Mission Concluding Statement 

2011 Staff Visit to Republic of Palau-- Concluding Statement of the IMF Mission

March 8, 2011

The mission would like to thank the authorities for warm hospitality and constructive discussions.

This statement summarizes the mission’s findings and recommendations. The economy is likely to have stabilized during FY2010, with a modest rebound expected for FY2011. Commendable efforts were made to cut expenditure and preserve the government’s liquidity position during FY2010. The FY2011 budget implies a continued adjustment in line with the mission’s recommendation. The mission encourages the authorities to embark on a set of comprehensive revenue and expenditure reform to sustain fiscal consolidation. The weak statistical capacity needs to be strengthened quickly.

I. Recent Developments and Prospects

1. Following two consecutive years of contraction, the economy is likely to have stabilized during FY2010. Higher tourist arrivals, reflecting the economic recovery in key tourist source countries and more flights to Palau, broadly offset lower FDI-financed activities and government spending. Inflation came down to 1½ percent from the peak two years ago.

2. Growth is projected to increase moderately to 2 percent in FY2011, thanks to the proceeding global recovery and a new direct flight from Japan. However, re-surging world food and energy prices are expected to raise inflation and weigh on consumption. Downside risks arise largely from the external environment, including a faltering of the global recovery dampening Palau’s tourist arrivals and foreign investment, and rising world commodity prices depressing domestic demand and straining the fiscal position.

II. Policy Recommendations

Fiscal Policy

3. Even with renewed U.S. Compact grants, large fiscal adjustments are needed to achieve self-sufficiency. To prevent a sharp policy correction when the Compact assistance ends in FY2024, current deficit excluding grants (i.e., current expenditure minus domestic revenues) would need to improve by 1½ percent of GDP annually over the next 10 years. Delaying the needed adjustments would imply more challenging policy decisions later, as larger fiscal consolidations will have to be achieved in a shorter period of time.

4. The authorities showed welcome fiscal restraint in FY2010, which ended the declining trend of cash reserves since FY2006. The cash balance stayed at $6½ million in FY2009-10. In the absence of concrete revenue measures, domestic revenues (i.e., the total of tax and non-tax revenues) fell by almost 1 percent of (estimated) GDP. However, expenditure cut more than compensated for the lower revenues, and the current deficit excluding grants declined by 1½ percent of GDP, in line with the mission’s recommendation above.

5. The FY2011 budget implies continued fiscal consolidation, based on an expenditure cut of almost $4 million relative to the previous year. In light of lower Compact grants for FY2011, the mission commends the authorities’ determination to preserve the existing cash buffers and not incur new arrears. The cut is largely on non-wage expenditures such as goods and services, which account for less than half of the expenditure financed by domestic revenues and Compact grants. This carries a risk that the cut may not be sustainable against the backdrop of re-surging fuel prices and worsening infrastructure maintenance and service delivery. Given that Palau’s tax revenue to GDP ratio is low among Pacific island economies, the mission encourages the passage of revenue measures submitted to Congress, including increasing the wage and salary tax rate for top earners and raising the hotel room tax rates. Doing so will also help ease the pressure on the spending side while preserving the planned fiscal adjustment of about 2 percent of GDP during FY2011. Even with the passage of these revenue measures, Palau still needs to embark on a comprehensive tax reform (see below) to facilitate economic development while raising government revenue to more appropriate and sustainable levels.

6. The mission welcomes the progress toward raising water and sewage charges and eventually eliminating the government’s net subsidies on these services. In this context, the mission suggests that disbursements for the water and sanitation project (excluding the $6 million allocated to the water company) be saved to rebuild much-need cash buffers and that the planned fiscal consolidation in FY2011 be adhered to. Some of the un-allocated funding could also be used to reduce arrears, provided that the reduction is conducted in a transparent and prioritized manner and that the budget process is fixed (see below). The mission encourages the authorities to continue drawing on technical assistance from the Pacific Financial Technical Assistance Center (PFTAC) in this area and to best utilize the $10 million Compact grants earmarked for arrears clearance.

7. The government’s efforts in strengthening cash management and fixing the budget process are commendable. The mission welcomes the authorities’ plan to implement a medium-term budget framework, including improving revenue projections, over two budget cycles. At the same time, to prevent further buildup of arrears and support medium-term budgeting efforts, allocations to line ministries should be based on realistic projections of resource availability. In this context, the mission looks forward to the work plan that will put in place a structured cash management system based on the current “spending control” practice. Establishing a cash management committee will also help ensure transparent and prioritized allocations of cash resources.

8. A set of coherent and comprehensive measures on both revenue and expenditure are needed to sustain fiscal adjustments over a prolonged period. Given the size of adjustments, piecemeal and ad hoc policy measures are unlikely to deliver long-lasting improvements. Comprehensive reforms will also likely create less distortion and be less politically costly than many incremental changes.

• On revenue, the mission would like to reiterate earlier recommendation of embarking on a comprehensive tax reform that aims to broaden the tax base and promote efficient administration. Steps should be taken to eliminate import duty exemption, move to cost, insurance, and freight (CIF) valuation, replace the gross revenue tax with a corporate income tax, and adopt a Value-added tax (VAT), which is in place in eight Forum Island Countries (FICs). The comprehensive tax reform will also support Palau’s ongoing efforts toward oil and gas exploration, which requires an effective legal and fiscal framework for managing potential revenues.

• On expenditure, the mission recommends a civil service reform that will examine government services and reduce the total wage bill, which exceeds the Pacific island average. The reform should ensure that adequate resources are available for essential government functions, such as budget, planning, and statistics, while reducing redundancies in other areas.

Private Sector Development

9. Liberalizing the FDI regime will help boost private sector development, which is key to sustaining growth in the face of required fiscal consolidation. Investors seek a stable investment regime as well as a clear, predictable, and rules-based licensing process. Palau is encouraged to resolve outstanding issues related to improvements in the Foreign Investment Act and establish a one-stop arrangement with state and national licensing requirements. Furthermore, creating a level playing field for foreign and domestic investors in access and cost of labor will increase incentives for foreign investment.

10. The mission welcomes the improvements of financial regulation and supervision, which have contributed to the relative resilience of Palau’s financial sector during the global crisis. Adequate staffing and funding of the Financial Institutions Commission (FIC) are a key factor underpinning the improvements. There is room for the financial sector to step up its role in supporting private sector development. In this regard, the mission welcomes the authorities’ ongoing efforts to improve the legal framework of collaterals, which will help facilitate bank lending. Separately, the mission encourages the passage of legislations on Financial Intelligence Unit (FIU), which will give FIU more enforcement flexibility and power and thereby strengthen efforts in anti-money laundering (AML) and combating the financing of terrorism (CFT). Given Palau’s limited policing capacity, the mission continues to caution against the establishment of a corporate or ship registry.

Statistics

11. The weak statistical capacity needs to be addressed quickly. Due to serious under-staffing, key data are not up to date, greatly hindering effective national policy analysis and formulation. The mission encourages the authorities to devote sufficient human and financial resources to Office of Statistics and to work closely with the upcoming PFTAC statistical missions. It is also essential that inflation, balance of payments, and national accounts data of FY2010-11 are compiled in time for the 2012 Article IV consultation. The mission encourages the authorities to consider adopting the new GDP numbers.

12. The mission proposes to schedule the next Article IV consultation mission in early 2012.