 with disbursement of new loans. - Under the baseline scenario, the public debt-to-GDP ratio is projected to peak at 90 percent of GDP in FY2022, before declining gradually to around 62 percent of GDP by FY2026. - The decline is aided by favorable interest rate-growth differentials reflecting a large share of concessional financing. - Composition and recent disbursements: - Public debt coverage in the analysis includes: - Central government’s external debt: 58.0 percent of GDP in FY2020. - Government’s domestic accounts payable or domestic arrears: 4.0 percent of GDP in FY2020. - SOEs’ debt: 9.7 percent of GDP in FY2020 (fully guaranteed by the government and a contingent liability). - Disbursements in FY2020 include: - ADB loans: US$15 million (Pacific Disaster Resilience Program), US$20 million (COVID-19 Pandemic Relief Option, CPRO), US$5 million (PPUC Reform Program). - Mega International Commercial Bank loan: US$15 million (Housing Development and Loan Program). - Additional AsDB disbursements contributing to the FY2021-22 debt increase: - US$55 million for the Recovery through Improved Systems and Expenditure Support (RISES) program. - US$5 million additional disbursements for the PPUC Reform Program. - Baseline macro-fiscal assumptions: - Real GDP: following a 9.7 percent drop in FY2020, projected to further contract by 17.1 percent in FY2021, then rebound by 9.4 percent in FY2022 and 18.3 percent in FY2023. - Fiscal deficit: from 10.9 percent of GDP in FY2020, projected to widen to 19.5 percent of GDP in FY2021 and moderate to 12.6 percent of GDP in FY2022. - Fiscal position projected to improve in the medium-term, turning to a surplus in FY2025. - Financing needs: - Under the baseline scenario, gross financing needs (fiscal deficit plus maturing debt) are projected to reach 21.7 percent of GDP in FY2021. - Projected budget surpluses from FY2026 are expected to allow the government to fully pay scheduled debt services. - Realism and distributional risk assessment: - Past assumptions about real growth and the GDP deflator have been relatively optimistic while assumptions about the primary balance have been pessimistic. - Under the baseline scenario, the projected 3-year adjustment in the cyclically adjusted primary balance (CAPB) is in a percentile rank of 57 percent compared to historical experience for market access countries. - The CAPB 3-year average level is in a percentile rank of 70 percent. - Fan-chart assessment: - Under a symmetric distribution, there is around a 50 percent probability that debt will remain below 62 percent of GDP over the medium term. - Under an asymmetric scenario (no positive shocks to the primary balance), there is a probability of around 25 percent that the debt path will remain below 62 percent of GDP over the projection horizon. - Stress test results and alternative scenarios: - GDP growth shock scenario: - Assumes a slower recovery pace from FY2022. - Public debt-to-GDP ratio would rise substantially to nearly 100 percent of GDP in FY2022 and remain above the 70 percent of GDP benchmark through FY2026. - Constant primary balance shock: - Assumes the considerably looser fiscal stance projected in FY2021 is maintained through the projection horizon. - Debt-to-GDP ratio would increase steadily and reach 146 percent in FY2026, putting debt sustainability severely at risk. - Gross financing needs would reach 62 percent of GDP in FY2026, well above the 15 percent of GDP benchmark. - Contingent liabilities to SOEs shock: - Assumes government absorbs all SOE guarantees over 5 years with negative feedback effects on interest rates. - Debt-to-GDP ratio would rise to 83 percent of GDP in the medium term, breaching the DSA benchmark. - Heat map summary: - By debt level and gross financing needs, all alternative scenarios would breach the DSA benchmarks. - By debt profile, the share of debt held by foreigners is high at 93 percent of GDP, though the preeminence of concessional financing from multilateral creditors is a mitigating factor. *Prepared by IMF staff as presented in the sourced chapter.