## 1. Real Sector Developments

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### Context
- Palau: a middle-income micro state in the Pacific relying heavily on tourism and grants; exposed to natural disasters and climate change.
- Recent shocks and institutional context:
  - Severe drought early in the year associated with El Niño led to water rationing and a state of emergency in March and April.
  - Political system: U.S. model, presidential term four-year; next elections in November 2016.
  - Environmental initiatives: world's first shark sanctuary (2009) and the world’s largest marine sanctuary (2015).
  - Legal tender: U.S. dollar. Fiscal year ends in September.
- Compact of Free Association with the United States:
  - Original 50-year Compact (1994–2009) included US$580 million in financial aid and an initial Compact Trust Fund (CTF) investment of US$70 million, intended to provide US$5 million in FY1999–09 and US$15 million in FY2010–44.
  - New assistance agreed in 2010 (not ratified by U.S. Congress) included US$30 million for the CTF, US$122 million in current grants, and US$67 million for infrastructure.
  - Projections assume ratification in FY2017, funds evenly disbursed during FY2018–24.
  - Post-FY2024: Compact grants expire; projections assume continued US$15 million CTF withdrawals until exhaustion of the CTF.
- FY2014–15 policy context:
  - Economic policies broadly in line with past IMF advice.
  - Fiscal position improved via spending restraint; a tax reform bill sent to Congress in FY2014 remains pending.
  - Upgrades to basic infrastructure and internet connectivity underway.
  - Efforts to expand financial supervision to the National Development Bank of Palau and other non-bank financial institutions are underway.

### Current developments, outlook, and risks
- Growth:
  - FY2015: real economy growth of 9.4 percent driven by tourist arrivals and construction; tourist arrivals expanded by 35 percent.
  - FY2016: projected growth of zero due to lower tourist arrivals and modest drought impact.
  - FY2017: projected growth of 5 percent as tourism recovers and construction picks up.
  - Medium term: growth projected to gradually moderate to 2 percent as hotel developments are restricted until infrastructure is upgraded.
  - Constraints from rapid FY2015 tourism boom: strain on water, sanitation, waste disposal; tilt toward low budget tourists; rise in low quality hotels; environmental risks.
  - Authorities limited number of charter flights; tourist arrivals slowed in FY2016.
- Inflation and credit:
  - Inflation: fell to 2.2 percent in FY2015; expected at 2 percent in FY2016–17.
  - Banking: domestic loans fell by 2.5 percent in FY2015; loan-to-deposit ratio declined to 13 percent.
  - Banks invest most assets abroad despite rapid rise in deposits.
  - Contributing factors to low domestic lending: ceiling on lending rates for commercial loans; lack of business plans and financial statements for SMEs.
- External stability:
  - Current account deficit: shrank from 12 percent of GDP in FY2014 to 0.5 percent of GDP in FY2015, mainly due to a fall in fuel imports by 10 percent of GDP; lower food imports and higher tourism receipts also contributed.
  - FY2016–18: current account deficit expected to rise to 7 percent of GDP due to higher imports related to fiber optic cable and sanitation projects financed with AsDB loans.
  - Medium term: projected to stabilize at 5.5 percent of GDP due to higher commodity prices and infrastructure-related imports financed with Compact grants.
  - Deficits expected to be fully financed with capital grants and FDI inflows.
- Risks:
  - Substantial downside risks from high reliance on tourism, grants, and commodity imports.
  - Specific risks: U.S. dollar appreciation; slowdown in key trading partners; natural disasters; higher commodity prices; further delays in ratifying the Compact agreement; sustained influx of low budget tourists and proliferation of low quality hotels.
  - Policy tool limitation: absence of independent monetary and exchange rate policies; primary policy instruments are fiscal and structural.
- Authorities’ views:
  - Authorities prioritize sustainable growth consistent with environmental protection and positioning Palau as a high-end tourism destination.
  - Airport departure tax increase from US$50 to US$100 per tourist effective April 1, 2017 intended to replace lost fishing license revenue and may discourage low budget tourists; authorities expect limited impact on arrivals.

### Key policy issues and priorities
- Overarching priorities:
  - Achieve selected SDGs prioritized by authorities: (i) SDG #8; (ii) SDG #9; (iii) SDG #13; (iv) SDG #14.
  - Key policy priorities: ensuring fiscal sustainability, raising potential growth and enhancing resilience, preserving financial stability and facilitating credit extension.

A. Ensuring Fiscal Sustainability

- Recent fiscal developments and stock positions:
  - Current fiscal deficit (expense less domestic revenue) fell from 11 percent of GDP in FY2014 to 5.5 percent of GDP in FY2015.
  - Tax revenue rose by 1 percent of GDP due to higher receipts from the airport departure tax amid soaring tourist arrivals.
  - Expense declined by 4.5 percent of GDP due to spending restraint.
  - Overall balance rose by 1.5 percent of GDP due to a drop in grants.
  - CTF reached 64 percent of GDP in FY2015.
  - Government deposits rose to 8.1 percent of GDP.
  - Domestic accounts payable fell to 5.4 percent of GDP.
  - Government external debt declined to 10.4 percent of GDP.

- Medium-term fiscal outlook (baseline assumptions):
  - Current fiscal deficit path:
    - FY2015: 5.5 percent of GDP.
    - FY2016: expected to stay at 5.5 percent of GDP.
    - FY2018: projected to fall to 4 percent of GDP.
    - From FY2018 onwards: current fiscal deficit expected to remain at 4 percent of GDP.
  - Airport departure tax increase (US$50 to US$100 per tourist from April 1, 2017):
    - Estimated to raise 2.4 percent of GDP in revenue.
    - Half reserved for the Civil Service Pension Fund (CSPF) and not reflected in government accounts: 1.2 percent of GDP.
    - Government revenue rise: 1.2 percent of GDP (0.6 percent in FY2017 and 0.6 percent in FY2018).
    - Expense rise: 1.2 percent of GDP (extra revenue reserved for state governments and marine sanctuary), no impact on current fiscal balance.
  - Public investment: limited to that financed with capital grants and AsDB loans.
  - Overall fiscal balance: temporarily moves into deficit due to higher capital spending funded with AsDB loans, then returns to surplus as current fiscal deficits decline and Compact grants rise.

- Long-term fiscal outlook (baseline):
  - Current fiscal deficit: expected to remain at 4 percent of GDP from FY2018 onwards.
  - Capital spending in FY2019–24 set by capital grants and AsDB loans.
  - Overall fiscal balance: stays in surplus as current grants exceed current fiscal deficit.
  - Government net worth (CTF + government deposits − domestic accounts payable − government external debt − CSPF’s unfunded liabilities):
    - FY2015: 48 percent of GDP.
    - FY2024: rises to 59 percent of GDP under baseline.
  - CTF trajectory: would fall to 51 percent of GDP in FY2014 due to larger withdrawals under the renewed Compact agreement.
  - Staff analysis: current fiscal deficit can be sustained at 4 percent of GDP post-FY2024 provided public investment is capped at 5.6 percent of GDP.
  - Overall fiscal balance falls after FY2024 as Compact grants expire, but government net worth stabilizes at 59 percent of GDP.

- Staff reform recommendations (strengthening fiscal framework and ensuring long-term sustainability):
  - Fiscal anchor and operational target:
    - Recommend targeting a net worth position of the public sector as the fiscal anchor.
    - Use the current fiscal balance as the operational target.
  - Fiscal adjustment and composition:
    - Recommend further fiscal adjustment in the medium term and shift public expenditure composition toward investment to support tourism and enhance resilience.
    - Baseline public investment: 6.2 percent of GDP in FY2019–24 and 5.6 percent of GDP after FY2024.
    - Historical public investment average: 8.3 percent of GDP.
    - Pacific islands comparator: 11 percent of GDP.
    - Staff target: government net worth of 70 percent of GDP after FY2024 (11 percentage points above baseline).
    - Staff proposes cutting the current fiscal deficit to 1 percent of GDP by FY2020.
    - Expected effects: real GDP growth to fall in FY2017–18 due to fiscal consolidation, then increase in FY2019–21 as higher public investment offsets consolidation; after FY2020, growth projected to increase by about 1 percentage point in line with higher public investment.
  - Fiscal measures and distribution:
    - Support replacing the gross revenue tax (GRT) with a single rate value added tax (VAT) with no exemptions.
    - Raise the net income tax on financial institutions and all VAT-registered businesses.
    - Strengthen tax compliance and use a bidding mechanism to manage charter flights instead of quantitative limits.
    - Contain expenditures by prioritizing spending and gradually eliminating subsidies.
    - Split fiscal adjustment equally between revenue and expenditure measures.
    - Quantified potential yields and savings:
      - VAT and net income tax reforms could yield 1.5 percent of GDP in additional revenue by FY2020.
      - Wage bill reduction could yield 1 percent of GDP.
      - Reduction of government subsidies could yield 0.5 percent of GDP.

- Strengthening public financial management (PFM) and debt sustainability:
  - PFM reforms recommended: sound public debt management, project administration, prioritizing infrastructure that supports tourism and resilience, adopting a medium-term budget framework, improving budget execution and planning, strengthening cash management.
  - Public debt assessment:
    - Staff analysis shows public debt remains sustainable despite recent AsDB loans by US$52 million to finance Koror-Arai waste management upgrade and the submarine fiber optic cable.
    - Public debt is highly sensitive to a real GDP growth shock, such as large natural disasters.
  - Project prioritization: emphasize infrastructure supporting tourism growth and resilience to natural disasters and climate change.

- Reforming public entities:
  - Civil Service Pension Fund (CSPF):
    - Estimated unfunded liabilities of 8.3 percent of GDP even after extra revenue from airport departure tax.
    - Staff recommends reducing benefits and raising contributions to ensure long-term sustainability.
  - Palau Public Utility Corporation (PPUC):
    - Relies on government subsidies for water services.
    - Staff advises raising tariffs and lowering operational costs to ensure full cost recovery while protecting vulnerable groups.
  - Palau National Communications Corporation and Belau Submarine Cable Corporation:
    - Able to cover costs with own revenue without government support.

