## _cr06108

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### Executive Summary — Economic developments and challenges
- Economic growth picked up and inflation remained low; infrastructure building financed by grants and direct investment supported construction and rising tourist and business arrivals.
- Fiscal performance improved by curtailing current spending.
- Near-term outlook upbeat; longer-term prospects uncertain and depend on magnitude of future grants and direction of economic policies.
- Authorities hope for extension of U.S. grants beyond 2009.
- Key challenges:
  - Achieve medium-term fiscal sustainability given high reliance on grants.
  - Promote environmentally sustainable private sector development.
  - Strengthen banking regulations and supervision.
- Serious statistical deficiencies hamper effective surveillance.
- Palau is on a 24-month consultation cycle.
- The authorities consent to publication of the PIN, Staff Report, and Selected Issues.

### Key staff recommendations
- Further fiscal consolidation is necessary to prepare for the possible decline in U.S. grants; consolidation desirable even if U.S. grants are extended at similar levels beyond 2009.
- To maintain recent fiscal gains, current spending must be contained in FY2006 below the level in the approved budget.
- To continue toward fiscal sustainability:
  - Further reductions in current spending.
  - Comprehensive reforms to increase revenue collection over the long term.
- To eliminate impediments to private sector activity:
  - Make investment regulations more transparent.
  - Accelerate land registration and dispute resolution.
  - Resist pressures to raise the minimum wage.
  - Introduce incentives to facilitate retention of trained Palauans.
- To protect banking sector soundness:
  - Adopt pending financial legislation and regulations.
  - Adequately staff the newly established supervisory agency and intelligence unit.

### Transformation since independence
- Palau gained independence in 1994 and joined the Fund in December 1997, accepting obligations of Article VIII, Sections, 2, 3, and 4.
- No central bank; the U.S. dollar is the official currency.
- Per capita income of about $6,500 and solid social indicators coexist with constraints typical of Pacific island countries: vulnerability to external shocks, narrow production and export base, geographical isolation, and scarce labor.
- Sizeable grants from the United States, Japan and Taiwan Province of China financed infrastructure to support tourism but risk damaging the fragile ecosystem.
- Public sector share receded in line with the government’s Management Action Plan of 2001.
- Compact of Free Association provides $600 million of grant assistance over 15 years from 1994; Compact aims to develop infrastructure and build a Compact Trust Fund (CTF) to enable Palau to replace grants through sustainable withdrawals from 1999–2044 ($5 million per year from 1999–2009 and $15 million inflation-adjusted annually from 2010).
- In recent years, budgetary grants from the United States have averaged about 18 percent of GDP, of which one third comes from federal grants outside of the Compact.

### Recent economic developments (FY2004–FY2005)
- Real GDP grew by 5 percent in FY2004 and FY2005.
- Growth drivers: steady increase in visitor arrivals (new airline routes and hotels) and foreign-funded public projects increasingly undertaken by domestic firms.
- Inflation low in line with U.S. inflation.
- Fiscal performance:
  - Overall fiscal deficit (including grants) declined from 21 percent of GDP to under 5 percent of GDP in FY2003–05.
  - Current budget balance improved by 8½ percent of GDP, mainly due to sustained annual reductions in non-wage current expenditure.
  - Revenue collection strengthened due to higher investment income, stronger economic activity, and re-instatement of excises on tobacco and alcohol in late 2003 and 2004.
- Compact Trust Fund (CTF):
  - Balance fell from a peak of $162 million at end FY2000 to $136 million at end-FY2003.
  - Under a new investment strategy, balance stood at $153 million at end-2005 (106 percent of GDP).
  - Government’s useable non-Trust Fund assets remained below one month of import cover at end-FY2005 as surpluses were used to finance infrastructure.
- External sector and tourism:
  - Strong tourist receipts helped offset higher oil prices.
  - Current account swung into surplus in FY2003 and improved further in FY2005 owing to recovering tourism and fish exports and lower capital imports.
- Banking and financial sector:
  - Bank oversight inadequate; bank reporting is incomplete and irregular.
  - About 80 percent of deposits held by branches of foreign banks, which provide about two thirds in domestic credit; most deposits insured under the FDIC.
  - Local commercial banks account for less than one third of banking system assets; interest rate spreads reach 15 percent.
  - National Development Bank (NDBP): loan portfolio about 10 percent of GDP, about 15 percent non-performing; provisioning increased and maintained 6 percent profit-to-asset ratio in the last four years.

### Economic outlook (FY2006–longer term)
- FY2006 and FY2007 outlook remains upbeat:
  - Relocation of government offices in 2006 following completion of the Capitol complex expected to facilitate expansion of housing and businesses out of crowded Koror.
  - Tourism to benefit from planned airport rehabilitation, new resorts, and expansion in scheduled flights.
  - Current account deficit expected to widen and inflation to rise due to higher fuel costs.
  - Preliminary estimates: a further 10 percent increase in oil prices can reduce the current account balance by 1 percent of GDP and lower growth by ¾ percent of GDP.
  - Downside risks from possible capacity constraints in capital project implementation.
- Longer-term prospects uncertain due to possible sharp reduction in U.S. Compact grants and non-Compact U.S. federal program assistance; availability unknown.
- U.S. officials underscore no obligation to provide another grant package; Palau officials expect Compact extension at levels consistent with current U.S. grants and replenishment of the CTF to originally envisioned levels.
- Initial bilateral economic consultations begun; resolution not expected soon.

### Fiscal policy and sustainability — policy discussions and scenarios
- Overarching macroeconomic challenge: prepare for eventual elimination of grant assistance. Current grants cover about one third of current spending needs; elimination would require sizeable fiscal contraction.
- Authorities’ paramount goal: achieve financial independence by strengthening domestic revenue to cover current spending and build an adequate reserve fund to cope with external vulnerabilities.
- Staff noted targets for long-run adjustment:
  - Current spending may need to decline by as much as one quarter (about 12 percent of GDP).
  - Tax revenue may need to increase by one fifth (about 5 percent of GDP).
  - Authorities concurred but viewed targets as impossible to achieve within a short period; staff agreed such adjustment could be spread over 10–15 years depending on future grants.

Box 1 — Long-Run Fiscal Adjustment Scenarios (illustrative)
- Assumptions if Compact renewed:
  - Average 18 percent of GDP in total budgetary support for 15 years plus an average 4 percent of GDP in Trust Fund contributions for 15 years (or equivalent of $210 million upfront replenishment of the CTF in FY2010).
- Scenario A — CTF depleted (no Compact renewal):
  - U.S. grants decline to under 2 percent of GDP in FY2010; Palau becomes ineligible for federal agency programs.
  - Limiting expenditure adjustment to ¾ percent of GDP per year would deplete the Trust Fund by FY2022, requiring large expenditure cuts.
- Scenario B — CTF value preserved without Compact renewal:
  - To preserve CTF in real per capita terms, expenditure would need to decline by 1½ percent of GDP per year between FY2005 and FY2014, after which CTF returns could sustain lower fiscal deficits.
  - Such expenditure compression could severely affect household incomes and public services and likely cause an economic slump in the medium term.
- Scenario C — With Compact renewal:
  - Grants extended at similar levels until FY2023 would allow a more gradual phasing of expenditure retrenchment.
  - Real per capita value of the CTF could be enhanced to generate annual income to replace foreign aid after 2023.
  - Higher public investment could allow real growth averaging 3-4 percent of GDP.