* ### 9. Considering Palau’s susceptibility to shocks and the impact of these shocks on debt ### 9. Considering Palau’s susceptibility to shocks and the impact of these shocks on debt ### Near-term priority and fiscal stance - Continued fiscal prudence in the near term and rebuilding fiscal buffers over the medium term should be a priority. - Enhancing domestic revenue mobilization and further rationalizing current expenditure would help to better secure debt sustainability. - Given Palau’s exposure to climate change risks, the country should continue to tap into concessional climate-related financing to enhance resilience and face potential future climate shocks. ### Baseline public debt dynamics and key projections (figures as presented) - Nominal gross public debt: 39.0 (2019), 38.6 (2020), 62.1 (2021), 85.7 (2022), 90.3 (2023), 74.0 (2024), 71.1 (2025), 66.7 (2026), 62.1 (as of June 30, 2021) — (in percent of GDP unless otherwise indicated). - Of which: guarantees: 15.9 (2019), 8.3 (2020), 9.7 (2021), 10.9 (2022), 9.7 (2023), 8.0 (2024), 7.7 (2025), 7.5 (2026), 7.2 (as of June 30, 2021). - Public gross financing needs: -2.0 (2019), 1.2 (2020), 12.7 (2021), 21.7 (2022), 16.1 (2023), 7.4 (2024), 4.3 (2025), 3.3 (2026), 3.2, 2.0, 5 (displayed across projections). - Real GDP growth (in percent): 1.6 (2019), -1.9 (2020), -9.7 (2021), -17.1 (2022), 9.4 (2023), 18.3 (2024), 2.9 (2025), 2.9 (2026), 2.7 (as of June 30, 2021). - Inflation (GDP deflator, in percent): 3.5 (2019), -1.8 (2020), 4.1 (2021), 1.2 (2022), 2.5 (2023), 2.8 (2024), 0.7 (2025), 0.7 (2026), 0.8 (as of June 30, 2021). - Nominal GDP growth (in percent): 5.3 (2019), -3.7 (2020), -6.0 (2021), -16.1 (2022), 12.2 (2023), 21.5 (2024), 3.6 (2025), 3.7 (2026), 3.5 (as of June 30, 2021). - Effective interest rate (in percent): 1.3 (2019), 1.8 (2020), 2.4 (2021), 2.0 (2022), 1.2 (2023), 1.1 (2024), 1.1 (2025), 1.1 (2026). ### Identified debt-creating flows and fiscal balances (selected series) - Change in gross public sector debt (cumulative): -1.3 (2019), 1.6 (2020), 23.5 (2021), 23.6 (2022), 4.6 (2023), -16.3 (2024), -2.9 (2025), -4.4 (2026), -4.6, 0.0. - Identified debt-creating flows: -2.9 (2019), -3.1 (2020), 25.2 (2021), 16.4 (2022), 4.7 (2023), -16.2 (2024), -2.8 (2025), -2.7 (2026), -2.4, -3.0. - Primary deficit: -3.1 (2019), -0.9 (2020), 10.2 (2021), 18.3 (2022), 11.3 (2023), 2.1 (2024), -0.5 (2025), -1.2 (2026), -2.8, 27.2. - Primary (noninterest) revenue and grants: 43.3 (2019), 44.5 (2020), 47.3 (2021), 46.3 (2022), 41.2 (2023), 38.0 (2024), 39.0 (2025), 38.6 (2026), 38.9, 242.0 (cumulative). - Primary (noninterest) expenditure: 40.2 (2019), 43.6 (2020), 57.6 (2021), 64.6 (2022), 52.6 (2023), 40.1 (2024), 38.4 (2025), 37.4 (2026), 36.1, 269.2 (cumulative). ### COVID-19 impact on public debt (Appendix VII) - Pre-pandemic trajectory: public debt fell from 49 percent of GDP in 2009 to about 28 percent of GDP in FY2015, hedging up slightly to 39 percent of GDP in 2019. - Cross-country perspective: Palau’s debt to GDP ratio during 2007-2019 was 40 percent of GDP versus the Pacific Islands countries (PICs) average of 36 percent of GDP. - Multilateral creditors: as of 2019, about 60 percent of Palau’s external debt comes from multilateral creditors, mostly the Asian Development Bank (AsDB). - Pandemic borrowing and composition: loans from multilateral creditors accelerated and are expected to reach 80 percent of total external debt in FY2025, from 59 percent of total debt in FY2019. - Specific AsDB loans during FY2020-22 total US$100 million, comprising: - Pacific Disaster Resilience Program: US$15 million - COVID-19 Pandemic Relief Option: US$20 million - Support to the PPUC’s reform: US$10 million - Recovery through Improved Systems and Expenditure Support: US$55 million - These loans are provided on a concessional basis with interest rates ranging between 1.5 percent and 2 percent, and a grace period of 3 to 5 years. - Public debt to GDP revision due to pandemic: revised upwards substantially—by an average of 52 percentage points of GDP during 2020-22 compared to pre-pandemic projections. - Cost of debt servicing: - Effective interest rate rose from 1.3 percent in 2009 to 1.8 percent in 2019. - With the pandemic shock, it is projected to reach 2.3 percent in 2020 but stabilize at 1.1 percent afterwards. - Debt service ratios: Palau’s debt service to GDP ratio was below the average of PICs before the pandemic, is projected to spike in the coming years and exceed PICs’ average; debt service to revenue rises sharply post-COVID but remains slightly below the average level in PICs. ### Debt-carrying capacity and constraints - Favorable interest-rate growth differential: - Average growth rate during 2010-19: 1.8 percent. - Average real interest rate: -1.0 percent. - Implication: modest primary deficits could be sustained