- Authorities’ stance on fiscal recommendations:
  - Authorities welcomed staff recommendations to strengthen fiscal framework and long-term fiscal sustainability analysis.
  - Authorities’ policy objective: self-finance expense with domestic revenue (zero current fiscal balance) by FY2024.
  - Support replacing GRT with VAT; VAT bill sent to Congress in FY2014 remains unapproved.
  - A bill shifting CSPF from defined-benefit to defined-contribution system was sent to Congress in FY2014 but not yet approved; authorities expect new airport departure tax revenues to finance benefits during the transition.
  - Authorities aim to make PPUC self-sufficient via higher tariffs and cost reductions, but note service quality must improve in line with planned water system upgrades before tariffs can be raised.

### Structural context, tourism, diversification, and business climate
- Structural constraints: narrow economic base, remote location, small population, inadequate infrastructure, weak business climate, exposure to natural disasters and climate change.
- Doing Business 2016: Palau ranked 136 among 189 economies.
- Tourism:
  - Main growth engine but lacks a comprehensive tourism policy; weak regulation led to excessive growth of low budget segment.
  - Staff recommendations:
    - Implement a comprehensive tourism strategy: land zoning rules, environmental protection, service quality regulation, infrastructure planning, labor-skill improvements.
    - Avoid new tourism developments in Koror until infrastructure upgraded; allow developments outside Koror and green tourism to continue.
    - Strengthen regulatory environment and coordination among national and state governments.
  - Authorities concur and are preparing a plan; open to high-end hotels that build own treatment plants.
- Diversification:
  - Staff recommendations: promote tourism from new destinations (including growing Asian markets); develop agriculture and aquaculture supplying tourism; stimulate activities that increase tourist spending.
- Business environment:
  - Foreign investment approvals currently case-by-case via Foreign Investment Board.
  - Staff recommends adopting a new foreign investment regime to simplify approvals and open business to foreign investment through joint ventures, subject to regulation.
- Infrastructure constraints and resilience:
  - Recent tourism surge strained water supply, sanitation, waste disposal; poor internet quality a main visitor dissatisfaction.
  - Ongoing AsDB projects aim to ease bottlenecks.
  - Staff recommends incorporating resilience to natural disasters and climate change when building new infrastructure; prioritize areas less at risk from storms and sea-level rise.
  - Authorities plan to upgrade Koror water pipeline and evaluate alternatives to broaden water sources.

### Financial sector stability and credit extension
- Banking sector indicators:
  - Nonperforming loans: 2.1 percent.
  - Liquid assets: 90 percent.
  - Return on assets: 1.4 percent.
- Market structure:
  - Three foreign owned U.S. FDIC-insured banks hold 93 percent of loans and 99 percent of deposits.
- Issues and recommendations:
  - Banks lend little domestically despite deposit rises; NDBP legislation passed to take deposits and will be regulated by FIC once licensed.
  - Staff recommendations:
    - Broaden FIC supervision to all non-bank financial institutions, including credit unions.
    - Encourage approval of the Credit Union Act.
    - Put NDBP under FIC supervision, allow it to take deposits and expand lending.
    - Continue improving AML/CFT regime in line with FATF standard.
    - Relax interest rate ceiling for commercial loans.
    - Help SMEs prepare business plans and financial statements; use NDBP to help fill SME financing gap once it can take deposits.
  - Authorities agree banks are sound and expect NDBP to help close financing gap once licensed.

### Statistics and external sector assessment
- Statistics: broadly adequate for surveillance due to IMF PFTAC and Graduate School USA TA; improvements needed in tourism statistics and data frequency.
- External sector:
  - Real effective exchange rate appreciated by 22 percent between FY2011 and FY2015.
  - Current account deficit fell reflecting lower commodity prices and strong tourism receipts.
  - Near-term: U.S. dollar expected to strengthen further as the Fed rises policy rates; current account deficit projected to increase due to higher commodity prices and infrastructure imports.
  - Financing: deficits expected to be covered by FDI inflows and capital grants.
  - Reserves and government deposits:
    - Government deposits FY2015: 8.1 percent of GDP or 2.7 months of government spending.
    - Projected to increase to about 6 months of spending by FY2021.
  - Data gaps impede fuller external assessment based on IMF EBA/EBA-Lite models.

### Staff appraisal and policy recommendations (summary)
- Recent performance and outlook:
  - Real GDP growth robust in FY2015; inflation low and stable; external and fiscal positions improved.
  - Outlook: growth temporarily declining to zero in FY2016, rebounding to 5 percent in FY2017–18.
  - Inflation expected to remain low; current account deficit to rise due to infrastructure imports; fiscal position to improve with spending restraint.
- Fiscal policy recommendations:
  - Target public sector net worth as fiscal anchor and current fiscal balance as operational target to ensure fiscal self-sufficiency when Compact grants expire in FY2024.
  - Further medium-term fiscal adjustment combining revenue and expenditure measures; reorient spending toward infrastructure investment.
  - Reform fiscal institutions and public entities: strengthen PFM, public debt management, project administration; reform CSPF; restructure PPUC to ensure full cost recovery and reduce subsidies.
- Tourism and diversification:
  - Implement comprehensive tourism strategy; avoid new hotel developments until infrastructure upgraded; promote high-end tourism and develop agriculture/aquaculture supply.
- Business climate and financial sector:
  - Adopt new foreign investment regime; broaden FIC supervision; relax interest rate ceilings; help SMEs with business plans; allow NDBP to expand lending once licensed.

### Selected quantitative indicators and projections (selected table highlights and scenarios)
- Tourist arrivals:
  - 125,674 (2013/14); 168,767 (2014/15); 148,515 (2015/16); projections: 158,911 (2016/17), 166,857 (2017/18), 173,531 (2018/19), 178,737 (2019/20), 184,099 (2020/21).
- Real GDP growth (percent change):
  - 4.2 (2013/14); 9.4 (2014/15); 0.0 (2015/16); projections: 5.0 (2016/17), 5.0 (2017/18), 4.0 (2018/19), 3.0 (2019/20), 2.0 (2020/21).
- GDP deflator (percent change): 5.2 (2013/14); 4.7 (2014/15); 3.0 (2015/16); 2.5 (2016/17); 2.0 (2017/18) through 2.0 (2020/21).
- Consumer prices (period average): 4.0 (2013/14); 2.2 (2014/15); 2.0 (2015/16) and 2.0 (2016/17) through 2.0 (2020/21).
- Key fiscal and macro shares (percent of GDP):
  - Central government revenue: 43.3 (2013/14); 40.6 (2014/15); 39.6 (2015/16); projections: 41.8 (2016/17) to 39.4 (2020/21).
  - Taxes and other revenue: 24.4 (2013/14); 25.4 (2014/15); 24.8 (2015/16); projections: 25.5 (2016/17) to 25.8 (2020/21).
  - Grants: 18.9 (2013/14); 15.3 (2014/15); 14.8 (2015/16); projections: 16.3 (2016/17) to 13.6 (2020/21).
  - Expenditure: 39.8 (2013/14); 35.6 (2014/15); 41.6 (2015/16); projections: 42.7 (2016/17) to 36.0 (2020/21).
  - Expense: 35.4 (2013/14); 30.9 (2014/15); 30.3 (2015/16); projections: 30.2 (2016/17) to 29.9 (2020/21).
  - Net acquisition of nonfinancial assets: 4.4 (2013/14); 4.7 (2014/15); 11.3 (2015/16); projections: 12.5 (2016/17) to 6.1 (2020/21).
  - Current fiscal balance (excluding grants): -11.0 (2013/14); -5.5 (2014/15); -5.5 (2015/16); projections: -4.7 (2016/17), -4.0 (2017/18) onward.
  - Net lending (+)/borrowing (–): 3.5 (2013/14); 5.0 (2014/15); -2.0 (2015/16); projections: -0.9 (2016/17), 1.2 (2017/18), 3.5 (2018/19).
- Compact Trust Fund (CTF) balance (millions of U.S. dollars): 199.2 (2013/14); 183.9 (2014/15); 188.9 (2015/16); projections: 194.2 (2016/17) to 222.8 (2020/21).
- Government cash and deposits (millions of U.S. dollars): 9.6 (2013/14); 23.4 (2014/15); 30.6 (2015/16); projections: 39.1 (2016/17) to 72.8 (2020/21). In percent of GDP: 3.8, 8.1, 10.4, 12.3, 13.1, 14.6, 16.6, 18.4.
- Trade balance (millions of U.S. dollars): -158.2 (2013/14); -142.4 (2014/15); -148.4 (2015/16); projections: -164.8 (2016/17) to -184.6 (2020/21).
- Tourism receipts (millions of U.S. dollars): 129.3 (2013/14); 150.4 (2014/15); 139.0 (2015/16); projections: 153.2 (2016/17) to 188.3 (2020/21).
- Current account balance (including grants, percent of GDP): -11.8 (2013/14); -0.5 (2014/15); -5.3 (2015/16); projections: -7.0 (2016/17) to -4.9 (2020/21).
- Public external debt (percent of GDP): 26.7 (2013/14); 22.0 (2014/15); 26.1 (2015/16); projections: 28.2 (2016/17) to 19.7 (2020/21).
- External debt (percent of exports of goods and services): 41.2 (2013/14); 35.2 (2014/15); 47.1 (2015/16); projections: 49.5 (2016/17) to 34.9 (2020/21).