### Composition and near-term fiscal adjustment (FY2006 illustrative)
- FY05 and FY06 budget comparisons and mission proposal (in percent of GDP):
  - Current revenue FY05: 26.2; FY06 Est.: 24.5; FY06 Budget: 26.7; Mission savings: 2.2
  - Tax revenue FY05: 21.0; FY06 Est.: 19.9; FY06 Budget: 21.4; Mission savings: 2.2
  - Nontax revenue FY05: 5.1; FY06 Est.: 5.3; FY06 Budget: 5.3; Mission savings: 0.0
  - Current grants FY05: 15.3; FY06 Est.: 15.7; FY06 Budget: 15.7; Mission savings: 0.0
  - Capital grants FY05: 10.8; FY06 Est.: 18.8; FY06 Budget: 18.8; Mission savings: 0.0
  - Total expenditure FY05: 54.2; FY06 Est.: 63.8; FY06 Budget: 61.7; Mission savings: 2.0
  - Current expenditure FY05: 45.1; FY06 Est.: 45.0; FY06 Budget: 42.9; Mission savings: 2.0
  - Wages and salaries FY05: 22.4; FY06 Est.: 21.0; FY06 Budget: 21.2; Mission savings: -0.2
  - Goods and services FY05: 16.2; FY06 Est.: 17.1; FY06 Budget: 15.2; Mission savings: 1.9
  - Current balance FY05: -18.9; FY06 Est.: -20.4; FY06 Budget: -16.2; Mission savings: 4.3
  - Overall balance (incl. grants) FY05: -3.9; FY06 Est.: -4.7; FY06 Budget: -0.4; Mission savings: 4.3
- Spending on health and education accounts for nearly 30 percent of total spending, among the highest in Pacific islands; this has contributed to good social indicators but is not sustainable in the long term and has created a culture of dependence on free public services.

### Private sector development, trade, and financial sector soundness (policy points)
- Private sector development and diversification:
  - Remove investment impediments to build basis for sustained growth.
  - Investment regulations need to be more transparent; land registration and dispute resolution accelerated.
  - Introduce incentives to retain trained Palauans.
- Exchange rate and trade:
  - Palau maintains an exchange system free of restrictions on the making of payments and transfers for current international transactions.
- Financial sector soundness:
  - Banking oversight inadequate; pending financial legislation and regulations need adoption.
  - Newly established supervisory agency and intelligence unit should be adequately staffed to protect banking sector soundness.

### Fiscal targets and FY2006 budget
- Staff cautioned that the targets of the FY2006 budget approved by Congress in October 2005 reverse recent consolidation efforts.
- Authorities concurred with staff that it would be more appropriate to target an overall deficit of ½ percent of GDP rather than 4¾ percent of GDP.
- Staff urged that spending on goods and services be lower than budgeted by about 2 percent of GDP in line with recent step reductions.
- Ministry of Finance officials intend to take additional measures to contain spending on goods and services.
- Authorities expect the ongoing hiring freeze to allow the wage bill to be compressed while accommodating the new civil service salary structure and addressing staffing shortages in banking supervision, if these cannot be filled through reassignment.
- Staff welcomed the planned phased repayment of spending arrears to suppliers that amount to 1 percent of GDP over three years.

### Revenue performance and composition
- Revenue is expected to outperform the budget projection, exceeding last year’s outcome by ½ percent of GDP.
- With unchanged tax collection effort, revenue would be maintained at 21 percent of GDP, and an additional ½ percent of GDP would come from recent measures (change in the import duty base from f.o.b. to c.i.f. and new airport fees).
- Selected domestic revenue structure (percent of GDP) as presented:
  - Palau FY2002: Income Tax 4.9; Tax on Goods and Services 6.1; Trade Taxes 4.5; Other Tax 2.7; Total Tax Revenue 18.3; Total Domestic Revenue 23.8
  - Palau FY2004: Income Tax 5.0; Tax on Goods and Services 5.8; Trade Taxes 6.0; Other Tax 3.2; Total Tax Revenue 20.0; Total Domestic Revenue 26.8
  - (Other countries and means preserved as in source tables.)

### Medium-term fiscal reforms and tax policy
- Staff advised that reforming the tax system could help raise domestic revenue collection closer to the long-term target of 32 percent of GDP.
- Current system described as inequitable and inefficient; Palau’s tax collections are around 20 percent of GDP, similar to the average for other island economies.
- Recommended reform elements (consistent with TA by LEG and PFTAC):
  - Replace narrow-based wages and salaries taxes with a personal income and corporate income tax.
  - Replace the cascading gross receipts tax by a consumption tax such as the Value Added Tax, that exempts exports and refunds VAT collected on inputs.
- Authorities intend to postpone modernizing the tax system for 2-3 years.
- Interim measures agreed by staff and authorities could yield up to 1 percent of GDP in FY2007:
  - Strengthen collection efforts.
  - Eliminate exemptions on import duties.
  - Adjust the reference price for the hotel room tax to allow the tourism sector to contribute more fully.
  - Accelerate administrative measures: introduce a full assessment system, a single taxpayer identification number, strengthened monitoring, and audit and penalty systems to improve compliance.

### Expenditure adjustment needs and measures
- Bulk of adjustment will fall on expenditure reforms.
- Estimated total expenditure adjustment needed over the long run is in excess of 20 percent of GDP (and as much as 30 percent of GDP without Compact renewal) spread over 10 to 25 years, of which capital spending cuts account for 10-15 percent of GDP.
- Capital expenditure is expected to gradually decline as its funding sources dwindle; short-term macroeconomic impact limited as much of it is spent on foreign goods and services.
- Adjusting current expenditure requires specific measures to cut the wage bill and spending on goods and services.
- Government cost reduction plan identified outsourcing measures that could yield savings of 2-3 percent of GDP in the next 2-3 years, including:
  - Outsourcing water and sewer, school and hospital meals, security and janitorial services, road repair, and management of airport facilities.
- Plans to introduce user fees for sports facilities and medical care.
- Further cuts will be needed over the long run to achieve remaining savings of about 8 percent of GDP.

### Public debt and reserves
- Public debt is low at 13 percent of GDP.
- Palau incurred a first loan (17 percent of GDP) on concessional terms in 2000 to finance construction of the new Capitol complex.
- Another $15 million loan was contracted in 2004 for airport rehabilitation, but only $1.5 million (1 percent of GDP) has been drawn due to subsequent availability of U.S. grant financing.
- Authorities intend to avoid contracting new loans, and to build a cushion of usable reserves, possibly from unspent CTF withdrawals or any revenue over-performance, to cope with vulnerability to shocks.

### Exchange rate regime, trade policy, and investment climate
- Use of the U.S. dollar provides monetary stability; exchange regime appropriate given Palau’s small size and predominance of U.S. grants and trade flows.
- Tariff structure: five nonzero bands, most imports subject to a 3 percent rate, and the unweighted average rate is below 3 percent.
- About 30 percent of trade taxes are collected from cigarette and alcohol duties that are subject to additional specific taxes.
- Customs modernization introduced a harmonized system nomenclature and on-line document filing.
- Staff advised against raising the general tariff rate from 3 percent to 5 percent but saw merit in removing duty exemptions.
- Investment impediments: non-transparent investment regulations, shortage of Palauan skilled labor, limited access to land, and infrastructure needs.
- FDI reached 13 percent of GDP in FY2005; barriers include inability to own land or use it as collateral, sectoral restrictions, requirement that 20 percent of employees be Palauan for investments below $0.5 million, and an annual $500 permit fee for hiring expatriates that Palauan employers do not have to pay.
- About 40 percent of plots remain unregistered; quiet title process and proposed extension of land leases to foreigners from 50 to 99 years under consideration.

