Public Information Notice No. 08/69

Public Information Notice: IMF Executive Board Concludes 2008 Article IV Consultation with Republic of the Marshall Islands

June 13, 2008

On June 4, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Republic of the Marshall Islands.¹

Background

The Republic of the Marshall Islands (RMI), scattered across an area of nearly 1 million square miles in the Central Pacific, is heavily dependent on external grants. Like other small Pacific island countries, RMI is remote from major markets, has a narrow production and export base, and is vulnerable to external shocks and climate change. The most important aid source has been U.S. financing, primarily through the Compact of Free Association (Compact).

RMI has grown continuously the past seven years, partly reflecting increased inflow of financial resources from the amended Compact with the United States. However, real GDP growth slowed, on average, to 1.3 percent in FY2005-06 (fiscal year ending September 30), from about 4 percent in the previous four years. Growth in FY2007 is estimated to have picked up to around 2.3 percent, driven by the new infrastructure construction and the influx of visitors. Nevertheless, unemployment remains high (especially among youth). The current account deficit increased to 3 percent of GDP in FY2007. Gross public and publicly guaranteed external debt is high, at about 70 percent of GDP at end-FY2006. The banking system is small, and provides little domestic credit, mostly concentrated in short-term consumer loans.

Inflation averaged about 4 percent (year-on-year) in the last two years, reflecting higher electricity costs and prices of food and oil. The U.S. dollar is the official currency and has provided a strong anchor for inflation expectations. The real effective exchange rate has remained broadly unchanged, reflecting a relatively stable inflation differential with the United States, a large trading partner, and a weakened U.S. dollar.

The fiscal position improved in FY2006-07, but the overall balance remained slightly negative at around ½ percent of GDP. The improvement reflects mainly the increased capital funds from the Compact agreement. The government has fully met its mandatory contributions to the Compact Trust Fund (CTF).

Growth is expected to moderate to about 1.5 percent on average in FY2008-09. Rising energy costs and a reduction in employment at the U.S. military base in Kwajalein will constrain growth. High energy and food costs are creating inflationary pressure. The external position is expected to remain roughly balanced, given the continual disbursement of foreign grants. The risk to this outlook is mainly on the downside. Further increases in oil prices could depress activity and the grounding of the domestic airline could reduce the nascent tourist business. In addition, global financial disturbances could depress the rate of return on the CTF, thereby undermining fiscal sustainability.

Executive Board Assessment

Executive Directors welcomed the recent steps taken by the authorities to move the Marshall Islands toward lasting growth. At the same time, they underscored the substantial challenges facing the economy, owing to the country's geographical remoteness, narrow production base, and increasing vulnerabilities to climate change and rising food and oil prices. In addition, the country faces anticipated declines in Compact grants and increases in debt-service payments. Against this background, Directors encouraged the authorities to press ahead with critical fiscal and structural reforms, with a view to spurring private sector-led growth and economic self-reliance.

Looking ahead, Directors emphasized that fiscal consolidation will be essential to maintain external stability and achieve budgetary self-reliance, and called for more ambitious fiscal objectives than those stated in the most recent budget. In particular, the authorities should aim for achieving, and maintaining, a fiscal surplus of about 3 percent of GDP in the medium term, to build reserves in the CTF and prepare for the elimination of Compact grants after 2023. Directors underlined that, as the level of current expenditure is not sustainable, steps to rationalize current expenditures, including for public sector wages and subsidies, will be essential, along with measures to raise tax and nontax revenue.

Directors stressed that the CTF is the cornerstone of the Marshall Islands' future. They urged the authorities to adopt prudent and transparent management of the CTF, in line with international best practices. Directors called on the authorities to weigh carefully the costs and benefits of securitizing future U.S. contributions before reaching a decision.

Directors underscored the importance of ambitious structural reforms to promote sustainable private sector growth and to complement fiscal consolidation, while reducing the dominant role of the public sector in the economy. These reforms should include shoring up infrastructure, resolving land issues, and scaling back the government's commercial activities. Directors encouraged the authorities to improve the country's business environment, in particular to spur nascent industries in the tourism, fishing, and shipping sectors.

Directors welcomed the progress that has been made in strengthening financial sector supervision. At the same time, they emphasized that further steps are needed to bolster the country's financial infrastructure and to ensure that the system performs its role in the development of the economy. Directors urged the authorities to introduce measures to reduce impediments to commercial lending. They also stressed the need to carefully monitor the widespread reliance on high-interest personal credit, and to safeguard against potential non-performing loans.

Directors encouraged the authorities to improve the coverage, reliability, and timeliness of key economic statistics, with the help of technical assistance from donors.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.