Medium-term outlook and reform scenario
- Baseline scenario real GDP growth (percent change): 4.2 (2013/14); 9.4 (2014/15); 0.0 (2015/16); projections: 5.0 (2016/17), 5.0 (2017/18), 4.0 (2018/19), 3.0 (2019/20), 2.0 (2020/21).
- Staff reform scenario:
  - Assumes the current fiscal deficit is reduced by 1.1 percent of GDP each year during FY2017-20 to 1 percent of GDP in FY2020, achieved by raising taxes and cutting current expenditure; additional savings used to increase public investment to 8.3 percent of GDP from FY2019 onwards.
  - Under the reform scenario:
    - Taxes and other revenue (percent of GDP) projected to reach 27.6 (2019/20) and 27.5 (2020/21).
    - Expense (percent of GDP) projected 29.4 (2018/19), 28.6 (2019/20), 28.6 (2020/21).
    - Net lending (+)/borrowing (–) projected 4.6 (2018/19), 4.2 (2019/20).
    - Reform scenario real GDP growth (percent change): 4.2 (2016/17), 4.8 (2017/18), 4.8 (2018/19), 4.2 (2019/20), 3.3 (2020/21).
    - Reform scenario current account balance (including grants, percent of GDP): -6.9 (2016/17), -7.9 (2017/18), -6.0 (2018/19), -5.6 (2019/20), -4.6 (2020/21).

### Appendix I — Risks of Natural Disasters (highlights)
- Exposure and historical incidence:
  - Among 12 Pacific island countries, Palau had the lowest average number of natural disasters per year during 1960-2014 and the lowest probability of occurrence of natural disasters calculated over 1970-2014.
  - Pacific Catastrophe Risk Assessment and Financing Initiative estimates a 50 percent chance that Palau could experience large losses (US$30 million or 10 percent of GDP) due to natural disasters in the next 50 years.
- The 2016 El Niño drought event:
  - NOAA report (March 21, 2016) placed Palau in extreme drought level 3 of 4.
  - Cumulative rainfall in the previous four months was at the lowest level since 1951.
  - Ngerimel Dam provides 80 percent of water consumption in normal times; was shut down in April 2016.
  - Water restriction: limited water consumption to three hours a day from March 29; lifted May 9.
  - Government emergency response estimated cost: US$3 million (1 percent of GDP).
- Fiscal buffers and financing capacity:
  - Government deposits were 8.1 percent of GDP (FY2015); assessed insufficient to finance potential 10 percent of GDP disaster losses.
- Water security and infrastructure options:
  - Alternatives: developing underground water sources; enhancing water storage facilities; using desalination plants for sea water.
- Staff policy recommendations:
  - Build fiscal buffers for fast post-disaster response.
  - Make infrastructure more resilient to natural disasters and climate change.
  - Broaden and diversify water sources; ensure sufficient fiscal savings or contingency financing.

### Appendix VII — Public Sector Debt Sustainability Analysis (selected findings)
- Summary:
  - Public debt remains sustainable despite AsDB loans by US$52 million for Koror-Arai waste management and submarine fiber optic cable disbursed during FY2014-20.
  - Staff baseline projects public debt falling from 27.3 percent of GDP in FY2015 to below 20 percent in FY2021, driven by large primary surpluses during FY2018-21 and a positive growth-interest rate differential.
  - Palau does not access private foreign capital markets; external debt from international organizations for projects.
  - Baseline assumes no new foreign loans by central government or SOEs during FY2016-21.
- Baseline public debt (nominal gross public debt, percent of GDP):
  - 2014: 43.1
  - 2015: 34.0
  - 2016: 27.3
  - 2017: 30.1
  - 2018: 30.7
  - 2019: 28.3
  - 2020: 24.6
  - 2021: 22.0 (alternate entry: 19.7)
- Real GDP growth (percent) series used in DSA:
  - 2014: -0.8
  - 2015: 4.2
  - 2016: 9.4
  - 2017: 0.0
  - 2018: 5.0
  - 2019: 5.0
  - 2020: 4.0
  - 2021: 3.0 (alternate entry: 2.0)
- Effective interest rate (percent): 1.4 (2014), 1.1 (2015), 1.0 (2016), 0.9 (2017), 1.2 (2018), 1.3 (2019), 1.5 (2020), 1.6 (2021).
- Contributions to change in gross public sector debt (percent of GDP) and dynamics summarized; notable sensitivity:
  - A decline in real GDP growth by 5.5 percentage points in FY2017-18 would increase the public debt-to-GDP ratio by 13 percent of GDP by FY2018; the ratio would decline by FY2021 to levels similar to FY2016.
  - Large natural disasters pose material fiscal risk and could worsen public debt dynamics.

### Joint Work and Technical Assistance
- Relations with AsDB:
  - Joined AsDB in December 2003; AsDB approved 6 loans totaling US$69.8 million and six technical assistance projects totaling US$3.8 million.
  - Cumulative disbursements amount to $17.7 million.
  - COBP 2016-2018 priorities: improve public sector effectiveness, facilitate private sector development, deliver safe water and sanitation, improve connectivity.
  - Notable AsDB project: US$25 million for North Pacific Regional Connectivity Investment Project (submarine fiber-optic cable).
- PFTAC engagement:
  - Palau was a heavy user in FY2012–16 with 24 missions; largest concentration in the Revenue Sector.
  - Achievements: revenue compliance strategies, strengthened bank supervision, improved national accounts and balance of payments methodologies, support for medium-term budgeting.
  - Ongoing PFTAC priorities: strengthen revenue administration, improve PFM, continue financial sector supervision strengthening, develop macroeconomic statistics.
- Statistics:
  - Improvements noted; further capacity building and reporting frequency increases needed.
- Authorities’ statement (September 9, 2016) — views and policy intentions:
  - Authorities largely agree with staff views; committed to building buffers, addressing structural impediments, prudent macroeconomic policies, scaling up infrastructure, implementing comprehensive tourism strategy, and ensuring fiscal self-sufficiency after Compact grant expiration.

*Source: IMF staff report excerpt — "1. Real Sector Developments" and associated appendices from the provided IMF chapter PDF.*

### 1.  Real Sector Developments ____________________________________________________________________ 15

### 1.  Real Sector Developments ____________________________________________________________________ 15

### Context
- Palau is a middle-income micro state in the Pacific that relies heavily on tourism and grants, and is exposed to natural disasters and climate change.
- Recent shocks and institutional context:
  - Severe drought early in the year associated with El Niño led to water rationing and a state of emergency in March and April (Appendix I).
  - Political system: U.S. model, presidential term four-year; next elections in November 2016.
  - Environmental initiatives: world's first shark sanctuary (2009) and the world’s largest marine sanctuary (2015) (Appendix II).
  - Legal tender: U.S. dollar. Fiscal year ends in September.

- Compact of Free Association with the United States:
  - Original 50-year Compact (1994–2009) included US$580 million in financial aid and an initial Compact Trust Fund (CTF) investment of US$70 million, intended to provide US$5 million in FY1999–09 and US$15 million in FY2010–44.
  - New assistance agreed in 2010 (not ratified by U.S. Congress) included US$30 million for the CTF, US$122 million in current grants, and US$67 million for infrastructure.
  - Projections in the report assume ratification in FY2017, with funds evenly disbursed during FY2018–24.
  - Post-FY2024: Compact grants expire; projections assume continued US$15 million CTF withdrawals until exhaustion of the CTF.

- FY2014–15 policy context:
  - Economic policies broadly in line with past IMF advice (Appendix III).
  - Fiscal position improved via spending restraint; a tax reform bill sent to Congress in FY2014 remains pending.
  - Upgrades to basic infrastructure and internet connectivity underway.
  - Efforts to expand financial supervision to the National Development Bank of Palau and other non-bank financial institutions are underway.

### Current developments, outlook, and risks

- Growth (FY2015–medium term):
  - FY2015: real economy growth of 9.4 percent driven by tourist arrivals and construction; tourist arrivals expanded by 35 percent.
  - FY2016: projected growth of zero due to lower tourist arrivals and modest drought impact.
  - FY2017: projected growth of 5 percent as tourism recovers and construction picks up.
  - Medium term: growth projected to gradually moderate to 2 percent as hotel developments are restricted until infrastructure is upgraded.
  - Constraints from rapid FY2015 tourism boom: strain on water, sanitation, waste disposal; tilt toward low budget tourists; rise in low quality hotels; environmental risks (Appendix IV).
  - Authorities limited number of charter flights; tourist arrivals slowed in FY2016.

- Inflation and credit:
  - Inflation: fell to 2.2 percent in FY2015; expected at 2 percent in FY2016–17.
  - Banking: domestic loans fell by 2.5 percent in FY2015; loan-to-deposit ratio declined to 13 percent.
  - Banks invest most assets abroad despite rapid rise in deposits.
  - Contributing factors to low domestic lending: ceiling on lending rates for commercial loans; lack of business plans and financial statements for SMEs.

- External stability:
  - Current account deficit: shrank from 12 percent of GDP in FY2014 to 0.5 percent of GDP in FY2015, mainly due to a fall in fuel imports by 10 percent of GDP; lower food imports and higher tourism receipts also contributed.
  - FY2016–18: current account deficit expected to rise to 7 percent of GDP due to higher imports related to fiber optic cable and sanitation projects financed with AsDB loans.
  - Medium term: projected to stabilize at 5.5 percent of GDP due to higher commodity prices and infrastructure-related imports financed with Compact grants.
  - Deficits expected to be fully financed with capital grants and FDI inflows.

- Risks (Appendix V):
  - Substantial downside risks from high reliance on tourism, grants, and commodity imports.
  - Specific risks: U.S. dollar appreciation; slowdown in key trading partners; natural disasters; higher commodity prices; further delays in ratifying the Compact agreement; sustained influx of low budget tourists and proliferation of low quality hotels.
  - Policy tool limitation: absence of independent monetary and exchange rate policies; primary policy instruments are fiscal and structural.

- Authorities’ views on outlook and policies:
  - Authorities agree with staff’s assessment and prioritize sustainable growth consistent with environmental protection and positioning Palau as a high-end tourism destination.
  - FY2015 surge in arrivals viewed as excessive—strained infrastructure and shifted toward low budget package tourists.
  - Policy responses: limits on charter flights and restrictions on hotel developments until infrastructure upgraded.
  - Airport departure tax: increase from US$50 to US$100 per tourist effective April 1, 2017 intended to replace lost fishing license revenue and may discourage low budget tourists; authorities expect limited impact on arrivals.