### Labor market and minimum wage
- Foreign workers make up nearly one half of the labor force, mostly in unskilled jobs.
- Staff argued against proposal to increase the minimum wage (already the highest among Pacific islands) as counter-productive.
- Staff saw potential merit in requiring recipients of state-sponsored scholarships for study abroad who do not return to repay study costs.

### Financial sector regulation and supervision
- Financial sector large relative to population but lacks adequate regulation and supervisory oversight.
- Financial sector composition: eight commercial banks, one development bank, and several other financial institutions (source variations preserved across sections).
- FIA passed in 2001 was watered-down; FIC lacks sufficient authority and resources: one out of five recommended professional staff and a fraction of the planned budget after four years.
- Palau assessed in 2002 as non-compliant on 16 out of 25 Basel core principles; situation remains unchanged.
- Fund TA missions in 2004 advised that unless the proposed FIA amendment is adopted without further modification, neither prudential nor AML/CFT supervision will be feasible in Palau; noted need to strengthen pending amendment to the MLPCA to comply with key aspects of the FATF 40+9 Recommendations.
- Staff stressed need for passage of FIA amendment and adequate resourcing of FIC and Financial Intelligence Unit; MFD and LEG stand ready to provide capacity-building technical assistance once bank examiners recruited.
- National Development Bank needs to strengthen loan recovery; external audits and capacity building encouraged.

### Statistical issues and data needs
- Serious deficiencies remain in most areas of economic statistics with the notable exception of public finance.
- Some collected statistics cannot be compiled or disseminated due to shortage of trained staff and high staff turnover.
- National accounts and balance of payments estimates are weak; consumer price index compiled since 2000 but with inconsistencies since late 2003.
- Monetary/banking data: audited balance sheet data not legally required, no official banking survey, bank reports often incomplete and lack standardized format; lack of data prevents preparation of most financial soundness indicators.
- PFTAC assistance and capacity-building interventions provided for national accounts, GDDS metadata, tax and customs administration, and banking supervision; authorities welcome further hands-on help and intend to seek training.

### Key macroeconomic and social indicators (selected)
- Nominal GDP (2004): US$133.6 million.
- Population (2004): 20,610.
- GDP per capita (2004): 6,480.
- Real GDP growth (percent change, 2000/01–2005/06): 1.3; -3.5; -1.3; 4.9; 5.5; 5.7.
- Consumer prices (percent change; period average, 2000/01–2005/06): 0.8; -1.2; -0.6; 5.8; 2.7; 3.0.
- Tourism receipts (millions of U.S. dollars, selected years): 58.5; 57.4; 75.6; 96.9; 97.2; 97.5.
- CTF balance at end-2005: US$153 million (106 percent of GDP).
- Budgetary grants from the U.S. averaged about 18 percent of GDP; one third of that from federal grants outside the Compact.
- Usable reserves (in months of imports, selected): 0.5; 0.4; 0.7; 0.2; 0.2; 0.5.
- External public debt (percent of GDP, selected): 16.2; 16.6; 15.9; 14.0; 13.2; 11.3.
- Public debt low at 13 percent of GDP.

### Executive Directors’ recommendations and authorities’ stance
- Directors recommended:
  - Do not postpone fiscal adjustment and structural reforms given uncertainty over U.S. Compact renewal beyond 2009.
  - Target a pace of fiscal consolidation consistent with a gradual decline in future grants to reduce risk of social strains.
  - Greater expenditure containment, particularly on goods and services; downsizing the public sector (maintain hiring freeze; outsource services).
  - Strengthen tax collection efforts, eliminate exemptions in the near term, and consider later a comprehensive tax overhaul centered on a non-cascading consumption tax and more efficient broader-based corporate and personal income taxes.
  - Continue use of the U.S. dollar and maintain an open trade regime; cautious fiscal and wage policies to preserve external competitiveness.
- Authorities’ commitments (Statement by Jong Nam Oh and Cyd Amador, February 15, 2006):
  - Preserve macroeconomic stability via responsible fiscal stewardship and aim to meet current spending from domestic revenue generation.
  - Strengthen revenue mobilization (intensified audits; enhanced automation; modernization of customs administration; consider further tax policy reforms).
  - Contain spending (rationalize government operations; outsourcing; performance-based budgeting; maintain hiring freeze).
  - Avoid undertaking new loans and build up usable reserves; settle arrears and pay government bills timely.
  - Promote private sector development and regional cooperation; enhance human resource training and development.

*Italic: IMF Staff report content as provided in the source PDF.*

### 2009. They urged the authorities to reduce Palau’s dependence on foreign assistance;

### _cr06108 - 2009. They urged the authorities to reduce Palau’s dependence on foreign assistance;

### Executive Summary — Economic developments and challenges
- Economic growth picked up and inflation remained low; infrastructure building financed by grants and direct investment supported construction and rising tourist and business arrivals.
- Fiscal performance improved by curtailing current spending.
- Near-term outlook upbeat; longer-term prospects uncertain and depend on magnitude of future grants and direction of economic policies.
- Authorities hope for extension of U.S. grants beyond 2009.
- Key challenges:
  - Achieve medium-term fiscal sustainability given high reliance on grants.
  - Promote environmentally sustainable private sector development.
  - Strengthen banking regulations and supervision.
- Serious statistical deficiencies hamper effective surveillance.
- Palau is on a 24-month consultation cycle.
- The authorities consent to publication of the PIN, Staff Report, and Selected Issues.

### Key staff recommendations
- Further fiscal consolidation is necessary to prepare for the possible decline in U.S. grants. Even if U.S. grants are extended at similar levels beyond 2009, consolidation is desirable to enhance resilience to external shocks and better prepare for self-reliance.
- To maintain recent fiscal gains, current spending must be contained in FY2006 below the level in the approved budget.
- Continuing the path toward fiscal sustainability requires:
  - Further reductions in current spending.
  - Comprehensive reforms to increase revenue collection over the long term.
- To eliminate impediments to private sector activity:
  - Make investment regulations more transparent.
  - Accelerate land registration and dispute resolution.
  - Resist pressures to raise the minimum wage.
  - Introduce incentives to facilitate retention of trained Palauans.
- To protect banking sector soundness:
  - Adopt pending financial legislation and regulations.
  - Adequately staff the newly established supervisory agency and intelligence unit.

### Transformation since independence
- Palau gained independence in 1994 and joined the Fund in December 1997, accepting obligations of Article VIII, Sections, 2, 3, and 4.
- No central bank; the U.S. dollar is the official currency.
- Per capita income of about $6,500 and solid social indicators coexist with constraints typical of Pacific island countries: vulnerability to external shocks, narrow production and export base, geographical isolation, and scarce labor.
- Sizeable grants from the United States, Japan and Taiwan Province of China financed infrastructure to support tourism but risk damaging the fragile ecosystem.
- The public sector’s share in economic activity has receded in line with the government’s Management Action Plan of 2001.
- Compact of Free Association provides $600 million of grant assistance over 15 years from 1994; grants aim to develop infrastructure and build a Compact Trust Fund (CTF) to enable Palau to replace grants through sustainable withdrawals from 1999–2044 ($5 million per year from 1999–2009 and $15 million inflation-adjusted annually from 2010).
- In recent years, budgetary grants from the United States have averaged about 18 percent of GDP, of which one third comes from federal grants outside of the Compact.