without a surge in debt. - Scenario illustration: a hypothetical longer-lasting fiscal shock of a lower primary balance by 1 percentage point of GDP compared to the DSA baseline, with GDP growth and real interest rate at historical average levels, illustrates debt to GDP would trend downward in the medium-term even with more adverse fiscal assumptions. - Constraints on debt-carrying capacity: - Vulnerability to climate-related risks and substantial climate adaptation costs. - Low economic diversification and high reliance on tourism, reducing potential growth and increasing volatility. - Limited institutional capacity for effective debt management: - Palau has neither a separate debt management unit nor a national debt management strategy. - Current debt data compiled by the Office of Planning and Statistics (OPS) include external debt of the central government, National Development Bank of Palau and other public nonfinancial corporations and external debt guaranteed by the central government. - Recommendation in text: expanding the scope of compilation to the general government would help better capture and monitor the full extent of debt obligations and reduce risk of disruption of debt service obligations. ### Stress tests and alternative scenarios (high-level) - Alternative scenarios examined in the DSA include: - Baseline Scenario - Historical Scenario - Constant Primary Balance Scenario (Primary Balance fixed at -18.3 across years) - Real GDP Growth Shock - Real Interest Rate Shock - Real Exchange Rate Shock - Combined Shock - Contingent Liabilities to SOEs Shock - Selected scenario specifics (as presented for 2021–2026): - Baseline: Real GDP growth sequence -17.1, 9.4, 18.3, 2.9, 2.9, 2.7; Primary Balance -18.3, -11.3, -2.1, 0.5, 1.2, 2.8. - Real GDP Growth Shock: Real GDP growth -17.1, 4.4, 13.2, 2.9, 2.9, 2.7; Primary Balance -18.3, -14.6, -7.0, 0.5, 1.2, 2.8. - Constant Primary Balance Scenario: Primary Balance remains -18.3 throughout 2021–2026. - Combined Shock: Real GDP growth -17.1, 4.4, 13.2, 2.9, 2.9, 2.7; Primary Balance -18.3, -16.3, -9.3, -0.8, 0.9, 2.0. - Contingent Liabilities to SOEs Shock: Real GDP growth -17.1, 7.4, 16.3, 0.9, 0.9, 0.7; Primary Balance -18.3, -13.3, -4.1, -1.5, -0.8, 0.8. - Stress test results (general): under various shocks gross nominal public debt and public gross financing needs can increase substantially relative to baseline; stress tests include Macro-Fiscal Stress Tests and Additional Stress Tests focusing on contingent liabilities. ### Policy implications and recommendations (as stated) - Rebuild fiscal buffers in the medium term when the economic recovery from the pandemic is fully entrenched. - Tap concessional climate-related financing to enhance resilience against climate-related risks. - Raise revenues through tax reform and improve spending efficiency. - Reduce fiscal risks and strengthen debt management capacity: - Establish a separate debt management unit and adopt a national debt management strategy. - Expand debt compilation scope to the general government to better capture and monitor full debt obligations. *Source: IMF staff (Chapter 9 and Appendices VII–VIII of the provided IMF document).* ### 1. The main components of the tax reform package include: ### 1plwea2021001 - 1. The main components of the tax reform package include: ### Tax reform: main components - Palau Goods and Services Tax (PGST) - Value added tax. - Rate: 10 percent on goods and services, excluding financial services. - Business Profits Tax (BPT) - From the 4 percent profits tax for only financial services, the expanded BPT will be applied to the PGST-registered businesses and financial institutions at the rate of 12 percent. - Gross Revenue Tax (GRT) - Current GRT of 4 percent will apply to businesses with a turnover exceeding $50,000 unless they opt in for the BPT. - Smaller businesses with a turnover below $50,000 will be only subject to a $100 per annum business license fee. - Adjustments to wages and salaries tax rates - Marginal tax rate reduced from 12 percent to 10 percent for incomes between $8,000 and $40,000. - Tax refunds will be provided for Palauan citizens with annual income below $15,000. - Marginal tax rate for the lowest income bracket below $8,000 is raised from 6 percent to 8 percent. - Social assistance to the vulnerable - Informal sector with revenue below $15,000 to receive a social assistance payment of 4 percent of total revenue, up to a maximum of $600. - Palauans receiving Social Security benefits or payments from the Civil Service Pension Fund, or both, whose total income is less than $15,000, are entitled to receive a social assistance payment of 4 percent, up to $600 yearly. - Conversion of import duty into an excise tax - “Sin” goods (for example, alcoholic beverages, cigarettes, and tobacco products) subject to excise duty at the rate similar to the import duty. - Carbon Tax - Existing fuel tax (5c per gallon) is turned into a carbon tax at rate of 2c per gallon. - Taxes on hotel rooms and vessel cabins - Tax rate changed from $12 or 12 percent to $10 or 10 percent whichever is higher. - Land transaction proceeds fee - Fee to be imposed at the rate of 4 percent on the proceeds of leases or land transfers, rather than the total value of land transactions under the existing land transfer tax. - Fee is not applied to leases made by the Palau Public Land Authority or public land authorities to Palauan. ### Expected fiscal and distributional effects of the tax reform - Expected outcomes - Expected to increase tax revenue by around 1 percent of GDP per year net of compensations. - Refunds under the PGST are expected to support investments. - Distributional considerations - Value added tax and excise duties likely to pass along to consumers via higher prices. - Wages tax rate adjustments combined with tax refunds and social assistance are included to compensate low-income and vulnerable households under the new tax system. ### Financial sector reforms: key findings - Structure and concentration - Commercial banks: three foreign-owned U.S. FDIC-insured banks and two non-FDIC-insured banks, all regulated by the Palau Financial Institutions Commission (FIC). - U.S. FDIC-insured banks hold 99 percent of total deposits and 90 percent of total loans as of December 2018. - Net foreign assets amount to nine times as much as credit to domestic private sector in FY2020. - Access to credit and intermediation - Loan-to-GDP ratio in FY2020 was around 12 percent, much lower than the deposit-to-GDP ratio of over 120 percent. - Commercial bank lending to private sector decreased by 2.4 percent in FY2020 (y/y). - Lending further shrunk in 2021q1 by 8.3 percent compared to the end of FY2020 (FIC data). - Loans to businesses amounted to 16 percent of total loans in FY2020, a 3.4 percent drop due to the pandemic. - Loans to households declined by 2.2 percent in FY2020, to 84 percent of total commercial bank loans to the private sector. - Size of individual loans at the end of FY2020 is 23.8 thousand USD per borrower. - Structural constraints on lending - Interest rate ceilings: corporate lending capped at prime rate on corporate loans plus 4 percentage points—which stands at 7.25 percent as of since May 2020. - Interest rate on individual loans capped at 18 percent by law; effective rate was 10.8 percent in FY2020. - Information asymmetry due to lack of reliable financial data for firms. - Land ownership limits collateral use: only residents can take title to land and repossession by foreign banks is complicated. - Role and characteristics of the National Development Bank of Palau (NDBP) - NDBP participates in domestic lending without taking deposits and is not currently under the FIC regulatory framework. - NDBP’s share in domestic credit is around 35 percent, the highest among state-owned development banks in Pacific islands. - Lending operations include agriculture and aquaculture financing, renewable energy programs, small business loans, guaranteed loans, microfinance and housing loans. - Fixed interest rates: 6 percent for microfinance (up to $15,000) and agriculture loans; 8 percent for small businesses, first time home buyers and fishing loans; and 10 percent for other housing and business loans. - Portfolio composition: 55 percent housing loans; 37 percent commercial loans other than primary industry (agriculture and fishing). - High level of capital adequacy; non-performing loans around 4 percent as of end-2017. NPL ratio as of September 2020 stood at 4.7 percent. - Major funding sources: retained earnings and loans from the European Investment Bank, the government, the Mega International Commercial Banks and the Republic of Palau Social Security Retirement Fund. - Concentration risk: significant customers represent 15 percent of total borrowings as of September 2019. - Weaknesses and risks - NDBP is neither licensed as a financial institution nor subject