### Key policy issues

- Overarching priorities:
  - Achieve selected SDGs prioritized by authorities: (i) SDG #8 Promoting sustained, inclusive and sustainable economic growth; (ii) SDG #9 Building resilient infrastructure; (iii) SDG #13 Combating climate change and its impacts; (iv) SDG #14 Conserving the ocean and marine resources for sustainable development.
  - Key policy priorities: ensuring fiscal sustainability, raising potential growth and enhancing resilience, preserving financial stability and facilitating credit extension.

A. Ensuring Fiscal Sustainability

- Recent fiscal developments and stock positions:
  - Current fiscal deficit (expense less domestic revenue) fell from 11 percent of GDP in FY2014 to 5.5 percent of GDP in FY2015.
  - Tax revenue rose by 1 percent of GDP due to higher receipts from the airport departure tax amid soaring tourist arrivals.
  - Expense declined by 4.5 percent of GDP due to spending restraint.
  - Overall balance rose by 1.5 percent of GDP due to a drop in grants.
  - CTF reached 64 percent of GDP in FY2015.
  - Government deposits rose to 8.1 percent of GDP.
  - Domestic accounts payable fell to 5.4 percent of GDP.
  - Government external debt declined to 10.4 percent of GDP.

- Medium-term fiscal outlook (baseline assumptions):
  - Current fiscal deficit path:
    - FY2015: 5.5 percent of GDP.
    - FY2016: expected to stay at 5.5 percent of GDP as fall in tourism revenue is offset by spending restraint.
    - FY2018: projected to fall to 4 percent of GDP.
    - From FY2018 onwards: current fiscal deficit expected to remain at 4 percent of GDP.
  - Airport departure tax increase (US$50 to US$100 per tourist from April 1, 2017):
    - Estimated to raise 2.4 percent of GDP in revenue.
    - Half of this (1.2 percent of GDP) reserved for the Civil Service Pension Fund (CSPF) and not reflected in government accounts.
    - Government revenue rise: 1.2 percent of GDP (0.6 percent in FY2017 and 0.6 percent in FY2018).
    - Expense rise: 1.2 percent of GDP (the extra revenue is reserved for state governments and marine sanctuary), with no impact on the current fiscal balance.
  - Public investment: limited to that financed with capital grants and AsDB loans.
  - Overall fiscal balance: temporarily moves into deficit due to higher capital spending funded with AsDB loans, then returns to surplus as current fiscal deficits decline and Compact grants rise.

- Long-term fiscal outlook (baseline):
  - Current fiscal deficit: expected to remain at 4 percent of GDP from FY2018 onwards.
  - Capital spending in FY2019–24 set by capital grants and AsDB loans.
  - Overall fiscal balance: stays in surplus as current grants exceed current fiscal deficit.
  - Government net worth definition: CTF plus government deposits, less domestic accounts payable, government external debt, and CSPF’s unfunded liabilities.
  - Government net worth trajectory:
    - FY2015: 48 percent of GDP.
    - FY2024: rises to 59 percent of GDP under baseline as some FY2018–24 windfall is saved and other government assets net increase to 8.5 percent of GDP.
  - CTF trajectory: would fall to 51 percent of GDP in FY2014 due to larger withdrawals under the renewed Compact agreement.
  - Staff analysis: current fiscal deficit can be sustained at 4 percent of GDP post-FY2024 provided public investment is capped at 5.6 percent of GDP (Appendix VI).
  - Overall fiscal balance falls after FY2024 as Compact grants expire, but government net worth stabilizes at 59 percent of GDP.

- Staff reform recommendations (strengthening fiscal framework and ensuring long-term sustainability):
  - Fiscal anchor and operational target:
    - Recommend targeting a net worth position of the public sector as the fiscal anchor.
    - Use the current fiscal balance as the operational target.
  - Rationale: targeting net worth ensures fiscal self-sufficiency when Compact grants expire in FY2024 by building sufficient non-CTF government assets to offset decline in CTF.
  - Fiscal adjustment and composition:
    - Recommend further fiscal adjustment in the medium term and shift public expenditure composition toward investment to support tourism and enhance resilience.
    - Baseline public investment: 6.2 percent of GDP in FY2019–24 and 5.6 percent of GDP after FY2024.
    - Historical public investment average: 8.3 percent of GDP.
    - Pacific islands comparator: 11 percent of GDP.
    - Staff target: government net worth of 70 percent of GDP after FY2024 (11 percentage points above baseline).
    - Staff proposes cutting the current fiscal deficit to 1 percent of GDP by FY2020.
    - Expected effects: real GDP growth to fall in FY2017–18 due to fiscal consolidation, then increase in FY2019–21 as higher public investment offsets consolidation; after FY2020, growth projected to increase by about 1 percentage point in line with higher public investment.
  - Fiscal measures and distribution:
    - Support replacing the gross revenue tax (GRT) with a single rate value added tax (VAT) with no exemptions.
    - Raise the net income tax on financial institutions and all VAT-registered businesses.
    - Strengthen tax compliance and use a bidding mechanism to manage charter flights instead of quantitative limits.
    - Contain expenditures by prioritizing spending and gradually eliminating subsidies.
    - Split fiscal adjustment equally between revenue and expenditure measures.
    - Quantified potential yields and savings:
      - VAT and net income tax reforms could yield 1.5 percent of GDP in additional revenue by FY2020.
      - Wage bill reduction could yield 1 percent of GDP.
      - Reduction of government subsidies could yield 0.5 percent of GDP.

- Strengthening public financial management (PFM) and debt sustainability:
  - PFM reforms recommended: sound public debt management, project administration, prioritizing infrastructure that supports tourism and resilience, adopting a medium-term budget framework, improving budget execution and planning, strengthening cash management.
  - Public debt assessment:
    - Staff analysis shows public debt remains sustainable despite recent AsDB loans by US$52 million to finance Koror-Arai waste management upgrade and the submarine fiber optic cable (Appendix VII).
    - Public debt is highly sensitive to a real GDP growth shock, such as large natural disasters.
  - Project prioritization: emphasize infrastructure supporting tourism growth and resilience to natural disasters and climate change.

- Reforming public entities:
  - Civil Service Pension Fund (CSPF):
    - Estimated unfunded liabilities of 8.3 percent of GDP even after extra revenue from airport departure tax.
    - Staff recommends reducing benefits and raising contributions to ensure long-term sustainability.
  - Palau Public Utility Corporation (PPUC):
    - Relies on government subsidies for water services.
    - Staff advises raising tariffs and lowering operational costs to ensure full cost recovery while protecting vulnerable groups.
  - Palau National Communications Corporation and Belau Submarine Cable Corporation:
    - Able to cover costs with own revenue without government support.

- Authorities’ stance on fiscal recommendations:
  - Authorities welcomed staff recommendations to strengthen fiscal framework and long-term fiscal sustainability analysis.
  - Authorities’ policy objective: self-finance expense with domestic revenue (zero current fiscal balance) by FY2024.
  - Support replacing GRT with VAT; VAT bill sent to Congress in FY2014 remains unapproved.
  - A bill shifting CSPF from defined-benefit to defined-contribution system was sent to Congress in FY2014 but not yet approved; authorities expect new airport departure tax revenues to finance benefits during the transition.
  - Authorities aim to make PPUC self-sufficient via higher tariffs and cost reductions, but note service quality must improve in line with planned water system upgrades before tariffs can be raised.

*Source: IMF staff report excerpt — "1.  Real Sector Developments" from the provided IMF chapter PDF.*

### 19.      Context. Palau faces several structural constraints common to small island states: a narrow

### 19. Context. Palau faces several structural constraints common to small island states: a narrow

### Structural context and business climate
- Palau faces: a narrow economic base, remote location, small population, inadequate infrastructure, weak business climate, and exposure to natural disasters and climate change.
- The 2016 World Bank’s Doing Business Report identifies weaknesses in: resolving insolvency, trading across borders, enforcing contracts, paying taxes, getting electricity, and access to credit.
- Doing Business 2016: Detailed Ranking noted for Palau: Palau (136) among 189 economies (ranking from 1 (best) to 189 (worst)).

### Tourism: current state and sustainable development
- Tourism is Palau’s main growth engine but lacks a comprehensive tourism policy and weak regulation has led to excessive growth of the low budget segment.
- Staff recommendations:
  - Implement a comprehensive tourism strategy that: clearly outlines land zoning rules, protects the environment, regulates service quality, has adequate infrastructure planning, and improves the skills of the labor force.
  - Avoid new tourism developments in Koror until infrastructure has been upgraded; allow developments outside Koror and green tourism to continue.
  - Strengthen the regulatory environment to enhance scrutiny and enforcement.
  - Improve coordination among national and state governments to ensure effective implementation.
- Authorities’ views:
  - Authorities concurred with the need for a comprehensive tourism strategy and noted the bureau of tourism is preparing a plan.
  - Agreed to avoid new hotel developments in Koror until infrastructure upgraded, but are open to high-end hotels that build own treatment plants.
  - Highlighted a new Japan-financed grants project to upgrade the water pipeline in Koror and are evaluating alternatives to broaden water sources.

### Diversification
- Rationale: Economic diversification would reduce volatility and broaden sources of growth.
- Staff recommendations:
  - Promote tourism from new destinations, including growing Asian markets.
  - Develop domestic business activities supplying tourism (agriculture and aquaculture).
  - Promote tourism activities that increase tourist spending.

### Improving the business environment
- Current practice: Foreign investment approvals decided by a Foreign Investment Board on a case-by-case basis.
- Staff recommendations:
  - Adopt a new foreign investment regime to simplify approvals and open all business to foreign investment through joint ventures, subject to proper regulations.
  - Support the Economic Advisory Group’s role in coordinating public–private dialogue to improve policy formulation and planning.