### Recent economic developments (FY2004–FY2005)
- Real GDP grew by 5 percent in FY2004 and FY2005.
- Growth drivers: steady increase in visitor arrivals (new airline routes and hotels) and foreign-funded public projects increasingly undertaken by domestic firms.
- Inflation low in line with U.S. inflation.
- Fiscal performance:
  - Overall fiscal deficit (including grants) declined from 21 percent of GDP to under 5 percent of GDP in FY2003–05.
  - Current budget balance improved by 8½ percent of GDP, mainly due to sustained annual reductions in non-wage current expenditure.
  - Revenue collection strengthened due to higher investment income, stronger economic activity, and re-instatement of excises on tobacco and alcohol in late 2003 and 2004.
- Compact Trust Fund (CTF):
  - Balance fell from a peak of $162 million at end FY2000 to $136 million at end-FY2003.
  - Under a new investment strategy, balance stood at $153 million at end-2005 (106 percent of GDP).
  - Government’s useable non-Trust Fund assets remained below one month of import cover at end-FY2005 as surpluses were used to finance infrastructure.
- External sector and tourism:
  - Strong tourist receipts helped offset higher oil prices.
  - Current account swung into surplus in FY2003 and improved further in FY2005 owing to recovering tourism and fish exports and lower capital imports.
- Banking and financial sector:
  - Bank oversight inadequate; bank reporting is incomplete and irregular.
  - About 80 percent of deposits held by branches of foreign banks, which provide about two thirds in domestic credit; most deposits insured under the FDIC.
  - Local commercial banks account for less than one third of banking system assets; interest rate spreads reach 15 percent.
  - National Development Bank (NDBP): loan portfolio about 10 percent of GDP, about 15 percent non-performing; provisioning increased and maintained 6 percent profit-to-asset ratio in the last four years.

### Economic outlook (FY2006–longer term)
- FY2006 and FY2007 outlook remains upbeat:
  - Relocation of government offices in 2006 following completion of the Capitol complex expected to facilitate expansion of housing and businesses out of crowded Koror.
  - Tourism to benefit from planned airport rehabilitation, new resorts, and expansion in scheduled flights.
  - Current account deficit expected to widen and inflation to rise due to higher fuel costs.
  - Preliminary estimates: a further 10 percent increase in oil prices can reduce the current account balance by 1 percent of GDP and lower growth by ¾ percent of GDP.
  - Downside risks from possible capacity constraints in capital project implementation.
- Longer-term prospects less certain due to possible sharp reduction in U.S. Compact grants and non-Compact U.S. federal program assistance; continued availability unknown.
- U.S. officials underscore no obligation to provide another grant package; Palau officials expect Compact extension at levels consistent with current U.S. grants and replenishment of the CTF to originally envisioned levels.
- Initial bilateral economic consultations begun; resolution not expected soon.

### Fiscal policy and sustainability — policy discussions and scenarios
- Overarching macroeconomic challenge: prepare for eventual elimination of grant assistance. Current grants cover about one third of current spending needs; elimination would require sizeable fiscal contraction.
- Authorities’ paramount goal: achieve financial independence by strengthening domestic revenue to cover current spending and build an adequate reserve fund to cope with external vulnerabilities.
- Staff noted targets for long-run adjustment:
  - Current spending may need to decline by as much as one quarter (about 12 percent of GDP).
  - Tax revenue may need to increase by one fifth (about 5 percent of GDP).
  - Authorities concurred but viewed targets as impossible to achieve within a short period; staff agreed such adjustment could be spread over 10–15 years depending on future grants.

Box 1 — Long-Run Fiscal Adjustment Scenarios (illustrative)
- Assumptions if Compact renewed:
  - Average 18 percent of GDP in total budgetary support for 15 years plus an average 4 percent of GDP in Trust Fund contributions for 15 years (or equivalent of $210 million upfront replenishment of the CTF in FY2010).
- Scenario A — CTF depleted (no Compact renewal):
  - U.S. grants decline to under 2 percent of GDP in FY2010; Palau becomes ineligible for federal agency programs.
  - Limiting expenditure adjustment to ¾ percent of GDP per year would deplete the Trust Fund by FY2022, requiring large expenditure cuts.
- Scenario B — CTF value preserved without Compact renewal:
  - To preserve CTF in real per capita terms, expenditure would need to decline by 1½ percent of GDP per year between FY2005 and FY2014, after which CTF returns could sustain lower fiscal deficits.
  - Such expenditure compression could severely affect household incomes and public services and likely cause an economic slump in the medium term.
- Scenario C — With Compact renewal:
  - Grants extended at similar levels until FY2023 would allow a more gradual phasing of expenditure retrenchment.
  - Real per capita value of the CTF could be enhanced to generate annual income to replace foreign aid after 2023.
  - Higher public investment could allow real growth averaging 3-4 percent of GDP.

### Composition and near-term fiscal adjustment (FY2006 illustrative)
- FY05 and FY06 budget comparisons and mission proposal (in percent of GDP):
  - Current revenue FY05: 26.2; FY06 Est.: 24.5; FY06 Budget: 26.7; Mission savings: 2.2
  - Tax revenue FY05: 21.0; FY06 Est.: 19.9; FY06 Budget: 21.4; Mission savings: 2.2
  - Nontax revenue FY05: 5.1; FY06 Est.: 5.3; FY06 Budget: 5.3; Mission savings: 0.0
  - Current grants FY05: 15.3; FY06 Est.: 15.7; FY06 Budget: 15.7; Mission savings: 0.0
  - Capital grants FY05: 10.8; FY06 Est.: 18.8; FY06 Budget: 18.8; Mission savings: 0.0
  - Total expenditure FY05: 54.2; FY06 Est.: 63.8; FY06 Budget: 61.7; Mission savings: 2.0
  - Current expenditure FY05: 45.1; FY06 Est.: 45.0; FY06 Budget: 42.9; Mission savings: 2.0
  - Wages and salaries FY05: 22.4; FY06 Est.: 21.0; FY06 Budget: 21.2; Mission savings: -0.2
  - Goods and services FY05: 16.2; FY06 Est.: 17.1; FY06 Budget: 15.2; Mission savings: 1.9
  - Current balance FY05: -18.9; FY06 Est.: -20.4; FY06 Budget: -16.2; Mission savings: 4.3
  - Overall balance (incl. grants) FY05: -3.9; FY06 Est.: -4.7; FY06 Budget: -0.4; Mission savings: 4.3
- Spending on health and education accounts for nearly 30 percent of total spending, among the highest in Pacific islands; this has contributed to good social indicators but is not sustainable in the long term and has created a culture of dependence on free public services.

### Private sector development, trade, and financial sector soundness (policy points)
- Private sector development and diversification:
  - Remove investment impediments to build basis for sustained growth.
  - Investment regulations need to be more transparent; land registration and dispute resolution accelerated.
  - Introduce incentives to retain trained Palauans.
- Exchange rate and trade:
  - Palau maintains an exchange system free of restrictions on the making of payments and transfers for current international transactions.
- Financial sector soundness:
  - Banking oversight inadequate; pending financial legislation and regulations need adoption.
  - Newly established supervisory agency and intelligence unit should be adequately staffed to protect banking sector soundness.

*Italic: IMF Staff report content as provided in the source PDF.*

### 17.      Staff cautioned that the targets of the

### _cr06108 - 17.      Staff cautioned that the targets of the

### Fiscal targets and FY2006 budget
- Staff cautioned that the targets of the FY2006 budget approved by Congress in October 2005 reverse recent consolidation efforts.
- Authorities concurred with staff that it would be more appropriate to target an overall deficit of ½ percent of GDP rather than 4¾ percent of GDP.
- Staff urged that spending on goods and services be lower than budgeted by about 2 percent of GDP in line with recent step reductions.
- Ministry of Finance officials intend to take additional measures to contain spending on goods and services.
- Authorities expect the ongoing hiring freeze to allow the wage bill to be compressed while accommodating the new civil service salary structure and addressing staffing shortages in banking supervision, if these cannot be filled through reassignment.
- Staff welcomed the planned phased repayment of spending arrears to suppliers that amount to 1 percent of GDP over three years.

