Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

Federated States of Micronesia—2011 Staff Visit Preliminary Conclusions

October 12, 2011

This statement summarizes the mission’s preliminary findings and policy recommendations based on meetings in Pohnpei.1 The discussions focused on policies to strengthen fiscal management, assess progress of infrastructure grants utilization, and promote the private sector. The economic recovery is expected to continue in the near term supported by ongoing construction activities and expansion of the fisheries sector, but faces headwinds over the medium-term from the scheduled declines in Compact sector grants. Continued efforts to advance tax reforms, targeted expenditure cuts, and structural reforms to nourish private sector growth are essential to secure long-term fiscal and economic sustainability.

I. Background and Outlook

1. Since the 2010 Article IV Consultation, the Federated States of Micronesia (FSM) economy continues to expand. The economy grew by 3.1 percent in FY2010, mainly driven by continuing expansion in construction activities, fishery sector, and public administration. Private sector employment grew by an impressive 8 percent in FY2010, but was driven mostly by construction projects financed by foreign grants or public funds. The economy remains dependent on the large public sector, with businesses relying on infrastructure projects and government services. Inflation has subsided to 4.3 percent in FY2010, after reaching 8.2 percent in FY2009, as a result of moderating food and fuel prices.

2.The recovery will likely weaken in the near and medium term. Growth in FY2011 is estimated to be 1.4 percent, supported mainly by expedition of construction projects from the unused infrastructure grants. The near-term outlook is hindered by sluggish private sector growth. In view of the annual decrements of Compact grants, the mission expects growth to stay at about 0.6 percent over the medium term. Inflation is expected to rise following the significant increase in commodity prices in early 2011, but is projected to moderate gradually over the medium term.

3. Risks to the outlook are on the downside. The economy could face headwinds if the current global slowdown proves to be more severe and prolonged than expected. While the release of unused infrastructure grants is expected to stimulate the economy, structural impediments to private sector development and volatile commodity prices could hold back the recovery. Long-term risks include acceleration of outward migration and loss of farmland from climate change.

4. The fiscal situation of the consolidated government has improved in FY2010 but progress varies across states. General tax revenue has improved owing to the recovery of the economy and better tax administration. As a result, the overall consolidated surplus was $3.4 million (about 1.1 percent of GDP) in FY2010, the second consecutive year of surplus. However, the gap among state finances has widened. Chuuk slipped to deficit again in FY2010 and continued to struggle over its significant debt ($28.9 million as of end-FY2010), and Pohnpei remained in deficits and had to draw down its reserves. On the other hand, Yap recorded its first surplus in 6 years (about $1½ million) after reducing direct subsidies to public enterprises, though tax revenues are likely to decline in FY2011. Kosrae had a small surplus in FY2009–10. Overall, a modest consolidated surplus is expected in FY2011, with the gain in tax collections somewhat offset by higher current expenditures.

II. Policies to Achieve Sustainable Growth

A. Fiscal Policy

5. Under current policies, the build up in government assets through the Compact Trust Fund (CTF) is projected to fall short of replacing Compact sector grants expiring in FY2023. The market value of the CTF stood at about $177 million as of end-FY2010, but the CTF is likely to suffer investment losses following the sharp fall in global equities. Assuming historical investment returns, little progress in fiscal adjustment and structural reforms, the projected income shortfall could reach $19 million (about 6 percent of GDP) when the Compact sector grants expire in FY2023.

6. Steadily increasing fiscal surpluses to about 5¼ percent of GDP over the medium term would help achieve long-term fiscal sustainability. This would involve gradually raising the fiscal surplus by about 1¼ percent per year for the next four years to 5¼ percent of GDP in FY2015, and then maintaining the surplus at that level until FY2023, before returning to a small surplus budget. Under the federal system in the FSM, each state would need to contribute its own fiscal savings. The mission urges the authorities to start the adjustment immediately, as further delay would only increase the cost of adjustment.

7. To achieve the required fiscal adjustment, containing current expenditures will be essential. Total public sector payroll increased in FY2010, ranking the FSM high among the region in terms of current expenditures as a share of GDP. Gaps between public and private sector wages have widened and remained large at about 2.3 times on average. Along with a reduction in the public wage bill and subsidy cutback, the mission advocates that the national and state governments commit to a medium-term fiscal adjustment plan, in which targets of public wages and budget surplus are clearly spelt out. Such multi-years plan would contribute to securing priority spending on infrastructure needed to foster sustainable development.

8. In parallel to the targeted expenditure cuts, the planned tax reform should be swiftly implemented. The Unified Revenue Authority (URA) Law was finally enacted in April 2011, setting the stage for the legislative process to implement the tax reforms. Prospects for tax reform implementation, however, are still uncertain, as state governments are slow to take actions to implement the URA law. Systematic consultation and public outreach, including community-based forums, would help mobilize public support. The mission urges the national and state authorities to bring forward the remaining legislative procedures and to overcome states’ concerns regarding tax administration and distributions under the URA, so as to implement the tax reforms beginning FY2013–14. Meanwhile, further efforts to strengthen the tax administration through staff training would help facilitate a quick and smooth transition to the new system.