### Infrastructure constraints and resilience
- Recent tourism surge strained water supply, sanitation, waste disposal, and poor internet quality has been a main visitor dissatisfaction in exit surveys.
- Ongoing projects funded by AsDB loans and grants aim to ease some bottlenecks.
- Staff recommendations:
  - Incorporate infrastructure planning in a broader tourism strategy.
  - Increase resilience to natural disasters and climate change when building new infrastructure.
  - Priorities: limit developments in areas at risk of tropical storms and rising sea levels; improve the water system.
- Authorities’ plans:
  - Upgrade the water pipeline system in Koror to reduce leakages and make distribution more efficient; evaluating alternatives to broaden water sources following a recent drought.

### Financial sector stability and credit extension
- Banking sector soundness indicators:
  - Nonperforming loans at 2.1 percent.
  - Liquid assets at 90 percent.
  - Return on assets at 1.4 percent.
- Market structure:
  - Three foreign owned U.S. FDIC-insured banks hold 93 percent of the loans and 99 percent of the deposits.
- Issues:
  - Banks lend little domestically despite rapid rise in deposits; domestic loans have fallen as percent of deposits and as percent of GDP.
  - NDBP legislation passed to take deposits; once licensed, NDBP will be regulated by the Financial Institutions Commission (FIC) and subject to the same regulations as commercial banks.
  - Correspondent banking loss not an issue due to the three foreign owned U.S. FDIC insured banks handling international transactions.
  - Anti-money laundering investigations have improved with enhanced role of the Financial Intelligence Unit (FIU).
- Staff recommendations to preserve stability and facilitate credit:
  - Broaden FIC supervision to all non-bank financial institutions, including credit unions.
  - Encourage legislators to approve the Credit Union Act to put credit unions under FIC supervision.
  - Put the NDBP under FIC supervision, allow it to take deposits and expand lending.
  - Continue improving the AML/CFT regime in line with the FATF standard.
  - Relax the interest rate ceiling for commercial loans to better reflect riskiness.
  - Help SMEs prepare business plans and financial statements.
  - Use NDBP to help fill financing gap for SMEs, especially in agriculture, once it can take deposits.
- Authorities’ views:
  - Agreed banks remain sound; deposits have increased rapidly and banks invest much of assets abroad.
  - Observed increase in number of individual loans but a fall in total loan stock due to repayment of some large commercial loans.
  - Not convinced interest rate ceiling is the key constraint to credit growth; cite lack of business plans for SMEs as more important.
  - Expect NDBP to help close financing gap for SMEs once licensed, noting it may take a few years to satisfy FIC requirements.
  - Welcomed broadening FIC supervision and staff support for the Credit Union Act.

### Statistics
- Palau’s statistics broadly adequate for surveillance due to technical assistance from IMF PFTAC and the Graduate School USA.
- Staff recommendations: improve tourism statistics and strengthen the statistics office to continue improving data quality.

### External sector assessment
- Real effective exchange rate appreciated by 22 percent between FY2011 and FY2015, in line with U.S. dollar strengthening.
- Current account deficit has fallen reflecting lower commodity prices and strong tourism receipts.
- Near-term outlook: U.S. dollar expected to strengthen further as the Fed rises policy rates; current account deficit projected to increase somewhat due to higher commodity prices and infrastructure-related imports.
- Financing: Deficits expected to remain fully covered by FDI inflows and capital grants; external sector broadly in equilibrium.
- Vulnerabilities: heavy reliance on tourists from a few countries; infrastructure and investment climate weaknesses could hinder tourism development.
- Currency regime: Use of the U.S. dollar as legal tender remains appropriate as a nominal anchor.
- Reserves and government deposits:
  - Government deposits in FY2015 stood at 8.1 percent of GDP or 2.7 months of government spending.
  - Projected to increase to about 6 months of spending by FY2021.
- Staff notes data gaps impede a more robust external sector assessment based on IMF EBA/EBA-Lite models.

### Staff appraisal and policy recommendations (summary)
- Recent performance and outlook:
  - Real GDP growth robust; inflation low and stable; external and fiscal positions improved.
  - Outlook: growth temporarily declining to zero in FY2016 due to lower tourist arrivals, but rebounding to 5 percent in FY2017–18 as tourism recovers and construction picks up.
  - Inflation expected to remain low; current account deficit to rise due to infrastructure imports; fiscal position to improve with spending restraint.
- Downside risks:
  - Further U.S. dollar appreciation, slowdown in key trading partners, natural disasters, higher commodity prices, and environmental degradation from mass tourism.
- Fiscal policy recommendations:
  - Strengthen fiscal framework by targeting public sector net worth as fiscal anchor and using the current fiscal balance as an operational target to ensure fiscal self-sufficiency when Compact grants expire in FY2024.
  - Further fiscal adjustment needed over the medium term relying on both revenue and expenditure measures; shift government expenditure composition toward infrastructure investment.
  - Reform fiscal institutions and public entities: strengthen public financial management, sound public debt management, project administration, reform the CSPF to eliminate unfunded liabilities, and restructure PPUC to ensure full cost recovery and reduce government subsidies.
- Tourism and diversification:
  - Implement a comprehensive tourism strategy, avoid new hotel developments until infrastructure upgraded, improve regulatory environment, strengthen coordination among national and state governments.
  - Promote high-end tourism from new destinations (including growing Asian markets), develop agriculture and aquaculture supply to tourism, and stimulate activities that increase tourist spending.
- Business climate and financial sector:
  - Adopt a new foreign investment regime to simplify approvals and open all business activities to foreign investment through joint ventures.
  - Broaden FIC supervision to credit unions and non-bank institutions, relax interest rate ceilings for commercial loans, help SMEs with business plans and financial statements, and allow NDBP to expand lending once licensed.

*Source: IMF staff report.*

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

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

### Real sector developments
- The economy grew strongly in FY15 led by robust tourism and construction activity.
- Tourist arrivals: 125,674 (2013/14); 168,767 (2014/15); 148,515 (2015/16); projections: 158,911 (2016/17), 166,857 (2017/18), 173,531 (2018/19), 178,737 (2019/20), 184,099 (2020/21).
- Real GDP growth (percent change): 4.2 (2013/14); 9.4 (2014/15); 0.0 (2015/16); projections: 5.0 (2016/17), 5.0 (2017/18), 4.0 (2018/19), 3.0 (2019/20), 2.0 (2020/21).
- GDP deflator (percent change): 5.2 (2013/14); 4.7 (2014/15); 3.0 (2015/16); 2.5 (2016/17); 2.0 (2017/18); 2.0 (2018/19); 2.0 (2019/20); 2.0 (2020/21).
- Consumer prices (percent change; period average): 4.0 (2013/14); 2.2 (2014/15); 2.0 (2015/16); 2.0 (2016/17); 2.0 (2017/18); 2.0 (2018/19); 2.0 (2019/20); 2.0 (2020/21).
- Tourism activity boomed due to the rapid rise in tourists from China; tourists from other countries declined.
- Tourist arrivals growth in Palau has been faster than in other Pacific islands, but arrivals are volatile, producing higher GDP growth volatility than peers.
- Banks continue to lend little domestically, investing most of their increased assets abroad.

### Tourism sector developments
- The share of Chinese tourists on total tourist arrivals increased significantly since 2010: composition snapshots—2010: Japan 35%, South Korea 17%, Taiwan, Province of China 27%, China 1%, USA/Canada 9%, Europe 5%, Others 6%; 2015: Japan 19%, South Korea 7%, Taiwan, Province of China 9%, China 54%, USA/Canada 5%, Europe 3%, Others 3%.
- Total revenue per tourist arrival slowed to US$912 from US1,045 in 2013-14.
- Slower growth in visitor nights in high-end A Grade hotels; sharp increase in occupancy rates of lower-grade hotels.
- Chinese tourists spend less in accommodation than Japanese and Taiwanese tourists.
- Resulted in lower increases in gross revenue tax (GRT) and hotel tax collections than in the airport departure tax and entry fees to the main touristic attractions.

### External sector developments
- Palau’s imports fell due to lower food and fuel prices despite the increase in tourist arrivals.
- The fall in food and fuel prices led to a sharp reduction in the current account deficit.
- Palau’s current account deficit is now lower than in other Pacific islands, partly due to growing service exports.
- Palau’s real exchange rate increased by over 20 percent in the last two years.
- Current account balance is expected to worsen in FY16-18 due to infrastructure related imports financed with AsDB loans; these loans would temporarily increase public external debt, but debt would remain lower than in other Pacific island countries.

### Fiscal sector developments
- Nominal GDP for FY2015: US$287 million.
- Population (2015): 17,885.
- GDP per capita for FY2015: US$16,070.
- Quota: SDR 3.1 million.
- Palau’s domestic revenues have been increasing rapidly in recent years supported by the buoyant economy.
- Expense has been declining, especially the wage bill, amid expenditure restraint; however, Palau’s wage bill remains above that of other Pacific islands, especially as a ratio to overall expenditure.
- The current and overall fiscal balances increased, particularly in FY2015.
- Fiscal consolidation is expected to continue, although at a slower pace; the government is expected to keep increasing its deposits to fund expenditure after FY2024.