### Revenue performance and composition
- Revenue is expected to outperform the budget projection, exceeding last year’s outcome by ½ percent of GDP.
- With unchanged tax collection effort, revenue would be maintained at 21 percent of GDP, and an additional ½ percent of GDP would come from recent measures (change in the import duty base from f.o.b. to c.i.f. and new airport fees).
- Table (Selected Pacific Island Countries: Structure of Domestic Revenue, in percent of GDP) shows country FY2002 and FY2004 tax component shares and totals (preserved as in source):
  - FSM FY2002: Income Tax 3.6, Tax on Goods and Services 5.1, Trade Taxes 3.2, Other Tax 0.4, Total Tax Revenue 12.3, Total Domestic Revenue 20.9
  - FSM FY2004: Income Tax 3.2, Tax on Goods and Services 4.8, Trade Taxes 2.9, Other Tax 0.2, Total Tax Revenue 11.1, Total Domestic Revenue 19.0
  - Vanuatu FY2002: Income Tax 0.2, Tax on Goods and Services 1.0, Trade Taxes 2.7, Other Tax 0.0, Total Tax Revenue 4.2, Total Domestic Revenue 19.6
  - Vanuatu FY2004: Income Tax 0.3, Tax on Goods and Services 1.2, Trade Taxes 7.2, Other Tax 0.0, Total Tax Revenue 18.7, Total Domestic Revenue 20.6
  - Fiji FY2002: Income Tax 7.0, Tax on Goods and Services 5.2, Trade Taxes 6.7, Other Tax 0.0, Total Tax Revenue 18.9, Total Domestic Revenue 23.6
  - Fiji FY2004: Income Tax 6.3, Tax on Goods and Services 6.6, Trade Taxes 6.1, Other Tax 0.0, Total Tax Revenue 19.0, Total Domestic Revenue 22.1
  - Palau FY2002: Income Tax 4.9, Tax on Goods and Services 6.1, Trade Taxes 4.5, Other Tax 2.7, Total Tax Revenue 18.3, Total Domestic Revenue 23.8
  - Palau FY2004: Income Tax 5.0, Tax on Goods and Services 5.8, Trade Taxes 6.0, Other Tax 3.2, Total Tax Revenue 20.0, Total Domestic Revenue 26.8
  - RMI FY2002: Income Tax 9.2, Tax on Goods and Services 3.3, Trade Taxes 5.7, Other Tax 1.0, Total Tax Revenue 19.2, Total Domestic Revenue 26.3
  - RMI FY2004: Income Tax 9.9, Tax on Goods and Services 3.7, Trade Taxes 5.8, Other Tax 1.6, Total Tax Revenue 21.0, Total Domestic Revenue 31.3
  - Samoa FY2002: Income Tax 4.5, Tax on Goods and Services 12.4, Trade Taxes 3.9, Other Tax 0.5, Total Tax Revenue 21.3, Total Domestic Revenue 23.2
  - Samoa FY2004: Income Tax 4.4, Tax on Goods and Services 14.0, Trade Taxes 3.6, Other Tax 0.6, Total Tax Revenue 22.6, Total Domestic Revenue 25.3
  - Tonga FY2002: Income Tax 4.9, Tax on Goods and Services 3.1, Trade Taxes 5.2, Other Tax 0.1, Total Tax Revenue 23.3, Total Domestic Revenue 29.2
  - Tonga FY2004: Income Tax 4.1, Tax on Goods and Services 3.0, Trade Taxes 14.4, Other Tax 0.1, Total Tax Revenue 21.7, Total Domestic Revenue 26.2
  - Kiribati FY2002: Income Tax 8.1, Tax on Goods and Services 0.0, Trade Taxes 17.2, Other Tax 0.1, Total Tax Revenue 25.4, Total Domestic Revenue 56.0
  - Kiribati FY2004: Income Tax 10.3, Tax on Goods and Services 0.0, Trade Taxes 15.1, Other Tax 0.1, Total Tax Revenue 25.5, Total Domestic Revenue 88.3
  - Mean FY2002: Income Tax 5.3, Tax on Goods and Services 5.7, Trade Taxes 7.9, Other Tax 0.6, Total Tax Revenue 19.5, Total Domestic Revenue 27.8
  - Mean FY2004: Income Tax 5.4, Tax on Goods and Services 6.1, Trade Taxes 7.6, Other Tax 0.7, Total Tax Revenue 20.0, Total Domestic Revenue 31.8

### Medium-term fiscal reforms and tax policy
- Staff advised that reforming the tax system could help raise domestic revenue collection closer to the long-term target of 32 percent of GDP.
- Current system described as inequitable and inefficient; Palau’s tax collections are around 20 percent of GDP, similar to the average for other island economies.
- Recommended reform elements (consistent with TA by LEG and PFTAC):
  - Replace narrow-based wages and salaries taxes with a personal income and corporate income tax.
  - Replace the cascading gross receipts tax by a consumption tax such as the Value Added Tax, that exempts exports and refunds VAT collected on inputs.
- Authorities intend to postpone modernizing the tax system for 2-3 years.
- Interim measures agreed by staff and authorities could yield up to 1 percent of GDP in FY2007:
  - Strengthen collection efforts.
  - Eliminate exemptions on import duties.
  - Adjust the reference price for the hotel room tax to allow the tourism sector to contribute more fully.
  - Accelerate administrative measures: introduce a full assessment system, a single taxpayer identification number, strengthened monitoring, and audit and penalty systems to improve compliance.

### Expenditure adjustment needs and measures
- The bulk of the adjustment will have to fall on expenditure reforms.
- Estimated total expenditure adjustment needed over the long run is in excess of 20 percent of GDP (and as much as 30 percent of GDP without Compact renewal) spread over 10 to 25 years, of which capital spending cuts account for 10-15 percent of GDP.
- Capital expenditure is expected to gradually decline as its funding sources dwindle; short-term macroeconomic impact somewhat limited as the bulk is spent on foreign goods and services.
- Adjusting current expenditure requires specific measures to cut the wage bill and spending on goods and services.
- Government cost reduction plan has identified outsourcing measures that could yield savings of 2-3 percent of GDP in the next 2-3 years, including:
  - Outsourcing water and sewer, school and hospital meals, security and janitorial services, road repair, and management of airport facilities.
- Plans to introduce user fees for sports facilities and medical care.
- Further cuts will be needed over the long run to achieve remaining savings of about 8 percent of GDP.

### Public debt and reserves
- Public debt is low at 13 percent of GDP.
- Palau incurred a first loan (17 percent of GDP) on concessional terms in 2000 to finance construction of the new Capitol complex.
- Another $15 million loan was contracted in 2004 for airport rehabilitation, but only $1.5 million (1 percent of GDP) has been drawn due to subsequent availability of U.S. grant financing.
- Authorities intend to avoid contracting new loans, and to build a cushion of usable reserves, possibly from unspent CTF withdrawals or any revenue over-performance, to cope with vulnerability to shocks.

### Exchange rate regime and trade policies
- The exchange rate regime remains appropriate given Palau’s small size and predominance of U.S. grants and trade flows.
- The tourism industry appears to be competitive; Palau compares well to other tourism-dependent island economies in visitor arrivals, expenditure, and infrastructure.
- Palau scores high in several categories of the World Bank’s Doing Business survey.
- Tariff structure:
  - Five nonzero bands, most imports are subject to a 3 percent rate, and the unweighted average rate is below 3 percent.
  - About 30 percent of trade taxes are collected from cigarette and alcohol duties that are subject to additional specific taxes.
- Customs modernization introduced a harmonized system nomenclature and on-line document filing to facilitate trade.
- Staff advised against raising the general tariff rate from 3 percent to 5 percent as a proposed revenue measure, but saw merit in removing duty exemptions.