to FIC supervision; government-directed lending and guarantee programs may dampen efficient allocation and increase fiscal risks. - NDBP’s capacity constrained by limited funding sources and operational issues (delays in processing loan applications). - Licensing and implementing regulations would enable NDBP to take deposits as stable funding sources. ### Financial sector: policy recommendations - Relax the interest rate ceiling for corporate loans. - Expand the coverage of the FIC’s financial regulation and supervision to include the NDBP. - Improve financial reporting practices for SMEs through capacity building to address information asymmetry. - Improve the FIC’s regulatory and supervisory framework for commercial banks, the NDBP and other financial intermediaries, including credit unions and microlenders. - Enhance NDBP operating efficiency by reducing delays in loan processing and building capacity to comply with regulatory requirements and manage potential risks. ### Rethinking Palau’s growth model: overview and tourism strategy - Strategic rationale - Pandemic has unprecedented and likely long-lasting negative impact on tourism; climate change poses rising threats. - Returning to pre-pandemic growth model entails risks. - Two key pillars for future growth: (i) tailor tourism to high-value activities with focus on eco-tourism; (ii) accelerate economic diversification. - A comprehensive policy package should improve the investment climate, enhance investment in human capital, and upgrade climate-resilient infrastructure. - Tourism sector risks and empirical projections - IMF study cited: under benchmark scenario of a 10 percent decline in productivity in the tourism sector over the long-term, real GDP of the pacific island countries 10 years after the pandemic will remain approximately 10 percent below the pre-COVID-19 forecast. - Climate change threats exemplified by Jellyfish Lake closure after severe drought in 2016. - Benefits of high-value and eco-tourism - Low-density tourism reduces health risks and may enhance Palau’s attractiveness post-pandemic. - Lower import leakages: Conservation Strategy Fund finding that 27 percent of high-end tourists spending remains within Palau’s economy, compared to 18 percent for mass-market tourism. - Mitigates environmental impact and helps sustain biodiversity. - Current challenges and opportunities - Tourism receipts per visitor in Palau are still to the average of pacific island small states, with room to increase revenue per tourist. - Source market concentration: China, Japan, South Korea, and Taiwan Province of China account for about 83 percent of total tourist arrivals. - Recommendation to shift composition of tourist arrivals towards Oceania, Europe, and the U.S. to reduce over-dependence and smooth seasonality. - Recent initiatives - Palau Bureau of Tourism, Sustainable Travel International, and Slow Food launched a project in August 2020 to mitigate the tourism sector’s carbon footprint and pursue “Carbon Neutral Tourism Destination.” - Specific measures include training of local eco-guides and development of local food supply chain. ### Diversification beyond tourism: potential areas and policies - Agriculture and food security - Agricultural industry share in GDP (including forestry and fishing) is about 3 percent. - 2015 agriculture strategy objective: 50 percent of food consumption to be produced locally by 2020 — progress has been modest. - Constraints: saltwater intrusion into taro patches, high local production cost relative to imports, diminished interest among youth. - Policy initiatives: investment in protection of low-lying arable land from seawater and vocational training for farmers. - Manufacturing - Manufacturing value added is currently 1 percent of GDP. - Opportunity for small-scale production linked to tourism or agriculture: food or fish processing and manufacturing of gifts and souvenirs for tourists. - Linkages - Reviving agriculture would support eco-tourism by enabling farm-to-table dining experiences for tourists. *Source: 1plwea2021001* ### 9. A comprehensive reform package is needed to support economic diversification. Such ### 9. A comprehensive reform package is needed to support economic diversification ### Reform package: three policy objectives - Improve the investment climate - Palau lags behind other Pacific island countries in timeliness of business-related procedures such as getting electricity and contract