### Selected fiscal and macro figures (from Tables)
- Central government: Revenue (percent of GDP) 43.3 (2013/14); 40.6 (2014/15); 39.6 (2015/16); projections: 41.8 (2016/17), 40.8 (2017/18), 40.3 (2018/19), 39.8 (2019/20), 39.4 (2020/21).
- Taxes and other revenue (percent of GDP): 24.4 (2013/14); 25.4 (2014/15); 24.8 (2015/16); projections: 25.5 (2016/17), 26.1 (2017/18), 26.0 (2018/19), 25.9 (2019/20), 25.8 (2020/21).
- Grants (percent of GDP): 18.9 (2013/14); 15.3 (2014/15); 14.8 (2015/16); projections: 16.3 (2016/17), 14.8 (2017/18), 14.4 (2018/19), 13.9 (2019/20), 13.6 (2020/21).
- Expenditure (percent of GDP): 39.8 (2013/14); 35.6 (2014/15); 41.6 (2015/16); projections: 42.7 (2016/17), 39.6 (2017/18), 36.7 (2018/19), 36.5 (2019/20), 36.0 (2020/21).
- Expense (percent of GDP): 35.4 (2013/14); 30.9 (2014/15); 30.3 (2015/16); projections: 30.2 (2016/17), 30.1 (2017/18), 30.0 (2018/19), 29.9 (2019/20), 29.9 (2020/21).
- Net acquisition of nonfinancial assets (percent of GDP): 4.4 (2013/14); 4.7 (2014/15); 11.3 (2015/16); projections: 12.5 (2016/17), 9.5 (2017/18), 6.7 (2018/19), 6.5 (2019/20), 6.1 (2020/21).
- Current fiscal balance (excluding grants, percent of GDP): -11.0 (2013/14); -5.5 (2014/15); -5.5 (2015/16); projections: -4.7 (2016/17), -4.0 (2017/18), -4.0 (2018/19), -4.0 (2019/20), -4.0 (2020/21).
- Net lending (+)/borrowing (–) (percent of GDP): 3.5 (2013/14); 5.0 (2014/15); -2.0 (2015/16); projections: -0.9 (2016/17), 1.2 (2017/18), 3.5 (2018/19), 3.3 (2019/20), 3.4 (2020/21).
- Compact Trust Fund (CTF) balance (in millions of U.S. dollars): 199.2 (2013/14); 183.9 (2014/15); 188.9 (2015/16); projections: 194.2 (2016/17), 201.8 (2017/18), 208.9 (2018/19), 215.9 (2019/20), 222.8 (2020/21).
- Government cash and deposits (in millions of U.S. dollars): 9.6 (2013/14); 23.4 (2014/15); 30.6 (2015/16); projections: 39.1 (2016/17), 44.7 (2017/18), 52.8 (2018/19), 63.0 (2019/20), 72.8 (2020/21). In percent of GDP: 3.8, 8.1, 10.4, 12.3, 13.1, 14.6, 16.6, 18.4 respectively.
- Trade balance (in millions of U.S. dollars): -158.2 (2013/14); -142.4 (2014/15); -148.4 (2015/16); projections: -164.8 (2016/17), -176.1 (2017/18), -177.0 (2018/19), -180.8 (2019/20), -184.6 (2020/21).
- Tourism receipts (in millions of U.S. dollars): 129.3 (2013/14); 150.4 (2014/15); 139.0 (2015/16); projections: 153.2 (2016/17), 163.2 (2017/18), 172.3 (2018/19), 180.1 (2019/20), 188.3 (2020/21).
- Current account balance (including grants, in percent of GDP): -11.8 (2013/14); -0.5 (2014/15); -5.3 (2015/16); projections: -7.0 (2016/17), -8.3 (2017/18), -6.3 (2018/19), -5.6 (2019/20), -4.9 (2020/21).
- Current account balance (excluding grants, in percent of GDP): -29.7 (2013/14); -14.7 (2014/15); -19.0 (2015/16); projections: -19.5 (2016/17), -19.4 (2017/18), -16.7 (2018/19), -15.3 (2019/20), -14.1 (2020/21).
- Public external debt (percent of GDP): 26.7 (2013/14); 22.0 (2014/15); 26.1 (2015/16); projections: 28.2 (2016/17), 27.1 (2017/18), 24.6 (2018/19), 22.0 (2019/20), 19.7 (2020/21).
- External debt (in percent of exports of goods and services): 41.2 (2013/14); 35.2 (2014/15); 47.1 (2015/16); projections: 49.5 (2016/17), 47.8 (2017/18), 43.4 (2018/19), 39.1 (2019/20), 34.9 (2020/21).

### Medium-term outlook and reform scenario
- Baseline scenario real GDP growth (percent change): 4.2 (2013/14); 9.4 (2014/15); 0.0 (2015/16); projections: 5.0 (2016/17), 5.0 (2017/18), 4.0 (2018/19), 3.0 (2019/20), 2.0 (2020/21).
- Staff’s reform scenario: assumes the current fiscal deficit is reduced by 1.1 percent of GDP each year during FY2017-20 to 1 percent of GDP in FY2020, achieved by raising taxes and cutting current expenditure; additional savings used to increase public investment to 8.3 percent of GDP from FY2019 onwards.
- Under the reform scenario: Taxes and other revenue (percent of GDP) projected to reach 27.6 (2019/20) and 27.5 (2020/21); Expense (percent of GDP) projected 29.4 (2018/19), 28.6 (2019/20), 28.6 (2020/21); Net lending (+)/borrowing (–) projected 4.6 (2018/19), 4.2 (2019/20).
- Reform scenario real GDP growth (percent change): 4.2 (2016/17), 4.8 (2017/18), 4.8 (2018/19), 4.2 (2019/20), 3.3 (2020/21).
- Reform scenario current account balance (including grants, percent of GDP): -6.9 (2016/17), -7.9 (2017/18), -6.0 (2018/19), -5.6 (2019/20), -4.6 (2020/21).

### Balance of payments highlights
- Current account balance (in millions of U.S. dollars): -29.5 (2013/14); -1.5 (2014/15); -15.6 (2015/16); projections: -22.4 (2016/17), -28.3 (2017/18), -22.8 (2018/19), -21.1 (2019/20), -19.3 (2020/21).
- Services balance (in millions of U.S. dollars): 99.0 (2013/14); 114.9 (2014/15); 106.0 (2015/16); projections: 116.0 (2016/17), 123.2 (2017/18), 129.6 (2018/19), 135.1 (2019/20), 140.8 (2020/21).
- Primary income balance (in millions of U.S. dollars): -11.6 (2013/14); -11.1 (2014/15); -12.0 (2015/16); projections: -12.8 (2016/17), -13.9 (2017/18), -14.8 (2018/19), -15.7 (2019/20), -16.6 (2020/21).
- Secondary income balance (in millions of U.S. dollars): 41.2 (2013/14); 37.1 (2014/15); 38.8 (2015/16); projections: 39.2 (2016/17), 38.4 (2017/18), 39.4 (2018/19), 40.2 (2019/20), 41.1 (2020/21).
- Capital account balance (in millions of U.S. dollars): 32.6 (2013/14); 17.2 (2014/15); 18.1 (2015/16); projections: 34.2 (2016/17), 32.7 (2017/18), 33.7 (2018/19), 34.5 (2019/20), 35.2 (2020/21).

### National government operations and balance sheet highlights
- National Government revenue (in millions of U.S. dollars): 108.6 (2014/15); 116.8 (2015/16); projections: 117.2 (2016/17), 133.1 (2017/18), 139.4 (2018/19), 145.8 (2019/20), 151.3 (2020/21), 155.9 (projection year shown).
- Grants (in millions of U.S. dollars): 47.3 (2014/15); 43.8 (2015/16); projections: 43.8 (2016/17), 52.0 (2017/18), 50.4 (2018/19), 51.8 (2019/20), 52.9 (2020/21), 53.6 (projection year shown).
- Expenditure (in millions of U.S. dollars): 99.8 (2014/15); 102.4 (2015/16); projections: 123.3 (2016/17), 136.0 (2017/18), 135.2 (2018/19), 133.0 (2019/20), 138.7 (2020/21), 142.4 (projection year shown).
- Compensation of employees (in millions of U.S. dollars): 37.6 (2014/15); 39.0 (2015/16); projections: 40.0 (2016/17), 42.0 (2017/18), 45.0 (2018/19), 47.7 (2019/20), 50.1 (2020/21), 52.1 (projection year shown).
- Government net worth (assets - liabilities, percent of GDP): -24.0 (2013/14); -15.8 (2014/15); -17.7 (2015/16); projections: -17.9 (2016/17), -16.0 (2017/18), -12.1 (2018/19), -8.6 (2019/20), -5.2 (2020/21).
- Compact Trust Fund (in percent of GDP, memorandum): 79.4 (2013/14); 64.0 (2014/15); 63.8 (2015/16); projections: 61.0 (2016/17), 59.2 (2017/18), 57.7 (2018/19), 56.8 (2019/20), 56.3 (2020/21).

### Deposit money banks (selected)
- Assets (in percent of GDP): 104.7 (2009/10); 113.6 (2010/11); 135.7 (2011/12); 140.4 (2012/13); 175.9 (2013/14); 231.8 (2014/15) [table values presented as millions and labels per source].
- Foreign assets (in percent of GDP or as reported): 73.4 (2009/10); 82.8 (2010/11); 105.3 (2011/12); 106.2 (2012/13); 140.8 (2013/14); 198.0 (2014/15).
- Loans (in percent of GDP): 13.4 (2009/10); 12.8 (2010/11); 11.9 (2011/12); 12.2 (2012/13); 11.8 (2013/14); 10.0 (2014/15).
- Loan/deposit ratio (in percent): 25.6 (2009/10); 24.5 (2010/11); 19.6 (2011/12); 20.6 (2012/13); 17.3 (2013/14); 12.8 (2014/15).

*Source: Republic of Palau—IMF staff report (figures, tables and text as provided).*

### Appendix I. Risks of Natural Disasters

### Appendix I. Risks of Natural Disasters

### Exposure and historical incidence
- The Pacific island countries are among the most exposed to natural disasters (earthquakes, tsunamis, cyclones, droughts, floods).  
- Among 12 Pacific island countries, Palau had:
  - the lowest average number of natural disasters per year during 1960-2014; and
  - the lowest probability of occurrence of natural disasters calculated over 1970-2014.
- The Pacific Catastrophe Risk Assessment and Financing Initiative estimates a 50 percent chance that Palau could experience large losses (US$30 million or 10 percent of GDP) due to natural disasters in the next 50 years.