### Private sector development and economic diversification
- Opportunities outside tourism: agriculture, fish processing, handicrafts, and services currently provided by the public sector.
- Tourism development plan encourages shift toward higher-end tourism with higher domestic value-added.
- Key impediments: non-transparent investment regulations favoring well-connected individuals, shortage of Palauan skilled labor, limited access to land, and infrastructure needs.
- Foreign direct investment (FDI):
  - FDI reached 13 percent of GDP in FY2005, far above the regional average, due to some large hotel and airline projects.
  - Barriers for foreign investors: inability to own land or use it as collateral, sectoral restrictions, stipulation that 20 percent of employees be Palauan citizens for investments below $0.5 million, and an annual $500 permit fee for hiring expatriates that Palauan employers do not have to pay.
  - These restrictions have promoted “fronts” (foreign investors operating under a Palau silent partner), reducing tax compliance and increasing fraud/liability risks.
  - One proposal under consideration: equalize the $500 annual permit fee between foreign investors and Palauan employers to reduce incentive for fronts and encourage employment of Palauan labor.
- Land access:
  - About 40 percent of plots remain unregistered; restricted access hampers agriculture and credit-financed investment.
  - Authorities intend to speed up titling and registration, introduced a quiet title process to register lots as state land after an undisputed 45-day announcement, allowing lease for private use.
  - A bill passed Senate hearings in December 2005 proposes extension of land leases to foreigners from 50 to 99 years.

### Labor market and minimum wage
- Skilled labor shortages exacerbated by Palauans seeking employment in the United States, making it difficult for foreign investors to hire required percentage of Palauan workers.
- Foreign workers make up nearly one half of the labor force, mostly in unskilled jobs unattractive to Palauans.
- Staff argued against proposal to increase the minimum wage (already the highest among Pacific islands) as ineffective for encouraging return of Palauans working abroad; could encourage substitution of Palauan unskilled workers by foreign labor not subject to minimum wage legislation.
- Staff saw potential merit in requiring recipients of state-sponsored scholarships for study abroad who do not return to repay study costs.

### Financial sector soundness and supervision
- Palau has a large banking sector relative to its population but lacks adequate regulation and supervisory oversight.
- Financial sector composition: eight commercial banks, one development bank, and several other financial institutions.
- Pending passage of regulations, the quality of the loan portfolio is not known nor the possible impact of banking sector problems on public finances.
- All banks reported improved profitability in the last two years and progress in loan recovery after a rise in delinquent loans following the 2001 economic slump.
- Since passage in 2001 of a watered-down Financial Institutions Act (FIA) and establishment of a governing Board for the Financial Institutions Commission (FIC), progress has been disappointing.
- Palau was assessed in 2002 under the Fund’s Offshore Financial Center assessment program as non-compliant on 16 out of 25 Basel core principles; the situation remains unchanged.
- Fund TA missions in 2004 advised that unless the proposed FIA amendment is adopted without further modification, neither prudential nor AML/CFT supervision will be feasible in Palau; also noted need to strengthen pending amendment to the MLPCA to comply with key aspects of the FATF 40+9 Recommendations.
- FIC capacity issues:
  - FIC lacks resources and sufficient authority to carry out supervisory responsibilities.
  - Four years after establishment, FIC has received only one out of five recommended professional staff and a fraction of the planned budget.
  - Absent adoption of the FIA amendment, FIC lacks clear authority to introduce regulations, investigate, or enforce compliance through on-site inspection.
  - Nevertheless, FIC officials reported advising remedial action and successfully decommissioning some banks despite lawsuits questioning authority.
- Staff stressed need for passage of the FIA amendment to allow FIC to issue financial regulations as recommended by MFD and LEG; FIC and the Financial Intelligence Unit must have necessary budget, staffing, training, and governance.
- Authorities agreed with staff recommendations but pointed to legislative bottlenecks; intend to strengthen efforts to engender support for needed legislation and regulations and to provide FIC with adequate resources.
- After the mission, the Senate held a first hearing on financial legislation in early December and FIC has initiated a recruitment search of additional staff.
- MFD and LEG stand ready to provide further capacity-building technical assistance once bank examiners have been recruited.
- National Development Bank needs to further strengthen loan recovery efforts; most bad loans initially arose from the weak economy in 2001; recent external audits to reinforce collection were welcomed and continued efforts encouraged with capacity building assistance.

### Statistical issues
- Serious deficiencies remain in most areas of economic statistics with the notable exception of public finance (Annex V).
- Some collected statistics cannot be compiled or disseminated due to shortage of trained staff and high staff turnover.
- Staff commended authorities’ efforts to improve national accounts and balance of payments statistics and welcomed intention to seek training for new staff.
- Office of Planning and Statistics would benefit from additional technical assistance to build capacity, especially to maintain the national accounts system.
- In the longer term, as customs and banking data become more readily available, assistance would help refine the balance of payments.
- Authorities welcomed further hands-on help at regular intervals; once more adequately staffed, they would be able to devote some resources to the GDDS project.

*Source: _cr06108 - 17.      Staff cautioned that the targets of the (PDF chapter/section).*

### 35.      Judicious management of foreign aid and political stability have helped build a

### _cr06108 - 35.      Judicious management of foreign aid and political stability have helped build a

### Growth, inflation, and external assistance
- Growth has picked up after several years of stagnation and inflation remains subdued.
- Foreign grants have supported infrastructure development that has encouraged tourist and business visitors since 2003 and provided opportunities for local companies.
- Fiscal performance has improved, with a narrowing of the large current fiscal deficit by 8½ percentage points of GDP in the last three years compared to the previous three years.
- Palau remains highly dependent on grant assistance to provide public services and pay the relatively large civil service wage bill, and vulnerable to external shocks and risks of over-exploiting its ecosystem.
- Nominal GDP (2004): US$133.6 million. Population (2004): 20,610. GDP per capita (2004): 6,480.
- Tourism receipts (selected years): 58.5, 57.4, 75.6, 96.9, 97.2, 97.5 (levels in Table 1, in millions of U.S. dollars as "Tourism receipts" row).

### Fiscal stance, revenue, and tax reform
- The government’s stated long-term objective of covering current spending from domestic revenue generation is appropriate.
- The tax base could be broadened by eliminating exemptions and addressing non-compliance.
- Over the medium term, the best option is a comprehensive overhaul of the tax system centered around a VAT or consumption tax that eliminates cascades in the gross receipts tax, and more efficient corporate and personal income taxes that would capture those currently outside the tax net.
- Domestic revenue and grants (selected fiscal-year shares of GDP from Table 3):
  - Total revenue and grants: 43.1, 42.4, 54.0, 54.3, 53.6, 61.3 (percent of GDP for fiscal years listed in Table 1/Table 3).
  - Domestic revenue: 25.7, 23.8, 26.0, 26.8, 27.6, 26.7 (percent of GDP).
  - Grants: 17.3, 18.6, 28.1, 27.6, 26.0, 34.5 (percent of GDP).
- The bulk of fiscal adjustment will nevertheless need to come from expenditure containment.
  - For 2006, current spending should be curtailed below the proposed budget.
  - In the medium term, current spending has to be steadily reduced from 45 percent of GDP to around 32 percent of GDP by downsizing the public sector.
  - Measures proposed: continuing the hiring freeze; capping the nominal rate of increase in non-wage current spending; raising user fees for medical and other public services; outsourcing and privatizing some services.