enforcement. - Palau performs better in property registration and insolvency resolution. - Invest in human capital - Palau performs well in primary education, but faces brain-drain (educated youth often choose to work abroad). - Under-representation of Palauan women in STEM (Science, Technology, and Engineering) fields. - Policy suggestion: expand scholarships for those who seek jobs in Palau and for women in STEM fields. - Footnote statistics: - 46 percent of women with post-high school education compared to 37 percent of men (education attainment). - Of Palauan citizens educated in engineering or construction, only 6 percent are female. - Upgrade infrastructure - Immense infrastructure needs to achieve sustainable and diversified economic growth. - Priority areas: improvement of road network, aviation connectivity, and telecommunication. - Social infrastructure needs: sewage and sanitation facilities. - Climate-adaptation needs: retrofitting and relocation of existing critical infrastructure; protection of low-elevation areas including through hard seawalls and ecosystem-based adaptation. - Financing suggestions: - Infrastructure that serves primarily the tourism sector could be financed by tourism revenues to the extent possible. - Climate-related projects could be financed by emerging “green” donors such as the Green Climate Fund. - Climate adaptation measure suggested by Miles et al. (2020): revegetating coastal areas with mangroves to reduce flooding and erosion, to protect coastal communities from storm surge and high winds. ### COVID-19 response, recent developments, and near-term outlook - Public health and vaccination - Palau recorded first COVID cases in August 2021 at the border; no community transmission detected and no deaths recorded. - With support from the US Operation Warp Speed, vaccination program has been very successful. - As of October, this year, full vaccination coverage was approaching 100 percent of the eligible population. - Focus is on the third booster dose. - Fiscal relief and macro impact - Coronavirus One Stop Shop Relief Act (CROSS Act) amounted to $20 million. - US Coronavirus Aid, Relief, and Economic Security Act (CARES Act) amounted to $19 million. - Combined relief packages amounted to 15.2 percent of GDP. - Current account deficit rose to 48 percent of GDP in FY2020. - Fiscal deficit in FY2020 was 10.9 percent of GDP. - The ADB loan financed the CROSS Act and partially offset the current account deficit. - Economic outlook and risks - Authorities expect a gradual economic recovery from FY2022; output will remain below pre-pandemic levels through FY2023. - Tourism activities will be the major determinant of the macroeconomic situation in the near future. - Major risks: new variants and vaccine effectiveness (affecting tourist arrivals), higher than expected inflation, extreme exposure to natural disaster and climate change, uncertain timing and terms of a new Compact Agreement with the US, and impacts from graduation from OECD DAC list of countries eligible for development assistance. - Tourism strategy adjustment - Authorities consider moving away from mass-tourism toward niche markets, focusing on high-value and eco-tourism that promote culture and safeguard biodiversity. - Potential complementarities: domestic agri-food supply chain, value-added industries, and preservation of historical sites. - Authorities are working to diversify source markets to include Oceania, Europe and the US. - Social and sovereign context - Palau is designated a high-income country and will graduate from OECD DAC list of countries eligible for development assistance in January 2022. - Population about 18,000. - Combined land area of about 177 square miles. - Palau’s Rock Islands were granted UNESCO World Heritage status in 2012. - Tourism contributed more than a third to GDP in FY2019. ### Fiscal and financial sector policy measures and priorities - Near-term fiscal measures - Authorities committed to fast-tracking rollout of targeted benefits under the CROSS Act and extending them until recovery is firmly entrenched. - An additional $100 per month supplementary benefit is planned. - A 10 percent across-the-board cut to recurrent expenditures in the FY2022 budget, save for crucial public services, was planned. - With ADB assistance, a review of public expenditures is underway; ex-post audits of spending and publication of results are planned. - Medium-term fiscal framework and reforms - Authorities recognize increased likelihood of breaching debt sustainability benchmarks and are committed to gradual fiscal adjustment as conditions permit. - A Comprehensive Tax Reform Legislation was signed by the President last month; it will contribute about a fifth of the required adjustment from FY2024. - Planned Fiscal Responsibility and Debt Management Act to lay foundation for enhanced budget processes, debt management and fiscal risk management. - Reforms to improve efficiency and financial stability of the public pension system, the social security, and the public utilities company will be needed to preserve medium and long-term fiscal sustainability. - Financial sector policies - Increased credit provision to the private sector could support growth given low level of lending and banks’ strong capital and liquidity provisions during the pandemic. - Introduction of the Palau Goods and Services Tax (PGST) will require businesses to prepare financial reports, helping to address information asymmetry that hindered lending to small and medium enterprises. - Capacity building needed in areas such as business plan preparation for bankable projects. - Plans to allow the National Development Bank of Palau (NDBP) to take deposits through a license of the Financial Institutions Commission (FIC). - Authorities continue to enhance AML/CFT compliance; moratorium on crypto assets and crypto currency activities will be maintained until adequate regulation is in place. - Notable improvements: Know-Your-Customer initiative and transparency of financial transaction reporting. - Concern on Correspondent Banking Relationships (CBR): Pacific region under severe pressure from de-risking (according to BIS, Swift data); existing relationships sometimes terminated with only several months’ notice. ### Data, statistics, and surveillance issues - General data assessment - Data provision has some shortcomings but is broadly adequate for surveillance. - External sector statistics need further improvement; coverage of fiscal and monetary statistics could be expanded; reporting lags could be shortened. - Office of Planning and Statistics (OPS) compiles and publishes macroeconomic data at an annual frequency; OPS relies heavily on external consultants and technical assistance. - Specific statistical areas and needs - National accounts: annual GDP estimates by production compiled since 2012; further improvements include incorporating recent business surveys and compiling GDP estimates by expenditure. - Price statistics: CPI regularly published on a quarterly basis. - Government finance statistics: annual fiscal data compiled using GFS2014 and published in the 2012-20 Palau Statistical Yearbook; further improvements include broadening coverage beyond central government, improving frequency and timeliness, and including audited accounts. Annual GFS data have not been reported to STA. - Monetary and financial statistics: depository corporations survey unavailable since there is no central bank; TA could assist in developing standardized report forms for other depository corporations. - Financial Access Survey (FAS): data reported through 2017 for some key series and indicators including commercial bank branches per 100,000 adults and ATMs per 100,000 adults. - Financial Soundness Indicators (FSIs): Banks submit quarterly financial statements to FIC since 2009; FIC publishes FSIs and balance sheet data quarterly, but FSIs do not include data from NDBP as it remains outside FIC supervision. - External sector statistics: annual balance of payments and international investment position reported according to BPM6 and published in the 2012-20 Palau Statistical Yearbook; large errors and omissions undermine usefulness. A Tourist Expenditure Survey is expected to improve tourism-related data quality. - Expected implementation of the comprehensive tax reform, including the Palau Goods and Services Tax, in January 2023 could help improve data quality. - Institutional and classification notes - Palau began participating in the General Data Dissemination System in August 2013 and provides only metadata. - No data ROSC is available. - Palau has no central bank; the government’s U.S. dollar deposits effectively serve as reserves. *Source: Republic of Palau — Staff Report for the 2021 Article IV Consultation—Informational Annex (November 8, 2021).* --- _Source: https://www.imf.org/-/media/files/publications/cr/2021/english/1plwea2021001.pdf_