### The 2016 El Niño drought event (recent shock)
- NOAA report (March 21, 2016) placed Palau in extreme drought level 3 of 4.
- Cumulative rainfall in the previous four months was at the lowest level since 1951.
- The two main sources of water had been declining since late 2015.
- The Ngerimel Dam, which provides 80 percent of water consumption in normal times, was shut down in April.
- Government water restriction: limited water consumption to three hours a day since March 29; restriction lifted on May 9 when weather conditions normalized.
- Government emergency response actions and estimated cost:
  - Importing drinking water and water test kits.
  - Improving water distribution in some areas.
  - Buying medications in case of disease outbreaks.
  - Promoting public awareness.
  - Estimated cost: US$3 million (1 percent of GDP).

### Fiscal buffers and financing capacity
- Government deposits were 8.1 percent of GDP (FY2015).
- Staff assessment: government deposits at 8.1 percent of GDP are insufficient to finance responses to potentially large natural disasters with losses close to 10 percent of GDP as estimated by the Pacific Catastrophe Risk Assessment and Financing Initiative.
- The 2016 drought underscored the need for:
  - fiscal buffers for fast post-disaster response;
  - investment to make infrastructure more resilient to natural disasters and climate change.

### Water security and infrastructure options
- Need to broaden sources of water due to:
  - unpredictable weather conditions from climate change;
  - rapid growth in water demand from expanding tourism.
- Alternative water-supply and resilience measures identified:
  - developing underground water sources;
  - enhancing water storage facilities;
  - using desalination plants for sea water.

### Key findings (bulleted)
- 50 percent chance of large losses (US$30 million or 10 percent of GDP) in next 50 years (Pacific Catastrophe Risk Assessment and Financing Initiative).
- Extreme drought in 2016: NOAA March 21, 2016 report; cumulative rainfall lowest since 1951.
- Ngerimel Dam supplies 80 percent of water in normal times; was shut down in April 2016.
- Water restrictions: three hours a day from March 29; lifted May 9.
- Government emergency response cost: US$3 million (1 percent of GDP).
- Government deposits: 8.1 percent of GDP (insufficient relative to potential 10 percent of GDP disaster losses).

### Policy recommendations (staff advice summarized)
- Build fiscal buffers to enable fast post-disaster response.
- Make infrastructure more resilient to natural disasters and climate change.
- Broaden and diversify water sources (underground sources, increased storage, desalination).
- Ensure sufficient fiscal savings or contingency financing given exposure and the potential scale of disaster losses.

*Source: Appendix I. Risks of Natural Disasters (IMF staff report text).*

### Appendix VII. Public Sector Debt Sustainability Analysis

### Appendix VII. Public Sector Debt Sustainability Analysis

### Summary findings
- Palau’s public debt remains sustainable despite the recent AsDB loans by US$52 million to fund the upgrade of the Koror-Arai waste management system and the submarine fiber optic cable, which will be disbursed gradually during FY2014-20.
- Staff uses a broad definition of public debt: central government external debt, government domestic accounts payable/domestic arrears, and SOEs’ debt (fully guaranteed by the government and treated as a contingent liability).
- Staff’s baseline scenario projects public debt will fall from 27.3 percent of GDP in FY2015 to below 20 percent in FY2021, driven mainly by large primary surpluses during FY2018-21 and a positive growth-interest rate differential.
- Palau does not have access to private foreign capital markets; all external debt is from international organizations for specific projects.
- Baseline projections assume no new foreign loans by the central government or SOEs during FY2016-21; debt declines with amortization of past loans.
- Central government debt stock increases temporarily during FY2016-18 due to AsDB loan disbursements, then declines.
- Primary surpluses and growth-interest rate flows in FY2016-21 are projected to be sufficient to fully repay domestic arrears and build government deposits; if insufficient, public debt could rise through larger domestic arrears as occurred during the global financial crisis.

### Baseline projections and key statistics (percent of GDP unless otherwise indicated)
- Public debt (nominal gross public debt):  
  - 2014: 43.1  
  - 2015: 34.0  
  - 2016: 27.3  
  - 2017: 30.1  
  - 2018: 30.7  
  - 2019: 28.3  
  - 2020: 24.6  
  - 2021: 22.0  
  - 2021 (alternate entry): 19.7
- Of which: guarantees:  
  - 2014: 21.1  
  - 2015: 14.4  
  - 2016: 11.6  
  - 2017: 10.3  
  - 2018: 8.8  
  - 2019: 7.4  
  - 2020: 6.2  
  - 2021: 5.1  
  - 2021 (alternate entry): 4.4
- Public gross financing needs: 0.8, -2.7, -4.3, 2.8, 1.7, 0.5, -2.7, -2.2, -2.4 (years corresponding to 2014–2021)
- Real GDP growth (in percent):  
  - 2014: -0.8  
  - 2015: 4.2  
  - 2016: 9.4  
  - 2017: 0.0  
  - 2018: 5.0  
  - 2019: 5.0  
  - 2020: 4.0  
  - 2021: 3.0  
  - 2021 (alternate entry): 2.0
- Inflation (GDP deflator, in percent): 4.0, 5.3, 4.7, 3.0, 2.5, 2.0, 2.0, 2.0, 2.0 (2014–2021)
- Nominal GDP growth (in percent): 3.1, 9.8, 14.6, 3.0, 7.6, 7.1, 6.1, 5.1, 4.0 (2014–2021)
- Effective interest rate (in percent) (defined as interest payments divided by debt stock, excluding guarantees, at end of previous year): 1.4, 1.1, 1.0, 0.9, 1.2, 1.3, 1.5, 1.6, 1.6 (2014–2021)

### Contributions to change in gross public sector debt (in percent of GDP)
- Change in gross public sector debt (yearly): -0.7, -3.9, -6.6, 2.7, 0.6, -2.4, -3.7, -2.6, -2.3 (2014–2021) — cumulative: -7.7
- Identified debt-creating flows (yearly): -0.5, -5.4, -4.4, 3.8, 1.6, -1.4, -2.7, -1.6, -1.6 — cumulative: -1.9
- Primary deficit (yearly): -0.2, -3.7, -5.2, 1.9, 0.8, -1.4, -3.7, -3.5, -3.5 — cumulative: -9.4
- Primary (noninterest) revenue (percent of GDP): 44.0, 43.3, 40.6, 39.6, 41.8, 40.8, 40.3, 39.8, 39.4 — cumulative: 241.7
- Primary (noninterest) expenditure (percent of GDP): 43.9, 39.6, 35.5, 41.5, 42.6, 39.4, 36.6, 36.3, 35.9 — cumulative: 232.3

### Automatic debt dynamics and other flows
- Automatic debt dynamics (yearly): -0.7, -3.0, -4.0, -0.6, -1.8, -1.7, -1.2, -0.8, -0.5 — cumulative: -6.6
  - Interest rate/growth differential (same as automatic debt dynamics): -0.7, -3.0, -4.0, -0.6, -1.8, -1.7, -1.2, -0.8, -0.5 — cumulative: -6.6
  - Of which: real interest rate contribution: -1.0, -1.5, -1.3, -0.6, -0.4, -0.2, -0.2, -0.1, -0.1 — cumulative: -1.5
  - Of which: real GDP growth contribution: 0.3, -1.5, -2.8, 0.0, -1.4, -1.4, -1.1, -0.7, -0.4 — cumulative: -5.0
- Exchange rate depreciation contribution: 0.0, 0.0, 0.0 (remaining entries not shown)
- Other identified debt-creating flows (yearly): 0.3, 1.3, 4.8, 2.4, 2.7, 1.6, 2.2, 2.7, 2.5 — cumulative: 14.1
  - Drawdown in Government Domestic (yearly): 0.3, 1.3, 4.8, 2.4, 2.7, 1.6, 2.2, 2.7, 2.5 — cumulative: 14.1
  - Contingent liabilities: 0.0 throughout
  - Other debt flows (incl. ESM and Euro): 0.0 throughout
- Residual, including asset changes (yearly): -0.2, 1.4, -2.2, -1.1, -1.0, -1.0, -1.0, -1.0, -0.7 — cumulative: -5.8

### Key assumptions and definitions
- Public sector is defined as central government and includes public guarantees (defined as SOE debt).
- Effective interest rate is defined as interest payments divided by debt stock (excluding guarantees) at the end of previous year.
- Automatic debt dynamics formula: derived as [(r - π(1+g) - g + ae(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and e = nominal exchange rate depreciation.
- Real interest rate contribution derived from numerator in footnote 5 as r - π (1+g); real GDP growth contribution as -g.
- Exchange rate contribution derived from numerator in footnote 5 as ae(1+r).
- Residual includes changes in stock of guarantees, asset changes, and interest revenues (if any). For projections, includes exchange rate changes during the projection period.
- Historical scenario assumption note: assumes key variables (real GDP growth, real interest rate, and other identified debt-creating flows) remain at the level of the last projection year.

### Alternative scenarios and risks
- Historical scenario (GDP growth, real interest rates, and primary balances equal to FY2006–15 averages) yields higher public debt and gross financing needs than the staff baseline.
- A scenario with a constant primary deficit at the projected FY2016 level of 1.9 percent of GDP also yields higher debt-to-GDP ratios and gross financing needs than the baseline.
- Growth shock sensitivity: a decline in real GDP growth by 5.5 percentage points in FY2017-18 would increase the public debt-to-GDP ratio by 13 percent of GDP by FY2018; the debt ratio would decline by FY2021 to levels similar to FY2016.
- Large natural disasters pose material fiscal risk: they could cause growth declines of the magnitude modeled and lead to larger government expenditures for relief and reconstruction, worsening public debt dynamics.