### Grants, Compact Trust Fund (CTF), and medium-term scenarios
- Possible renewal of Compact grants would allow the adjustment to be phased over a longer period of time, but it would not obviate the need for adjustment.
- Given uncertainty over future grants, targeting a pace of adjustment consistent with a lower level of future grants reduces the risk of future fiscal and social strains.
- Table 6: Medium-Term Scenarios (selected rows as presented)
  - Scenario A. CTF Depleted — Real GDP growth (percent): 4.9, 5.5, 5.7, 5.5, 4.8, 4.4, 4.0, -2.0
    - Revenue and grants (percent of GDP): 54.3, 53.6, 61.4, 58.5, 49.6, 48.5, 37.3, 35.9
    - Total grants (actual to 2006): 27.6, 26.0, 34.6, 31.3, 21.8, 20.2, 8.5, 3.9
    - Expenditure (percent of GDP, actual to 2004): 61.7, 54.2, 61.8, 58.7, 56.8, 55.0, 53.3, 35.9
    - Current balance (percent of GDP): -19.7, -17.5, -16.2, -14.9, -13.6, -12.3, -11.1, 0.1
    - Overall balance (percent of GDP): -6.9, -0.6, -0.4, -0.1, -7.2, -6.5, -16.0, 0.0
    - CTF Balance: 142, 153, 161, 169, 166, 163, 142, 0
  - Scenario B. Preserve CTF RPCV without Compact Renewal — Real GDP growth (percent): 4.9, 5.5, 5.7, 4.5, 3.0, 2.0, 1.0, 0.5
    - Revenue and grants (percent of GDP): 54.3, 53.6, 61.4, 58.5, 49.6, 48.5, 37.3, 35.9
    - Total grants (actual to 2006): 27.6, 26.0, 34.6, 31.3, 21.8, 20.2, 8.5, 3.9
    - Expenditure (percent of GDP, actual to 2004): 61.7, 54.2, 61.8, 58.0, 53.5, 49.7, 46.4, 36.1
    - Current balance (percent of GDP): -19.7, -17.5, -16.2, -14.2, -12.3, -10.3, -8.5, 0.0
    - Overall balance (percent of GDP): -6.9, -3.9, -0.4, 0.6, -4.0, -1.2, -9.1, -0.3
    - CTF Balance: 142, 153, 160, 171, 170, 176, 159, 324
  - Scenario C. Increase CTF RPCV Under New Compact — Real GDP growth (percent): 4.9, 5.5, 5.7, 5.5, 4.8, 4.8, 4.5, 3.3
    - Revenue and grants (percent of GDP): 54.3, 53.6, 61.4, 58.5, 49.6, 48.5, 58.2, 35.4
    - Total grants (actual to 2006): 27.6, 26.0, 34.6, 31.3, 21.8, 20.2, 29.4, 3.4
    - Expenditure (percent of GDP, actual to 2004): 61.7, 54.2, 61.8, 58.7, 56.9, 55.3, 53.7, 40.9
    - Current balance (percent of GDP): -19.7, -17.5, -16.2, -14.9, -13.7, -12.4, -11.2, 0.0
    - Overall balance (percent of GDP): -7.4, -0.6, -0.4, -0.2, -7.3, -6.8, 4.5, -5.4
    - CTF Balance: 142, 153, 161, 172, 168, 165, 365, 1256
  - Memorandum: CTF-constant real per capita value series: 142, 153, 160, 168, 175, 183, 191, 357 (as shown).

### Expenditure composition and public sector wage bill
- Current spending was 45 percent of GDP (reference point for medium-term reduction to around 32 percent of GDP).
- Wage expenditure (2004, percent of GDP series shown in Figure 2 and Table 3): wages and salaries as percent of GDP in Table 3: 24.1, 24.7, 24.1, 22.1, 22.6, 24.4, 22.4, 21.0, 21.2 (years as listed).
- Proposed measures to reduce wage and current spending: downsizing the public sector, hiring freeze, capping nominal increases in non-wage current spending.

### Monetary and exchange arrangements; trade policy
- Use of the U.S. dollar as domestic currency provides welcome monetary stability.
- Over one half of grants and imports come from the United States and the real effective exchange rate has been relatively stable.
- It is Palau’s best interest to maintain its open trade system.
  - Recommended approach: removing duty exemptions, followed by introducing a consumption tax in the context of comprehensive tax reform, instead of raising tariff rates.
  - Recent improvements: introduction of the harmonized system of tariff classification and computerized customs filing system.

### Investment climate and structural reforms
- Shortages of skilled staff, restrictions on land ownership, and cumbersome and non-transparent investment procedures impede private sector activity.
- Removing investment impediments would help establish the basis for sustained growth.
  - Foreign investors seek local partners to circumvent foreign investment restrictions on sectors of activity, owning land, minimum domestic labor requirements, and the higher cost for foreign labor permits.
  - Staff welcome proposals before Congress that aim to reduce investment restrictions, and the quiet title process that has facilitated registration and leasing of state land.
  - A consensus will need to be reached on the benefits of further removing impediments to foreign investment in Palau, while safeguarding the interests of the local community.
- Indicators of investment climate, 2005: Average Starting Business Costs = 33.9 (percent of income per capita); Dealing with Licenses Cost Average = 110.2 (percent of income per capita); Firing Costs Average = 26.2 (week of wages); Enforcing Contract Time Average = 451.5 (days); Enforcing Contract Costs Average = 76.7 (percent of debt); Closing Business Recovery Rate Average = 12.2 (cents on the dollar). (Figure 3 summary values as presented.)

### Labor, migration, and human capital
- Palau is becoming increasingly dependent on foreign labor.
- Raising the minimum wage for Palauans would be counter-productive given easy access to employment opportunities in the United States at much higher wages, combined with a much lower reservation wage for unskilled Asian labor.
- Requiring recipients of state-sponsored scholarships for study abroad who do not return to repay study costs may increase incentives of Palauans to return.

### Financial sector regulation and supervision
- In spite of initial progress, the relatively large banking sector lacks adequate regulation and supervisory oversight.
- The Financial Institutions Act (FIA) adopted in 2001 provides for establishment of a Financial Institutions Commission but did not provide it sufficient authority to undertake oversight.
- Urgent adoption of the amendment to the FIA, and adequate resources including two bank examiners, would allow the Commission to issue regulations, and to exercise supervisory functions.
- Amending the Money Laundering and Proceed of Crimes Act would help address money laundering concerns.
- Both the FIC and Financial Intelligence Unit must have the necessary authority, budget, and governance structure to fulfill their duties.
- Ongoing efforts to strengthen the National Development Bank should be continued.

### Data, statistics, and surveillance
- While data provision for surveillance purposes is still adequate overall, staff’s analysis was affected by serious shortcomings in the areas of banking and national accounts.
- Further efforts are needed to improve data collection, compilation methodology, and dissemination.
- Specific statistical weaknesses:
  - National accounts: estimates compiled sporadically since 1984, interrupted since late 2002; GDP growth rates in the staff report are based on preliminary estimates from sector indicators.
  - Consumer price index compiled since 2000 on a quarterly basis, but inconsistencies have appeared since the last quarter of 2003.
  - Monetary/banking data: audited balance sheet data are not legally required to be provided by banks, no official banking survey, bank reports to the Financial Institutions Commission are often incomplete and lack standardized format; lack of data prevents preparation of most financial soundness indicators.
  - Balance of payments: compilation weak; staff prepared estimates based on available imports, interest income, official grants, debt service, financial holdings of the government, and rough estimates of exports, services, private transfers and FDI.
- PFTAC assistance and capacity-building interventions have been provided for national accounts, GDDS metadata, tax and customs administration, and banking supervision (missions and advisor visits listed in Annexes).

