Public Information Notice No. 02/14

Public Information Notice: IMF Concludes 2001 Article IV Consultation with the Republic of the Marshall Islands

February 22, 2002

On January 18, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of the Marshall Islands.¹

Background

The Republic of the Marshall Islands (RMI) consists of a group of atolls and islands in the central Pacific with a population of about 52,000. Per-capita GDP of around US$2,000 remains one of the highest among the Pacific island economies. However, the income distribution is relatively uneven—with a high incidence of poverty on some outer atolls—and social indicators lag behind other countries in the same income group.

The RMI's economy remains strongly dependent on external grants, most of which have been provided by the United States under a Compact agreement that is currently being renegotiated. Except for small contributions from agriculture, fishery, and tourism, the private sector has evolved mainly to meet the needs of the government which, through the budget, distributes the bulk of Compact funds in the economy. Growth prospects have also suffered from factors that are common to most small island economies-including geographic dispersion, difficult access to world markets, limited export diversification, and exposure to natural disasters.

Since 1995, the economy has faced drastic cutbacks in public expenditure and employment. In the early 1990s, the RMI had borrowed substantial funds on commercial terms against future Compact receipts in order to finance domestic infrastructure projects. However, the economy subsequently failed to pick up as expected, and the government was forced to curtail current expenditure by about 15 percent in nominal terms since 1995 in order to maintain debt service payments. In 2001, the government repaid all commercial debt but, despite exceptionally strong grant inflows, useable fiscal reserves remained precariously low throughout the year. The financial situation of the social security system was of particular concern as fund shortages forced a temporary cutback in health services.

Although statistical deficiencies make an assessment difficult, the relative economic standstill in the private sector appears to have continued in 2001. A rise in copra production and the first full year of operations of a new tuna loin processing plant are estimated to have contributed to a small rebound in private sector activity—bringing overall GDP growth to an estimated 2 percent in FY2001—but other sectors largely stagnated in the face of weak government demand. Inflation, as measured by the Majuro-based CPI, remained unchanged below 1 percent.

Although weak domestic demand continued to impact imports in FY2001, improvements in the trade balance were limited by adverse developments in the RMI's terms of trade. Compared to the mid-1990s, imports have been reduced on a sustained basis across all product categories, but exports have not recovered from the collapse of a major fish exporting company in 1997. The rise in copra shipments has not translated into significantly higher export earnings, owing to a continuing slump in world markets, and low tuna prices have also had a dampening effect on fishing license fees. The current account surplus moved into surplus in FY2000 and FY2001, boosted by a pick-up in official transfers, and external debt has fallen to 67 percent of GDP.

Efforts to attract large-scale foreign investment and develop new export products have proved mostly futile. Larger investors continue to show little interest in the RMI, partly owing to an undereducated labor force, and a restricted list also narrows the scope for small-scale foreign direct investment. Initiatives to exploit abundant natural resources to generate stronger export revenues (e.g., in aquaculture or outer island tourism) have not grown much beyond pilot status, partly because of their risky and capital-intensive nature, and partly because they remain heavily dependent on complementary public infrastructure funding.

Executive Board Assessment

Directors emphasized the need for cautious fiscal policy and greater public expenditure efficiency, noting that the central long-term challenge for the authorities was to adjust to the likely reduction of U.S. budgetary grants following the expiration of the second Compact phase, negotiations on which are currently under way. They stressed that a viable economic strategy is needed, supported by structural reforms in the public sector, improvement of infrastructure, capacity building, and improved governance.

Directors stressed that the immediate priority for the authorities was to resist the use of temporary higher Compact revenue during the two-year negotiation period for fiscal expansion. Instead, they recommended that overall expenditure in both the current and the next fiscal year be kept close, in nominal terms, to last year's level and that the surplus be used to rebuild fiscal reserves from their current low levels.

While agreeing that expenditure increases in health and education were necessary to raise output levels in these sectors, Directors called for spending offsets in non-essential areas. In particular, they suggested that the general freeze on public sector wages should continue, that no new government positions be created on a net basis, and that remaining public subsidies be quickly scaled back. In addition, they encouraged the authorities to strengthen their revenue performance, primarily through intensification of tax collection efforts. Directors observed that both the government and public sector enterprises could be subjected to import tariffs and the gross revenue tax, and that income taxation could be made more progressive, including by bringing rent incomes deriving from the Compact under the income tax net.

Directors stressed that the long-term sustainability of the RMI's fiscal position hinged on its ability to eventually substitute Compact income with returns from the Marshall Islands Intergenerational Trust Fund (MIITF). They welcomed the government's decision to use the bulk of resources freed by the decline in debt service, following the recent retirement of all external commercial debt, to establish MIITF. They noted, however, that building up the MIITF to an adequate size would require maintaining sizeable fiscal surpluses for the next decade and beyond, with appropriate safeguards in place to avoid premature disbursements from the fund.

Directors emphasized that the RMI's long-term strategy for economic development needs to be tailored closely to the government's institutional capacities. While welcoming recent measures to strengthen governance, they noted that further capacity improvements will require the concentration of technical assistance on projects to build essential skills of key government officials, as well as reallocation of manpower resources within the government to accommodate the hiring of a limited number of outside specialists.

Director considered that the main focus of the authorities' structural reform agenda should be the removal of key obstacles for private sector development. They urged stronger efforts to boost export prospects by attracting foreign direct investment, including through a reduction in the minimum wage, speedy implementation of the provisions of the land registration act, and by pruning the reserved list for small-scale investment.

Directors observed that more decisive steps are needed to strengthen the RMI's financial infrastructure and harness domestic savings for financing growth. They agreed that developing micro finance schemes and enhancing access to financial services in remote areas could play a role in building small-scale productive capacity. Directors saw room for further improvement in domestic supervisory capacities, and urged the early completion of a full round of on-site bank inspections.

Directors welcomed the steps already taken by the RMI to strengthen money laundering defenses, and noted that it will be important to identify and address, in conjunction with the Financial Action Task Force (FATF), any outstanding issues so as to facilitate the RMI's removal from FATF money laundering list.

Directors expressed concern that serious statistical deficiencies continue to impede effective economic surveillance. They encouraged the authorities to strengthen their statistical systems.