*Source: IMF staff.*

### 3. Joint Work

### 3. Joint Work

### Program / Mutual Update
- Semi-annual mutual update on work program developments and information sharing.  
- Status: Ongoing

### Relations with the Asian Development Bank (AsDB)
- Membership and classification:
  - Joined AsDB in December, 2003 as the sixty-third member country.
  - Classified as an AsDB developing member country in December 2005.
- Approvals and disbursements:
  - AsDB has approved 6 loans totaling US$69.8 million and six technical assistance projects totaling US$3.8 million.
  - Cumulative disbursements to Palau for lending and grants financed by Ordinary Capital Resources (OCR), the Asian Development Fund (ADF), and other special funds amount to $17.7 million.
- COBP 2016-2018 priorities:
  - Provide support to improve public sector effectiveness.
  - Facilitate private sector development.
  - Deliver safe water and sanitation services.
  - Improve connectivity.
- Notable projects and assistance:
  - In December 2015, AsDB approved lending of US$25 million for the North Pacific Regional Connectivity Investment Project to support development of a submarine fiber-optic cable system linking Palau to Guam.
  - AsDB provided technical assistance in 2015 to help generate policy options for tourism development.
  - AsDB assistance helped develop a medium-term budget framework and prepare the Medium-Term Development Strategy.
  - AsDB supported a household income and expenditure survey in 2014.
  - Technical assistance for secured transaction legislation led to a secured transaction registry, improving access to business credit.
  - Support for SOE governance improvements, business registration system improvements, and development of an SOE policy including legislative measures.
  - AsDB assistance for sustainable health care financing in 2013 included cost accounting of all health services.
  - AsDB approved a sewerage network upgrade project in Koror and Arai expected to directly benefit about 70 percent of the population.
- Pipeline and allocations:
  - No lending pipeline for Palau proposed in the COBP, 2016–2018 as the government will focus on project implementation.
  - Proposed allocation of US$500,000 for technical assistance.

### Relations with the Pacific Financial Technical Assistance Centre (PFTAC)
- Utilization and missions:
  - Palau was a heavy user of PFTAC TA in phase IV (FY2012–16) with 24 missions, largest concentration in the Revenue Sector.
- Key achievements in phase IV:
  - Revenue compliance strategies developed.
  - Strengthened bank supervision via adoption of regulations, improved bank reporting, and establishment of an on-site supervision program.
  - Methodologies developed for producing a broader range of national income and balance of payments statistics.
- Strategy 2014–16 and priorities:
  - Guided by the APD regional strategy note; planned within PFTAC Phase IV (FY2012–16) results framework.
  - Aim to support fiscal consolidation and strengthen the financial sector.
  - Priorities: strengthen revenue administration; in close coordination with AsDB, improve public financial management (PFM); continue strengthening financial sector supervision; develop macroeconomic statistics via annual sub-regional workshops.
- PFM and budgeting:
  - Focus on supporting AsDB’s medium-term budgeting project.
  - PFTAC assisted Palau to undertake a PEFA Self-Assessment in 2013.
  - Palauan officials have attended PFTAC PFM workshops including Medium-term Expenditure Forecasting (November 2015) and Social Security Finance Reform (April 2017).
- Tax policy and revenue administration:
  - Anticipated reforms including VAT have not materialized due to the Senate Ways and Means Committee unable to secure a majority vote.
  - PFTAC recommendations accepted, producing:
    - A new strategic and business plan for the next three years.
    - Ministerial approval to implement a new function based organizational structure.
  - Budget clearance for additional resourcing is underway and new staff position descriptions are being negotiated with the Bureau of Public Service System.
- Financial sector supervision:
  - Prudential returns implemented.
  - Palau is in line for integration of the Financial Sector Information System (FSIS) in late 2014.
  - In June 2016, the Commission hosted the annual meeting of the Association of Financial Supervisors of Pacific Countries (PFTAC is the secretariat).
  - Continued capacity building in risk-based banking supervision, including workshops for management.
- Macroeconomic statistics and analysis:
  - PFTAC will provide TA for GDP estimates by expenditure and capacity building in national accounts statistics (RBM code 4.1).
  - IMF HQ to provide resources for better current and capital accounts of the balance of payments (RBM codes 4.6-4.8) and government finance statistics.
  - TA to develop revenue forecasting methodology focused on planned tax reform measures.
  - TA to develop capacity to assess alternative fiscal consolidation options for preserving fiscal/debt sustainability when the Compact grants expire in FY2024.

### Statistical Issues
- General assessment:
  - Palau’s statistics have improved and are now broadly adequate for surveillance.
  - Office of Planning and Statistics (OPS) compiles and publishes macroeconomic data at an annual frequency.
  - The 2012-14 Palau Statistical Yearbooks published comprehensive data on macroeconomic indicators and other areas; published on Palau’s website.
  - Further improvements needed: broaden coverage and increase reporting frequency, particularly for fiscal and external sector data.
  - OPS still relies heavily on external consultants and TA; further capacity and TA needed to improve quality and timeliness.
- National accounts:
  - Since 2012, GDP estimates by production have been compiled and published; methodology has improved.
  - Further improvement needed: incorporate recent business surveys and compile GDP estimates by expenditure.
- Price statistics:
  - Consumer Price Index regularly published on a quarterly basis on Palau’s website.
- Government Finance Statistics (GFS):
  - Fiscal data compiled using GFSM2001 and published in the 2012-14 Yearbooks.
  - Improvements needed: broaden coverage beyond central government and improve frequency and timeliness, including audited accounts.
  - New staff recruited to compile GFS and participate in regional training and remote TA from STA.
  - Annual GFS data have not been reported to STA.
- Monetary and Financial Statistics (MFS):
  - Monetary survey unavailable since there is no central bank.
  - MFS TA could assist in developing standardized report forms for depository corporations and strengthening data reporting.
- Financial sector surveillance:
  - Banks have submitted quarterly financial statements to the Financial Institutions Commission (FIC) since 2009.
  - FIC publishes financial soundness indicators (FSIs) and balance sheet data on a quarterly basis; FSIs exclude the National Development Bank of Palau, which remains outside FIC supervision.
- External sector statistics:
  - Balance of payments and international investment position reported according to BPM6 and published in the 2012-14 Yearbooks.
  - Business Enterprise Survey, Hotel Accommodation Survey, and Tourist Expenditure Survey expected to improve tourism-related data.
  - Financial accounts improvements have reduced errors and omissions.
- Data dissemination:
  - Palau began participating in the General Data Dissemination System in August 2013.
  - No data ROSC available.

### Statement by Barry Sterland and Ronald Cafrine (September 9, 2016) — Authorities’ Views and Policy Intentions

- General:
  - Authorities largely agree with staff views in the 2016 Article IV report and appreciate IMF technical assistance including PFTAC.
  - Palau is a small middle-income island state with a narrow production base and heavy reliance on tourism and grants; economy vulnerable to natural disasters and external shocks.
  - Authorities determined to build adequate buffers against downside risks, address structural impediments to growth, and maintain prudent macroeconomic policies.
  - Authorities value continued international assistance, noting U.S. Compact of Free Association support.
- Economic Development and Outlook:
  - Economy expanded by close to 9½ percent in 2015 driven by a massive increase in tourist arrivals and significant expansion in construction activity.
  - Rapid tourist increase concentrated in Koror State strained infrastructure and raised sustainability and environmental concerns.
  - Short-term measures announced:
    - Limit number of charter flights.
    - Impose restrictions on new hotel developments in Koror State unless developments meet environment and infrastructure standards (including own water, sewerage, and electricity).
    - Tourism investments outside Koror are exempt from these restrictions to relieve Koror’s infrastructure pressure while supporting activity.
  - Medium- and long-term responses:
    - Scale up infrastructure investment to handle private sector development.
    - Implement a comprehensive tourism strategy to preserve environment and support long-term growth.
  - Growth projections:
    - Growth expected to be flat in 2016 due to temporary decline in arrivals from restrictions, before accelerating in 2017 and 2018.
    - Authorities confident growth will rebound as new hotels and infrastructure come online.
  - Authorities recognize predominant downside risks and limited risk mitigation options in absence of monetary and exchange rate policies; emphasize fiscal and structural policy measures and building fiscal buffers.
  - Active consideration of economic diversification and resilience to climate change.
- Fiscal Sustainability:
  - Authorities agree on necessity for additional medium-term fiscal adjustment to ensure fiscal self-sufficiency after US Compact grant ends in FY2024.
  - In 2015, expenditure savings were 4.5 percent of GDP, and revenues increased by about 1 percent of GDP.
  - Medium-term fiscal strategy:
    - Target a zero current fiscal balance by 2024 while continuing public investment to support tourism and disaster resilience.
    - New revenue measures: increase existing airport departure tax in the short-term.
    - Medium-term comprehensive tax reform projected to mobilize over 4 percent of GDP in additional revenue.
    - Careful monitoring of investment projects to avoid fiscal slippage and expenditure constraint supported by improved PFM implementation.
  - Contingent liabilities:
    - Staff concerns on Civil Service Pension Fund (CSPF) and SOEs acknowledged.
    - Steps taken to correct large unfunded CSPF liabilities; Congress considering legislation to improve sustainability.
    - Authorities considering cost recovery strategies for SOEs and committed to removing subsidies once service quality is upgraded.
    - Planned investment to improve water distribution underway.
- Banking and Financial Sector Stability:
  - Banking system described as strong and resilient: banks well capitalized and liquid with a low non-performing ratio of about 2 percent.
  - Three U.S. FDIC-insured banks constitute the backbone of the system, holding 93 percent of the loans and 99 percent of the deposits.
  - Supervision improvements:
    - Financial Institutions Commission (FIC) enhancing capabilities through Fund TA and training.
    - Financial Intelligence Unit (FIU) improved anti-money laundering investigation capacity.
    - De-risking assessed by staff not to be a problem in Palau due to dominance of three U.S. banks.
  - Efforts to improve access to credit:
    - Advisory services to help applicants improve business plans and financial statements.
    - Development Bank increasing lending to smaller borrowers.
- Growth and Private Sector Development:
  - Government committed to improving business environment to expand private sector role.
  - Focus on reducing impediments to new business entry to improve investor confidence and lift potential growth.
  - ADB and development partners assist with infrastructure improvements and reducing business costs; ensure infrastructure projects assess resilience to natural disasters and climate change.
  - Structural challenges persistent; continued assistance and long-term reform perspective emphasized.
  - Economic Advisory Group (EAG) established with public and private representatives to promote private sector development and address policy and structural matters; short-term focus on environmentally sustainable tourism growth.

*Source: IMF staff report content (3. Joint Work).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16328.pdf_