9. Building the right incentive mechanism into the public financial management is a key step to secure fiscal discipline over the medium term. The mission notes the public performance audits currently extend to cover general operations financed by local revenues in addition to the Compact-funded expenditures. Considerations should be given to developing an independent prosecuting agency responsible for public sector frauds.

B. Private Sector Development

10. A vibrant development of private sector would contribute to sustainable economic growth. The private sector is stagnant and contributes little to growth—the share of private sector has remained unchanged at about 25 percent over the past 20 years, even after the considerable decline of government services and public sector enterprises (PSEs). While some key infrastructure projects are underway, the government could further support private sector growth by providing an enabling environment. In this regard, the authorities would need to address the restrictive legislations on investment, lack of skilled labor, and inadequate infrastructure.

C. Financial Stability

11. Strengthening the regulatory framework for financial institutions would help safeguard the financial stability. The overall banking system remains profitable, liquid, and well-capitalized. The mission encourages the authorities to:

  • Step up the efforts in supervising properly the Development Bank and other nonbank lending institutions (for example, credit unions). Risk exposure in the FSM Development Bank remains high and credit risk could rise in the event of an economic downturn;
  • Continue strengthening bank supervision on risk-based assessment and improving the AML/CFT capacity through staff training; and,
  • Strengthen insurance sector supervision, particularly in the area of captive insurance given its increasing activities and very limited capacity of the Insurance Board.

A more determined policy effort and broad political consensus on the above reform package would help generate broader public support to implement reforms. The mission would like to thank the authorities for their hospitality and thank members of the government and private sector representatives for the fruitful discussions.


 
Table 1. Micronesia: Medium-term Scenario (Current Policies), FY2007–16 1/
 
  FY2007 FY2008 FY2009 FY2010 FY2011   FY2012 FY2013 FY2014 FY2015 FY2016
 

Real sector

        Est.   Projections

Real GDP (percent change)

-1.9 -2.3 0.4 3.1 1.4   0.9 0.4 0.6 0.6 0.6

Consumer prices (percent change)

3.6 6.6 8.2 4.3 7.9   0.9 2.0 2.0 2.0 2.0
                       

General government finance (in percent of GDP)

                     

Revenue and grants

56.5 56.8 65.3 68.1 61.7   63.7 63.2 62.4 61.8 61.1

Total domestic revenue

20.5 21.0 21.2 22.3 20.4   20.3 20.4 20.4 20.4 20.3

Grants

36.0 35.8 44.2 45.8 41.3   43.4 42.9 42.0 41.3 40.8

Expenditure

58.9 58.5 63.7 66.9 61.3   63.2 62.8 61.9 61.3 60.6

Current

51.3 49.8 47.0 47.5 45.6   45.7 45.3 44.8 44.5 44.2

Capital

7.6 8.8 16.7 19.4 15.7   17.5 17.5 17.1 16.8 16.5

Overall balance

-2.4 -1.7 1.6 1.1 0.4   0.5 0.5 0.5 0.4 0.5
                       

Compact Trust Fund

122.6 119.1 138.3 177.2 209.9   245.7 284.8 327.5 373.9 424.4

(in millions of US$; end of period)

                     
                       

Balance of payments (in millions of US$)

                     

Trade balance

-104.4 -119.4 -127.7 -127.6 -132.0   -134.2 -132.7 -135.4 -135.2 -136.8

Net services

-33.2 -39.6 -52.5 -44.6 -45.8   -45.1 -45.3 -45.0 -45.2 -45.1

Net income

17.5 12.3 18.8 14.2 15.7   16.8 18.0 19.2 20.5 21.7

Private and official transfers

101.2 105.5 108.4 111.8 107.7   107.1 105.2 104.2 102.6 100.5

Current account

-18.9 -41.2 -53.0 -46.2 -54.4   -55.3 -54.8 -57.0 -57.3 -59.8

(In percent of GDP)

-7.3 -15.6 -18.9 -15.5 -17.1   -17.1 -16.6 -17.0 -16.7 -17.1

Current account excluding official transfers

-115.3 -140.0 -157.5 -154.5 -158.9   -159.6 -157.0 -158.2 -157.0 -157.4

(In percent of GDP)

-44.8 -53.2 -56.3 -52.0 -49.9   -49.4 -47.7 -47.1 -45.9 -45.1
                       

External debt (in millions of US$; end of period) 2/

                     

Stock

65.9 68.0 80.5 80.1 79.7   79.4 79.1 78.6 78.1 77.7

(In percent of GDP)

25.6 25.8 28.8 26.9 25.0   24.6 24.0 23.4 22.8 22.2

Debt service

2.7 3.1 3.5 4.3 5.2   5.1 5.0 5.1 5.0 5.0

(in percent of exports of goods and services)

4.8 5.3 5.9 6.4 7.1   6.7 6.4 6.2 5.9 5.7
 

Sources: the FSM authorities and Fund staff estimates.

1/ Estimates for FY2011 and projections from FY2012–16 are preliminary and based on data received from the authorities.

2/ Government and public enterprise debts only.


1 The mission met with government officials, political leaders, donors, and private sector representatives in Pohnpei from October 10–12, 2011.



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