### Surveillance and next steps
- It is proposed that the next Article IV consultation be conducted on the 24-month consultation cycle.
- The Executive Board concluded the Article IV consultation on February 27, 2004; Article IV consultation discussions were held during November 2003; the PIN notes the Executive Board concluded consultations on February 15, 2006 (dates as presented in source material).

*Source: IMF staff report and Public Information Notice on the Republic of Palau (Article IV consultation).*

### 2043. In recent years, budgetary grants from the U.S. have averaged about 18 percent of GDP,

### _cr06108 - 2043. In recent years, budgetary grants from the U.S. have averaged about 18 percent of GDP,

### Fiscal position, grants, and reserves
- Budgetary grants from the U.S. have averaged about 18 percent of GDP, of which one third comes from federal grants outside of the Compact.
- Compact Trust Fund (CTF) balance stood at US$153 million (106 percent of GDP) at end-2005.
- CTF balances (selected years, in millions of U.S. dollars): 135.0, 124.5, 136.3, 141.6, 152.5, 155.8.
- Government non-CTF financial assets (in millions of U.S. dollars): 43.7, 13.7, 16.4, 9.5, 12.6, 15.9.
- Usable reserves (in millions of U.S. dollars): 3.9, 2.9, 5.5, 2.2, 2.0, 5.1; usable reserves (in months of imports): 0.5, 0.4, 0.7, 0.2, 0.2, 0.5.
- External public debt (in percent of GDP): 16.2, 16.6, 15.9, 14.0, 13.2, 11.3.
- Debt service ratio (in percent of exports of goods and nonfactor services): 1.2, 1.2, 1.7, 1.9, 1.8, 1.9.

### Recent fiscal performance and policy recommendations
- Overall fiscal deficit (including grants) declined from 21 percent of GDP to under 5 percent of GDP in FY2003-05 compared to the previous three years.
- Current budget balance improved by 8½ percent of GDP, mainly due to capping the rate of increase of non-wage current expenditure.
- Domestic revenue measures: re-instatement of excises on tobacco and alcohol in 2003 and 2004; strengthened revenue collections from higher investment income and economic strengthening.
- Public debt is low at 13 percent of GDP.
- Executive Directors’ recommendations:
  - Do not postpone fiscal adjustment and structural reforms given uncertainty over U.S. Compact renewal beyond 2009.
  - Target a pace of fiscal consolidation consistent with a gradual decline in future grants to reduce risk of social strains.
  - Greater expenditure containment, particularly on goods and services; downsizing the public sector (maintain hiring freeze; outsource services).
  - Strengthen tax collection efforts, eliminate exemptions in the near term, and consider later a comprehensive tax overhaul centered on a non-cascading consumption tax and more efficient broader-based corporate and personal income taxes.
  - Continue use of the U.S. dollar and maintain an open trade regime; cautious fiscal and wage policies to preserve external competitiveness.

### Economic growth, inflation, and external accounts
- Real GDP growth (percent change): 1.3, -3.5, -1.3, 4.9, 5.5, 5.7 (2000/01–2005/06).
- Consumer prices (percent change; period average): 0.8, -1.2, -0.6, 5.8, 2.7, 3.0.
- Business and Tourist arrivals: 49,731; 48,157; 60,734; 83,452; 85,004; ...
- Tourism receipts (millions of U.S. dollars): 58.5, 57.4, 75.6, 96.9, 97.2, 97.5.
- Exports (f.o.b., millions of U.S. dollars): 16.6, 20.3, 8.4, 5.9, 13.4, 13.5.
- Imports (f.o.b., millions of U.S. dollars): -99.9, -96.7, -88.2, -107.3, -105.2, -115.5.
- Balance of payments:
  - Current account balance (including grants, in millions of U.S. dollars): -9.4, -11.0, 9.6, 12.6, 15.1, 3.9.
  - Current account balance (including grants, in percent of GDP): -7.6, -9.1, 7.9, 9.6, 10.6, 2.5.
  - Current account balance (excluding grants, in millions of U.S. dollars): -29.8, -31.5, -11.4, -10.8, -6.6, -20.4.
  - Current account balance (excluding grants, in percent of GDP): -24.1, -26.1, -9.3, -8.3, -4.6, -13.2.
- Overall balance (in millions of U.S. dollars): -25.1, -34.2, -3.4, -10.2, -5.2, -1.8.

### Banking and financial sector
- Financial sector composition: four foreign branches of commercial banks, four domestically chartered banks, five insurance companies, a number of credit unions, and some twelve remittance companies.
- Dominant role of U.S.-based banks that hold the majority of deposits mitigates risks; reported overall bank profitability has improved though banking statistics are lacking.
- Five financial laws introduced in 2001 created the Financial Institutions Commission (FIC) and Financial Intelligence Unit (FIU).
- Existing legislation does not allow FIC to issue regulations; both FIC and FIU do not have adequate resources.
- Executive Directors urged passage of amendments to the Financial Institutions Act and anti-money laundering legislation; ensure adequate authority, budget, and staffing for FIC and FIU.
- Directors welcomed efforts to strengthen the National Development Bank of Palau.

### Structural reforms, investment climate, and labor/land issues
- Private sector activity contributed to recent growth; foreign-financed projects increasingly undertaken by local firms.
- Foreign direct investment reached an estimated 13 percent of GDP in FY2005.
- Investment impediments: restrictions to specific activities; about half of available land lots lack title and cannot be used to secure loans; non-transparent investment regulations benefit few citizens; labor regulations raise costs amid shortage of skilled Palauan labor.
- Recommendations and ongoing actions:
  - Improve investment climate; progress on land titling and leasing welcomed; government pushing for completion of land titling by early 2008.
  - Draft law to enhance collateralization of long-term leases to facilitate use of leased lands as collateral.
  - Consider regulatory framework reform to establish simple, transparent, effective economic rules and incentives for foreign investment.
  - Work on a new commercial code aligned with international best practices.
  - Continue work on tourism long-term vision; diversify tourism products; consider reorganizing tourism management to define responsibilities for regulation, marketing and enforcement.
  - Caution against raising the minimum wage to safeguard employment opportunities for Palauans.

### Data, capacity building, and technical assistance
- Directors encouraged improvement in coverage, reliability, and timeliness of national accounts and banking statistics.
- Authorities requested more technical assistance in these areas.
- Authorities prioritize institutional and human capacity building, statistical database improvements, and continued strong technical assistance from the Fund.

### Authorities’ assessment and policy stance (Statement by Jong Nam Oh and Cyd Amador, February 15, 2006)
- Key points:
  - Disciplined policies and reform progress contributed to favorable economic performance.
  - Fiscal soundness will help preserve macroeconomic stability and prepare economy for potentially-substantial fiscal adjustments over the medium term.
  - Robust and sustainable growth requires more meaningful advances in structural reforms, promotion of a more business-friendly environment, and strengthening of the financial system.
- Authorities’ commitments:
  - Preserve macroeconomic stability via responsible fiscal stewardship and aim to meet current spending from domestic revenue generation.
  - Strengthen revenue mobilization (intensified audits; enhanced automation; modernization of customs administration; consider further tax policy reforms).
  - Contain spending (rationalize government operations; outsourcing; performance-based budgeting; maintain hiring freeze).
  - Avoid undertaking new loans and build up usable reserves; settle arrears and pay government bills timely.
  - Promote private sector development and regional cooperation; enhance human resource training and development.
- Recognize challenges: need for sustained policy and reform efforts, capacity constraints, and the importance of public consultation and ownership of reforms.

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