Public Information Notice No. 06/23

Public Information Notice: IMF Executive Board Concludes Article IV Consultation with the Republic of Palau

March 2, 2006

On February 15, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Palau.¹

Background

The Republic of Palau is a small island economy that relies heavily on tourism and external assistance. Palau faces development constraints common among other Pacific island economies, including vulnerability to external shocks, a narrow production and export base, geographical isolation, and scarce labor.

Palau benefits from substantial U.S. assistance under the fifty-year Compact of Free Association. Under the agreement, direct payments from 1994 to 2009 aim to support economic self-reliance by financing current expenditure, developing infrastructure, and building the balance of the Compact Trust Fund (CTF) to provide a sustainable income stream from 2010 to 2043. In recent years, budgetary grants from the U.S. have averaged about 18 percent of GDP, of which one third comes from federal grants outside of the Compact. CTF returns have been lower than anticipated and the CTF balance stood at US$153 million (106 percent of GDP) at end- 2005. In addition to U.S. grants, Palau receives sizable grants from Japan and Taiwan Province of China to finance infrastructure projects.

Economic growth has picked up in recent years while inflation has been low. After several years of slow growth, real GDP grew by 5 percent in FY2004 and FY2005, driven by a steady increase in visitor arrivals with the start of new airline routes and hotels, and externally funded government projects.

Palau's fiscal performance has continued to improve in FY2004 and FY2005. The overall fiscal deficit (including grants) declined from 21 percent of GDP to under 5 percent of GDP in FY2003-05 compared to the previous three years, while the current budget balance improved by 8½ percent of GDP, mainly due to the capping of the rate of increase of non-wage current expenditure. On the revenue side, revenue collections strengthened as a result of higher investment income, stronger economy, and the re-instatement of excises on tobacco and alcohol in 2003 and 2004. Fiscal consolidation has allowed Palau to avoid borrowing and public debt is low at 13 percent of GDP.

The balance of payments position has strengthened in recent years. The external current account swung into surplus in FY2003 and improved further in FY2005 on account of improved tourism and fish exports, and lower capital imports. Higher tourism receipts partially offset the impact of higher oil prices on the current account.

Banking sector reform has progressed slowly since it was initiated in 2001. Palau's large financial sector relative to its size consists of four foreign branches of commercial banks, four domestically chartered banks, five insurance companies, a number of credit unions, and some twelve remittance companies. Risks are mitigated by the dominant role of U.S.-based banks that hold the majority of deposits, and overall bank profitability is reported to have improved although banking statistics are lacking. Five financial laws were introduced in 2001 that allowed for establishment of the Financial Institutions Commission (FIC) to supervise banks and the Financial Intelligence Unit (FIU) to investigate suspicious transactions. However, existing legislation does not allow FIC to issue regulations and both FIC and FIU do not have adequate resources to fulfill their duties.

Private sector activity has contributed to recent growth. A larger share of foreign-financed projects are undertaken by local firms and tourism-related infrastructure has been improving, albeit from a low base. Palau ranks highly in several indicators of the cost of doing business. Although foreign direct investment reached an estimated 13 percent of GDP in FY2005, a number of investment impediments remain. Investment is restricted to specific activities, about half of available land lots do not yet have title and cannot be used to secure loans,
non-transparent investment regulations benefit few citizens, and labor regulations raise costs in the context of shortage of skilled Palauan labor.

Economic prospects in the near term remain upbeat but are uncertain in the longer term. Tourism will continue to be a main source of near-term growth while ongoing externally financed large infrastructure projects will support construction and other services. However, longer-term prospects depend on the direction of government's economic policies and whether the U.S. Compact is renewed beyond 2009.

Executive Board Assessment

Executive Directors welcomed the improved economic performance and disciplined policies over the past two years. They commended the authorities for the judicious management of foreign aid focused on infrastructure building and strengthening of human capital, and for the success in reducing public sector spending in line with the government's Management Action Plan of 2001.

Looking ahead, Directors noted that a renewal of U.S. Compact grants beyond 2009 was uncertain and cautioned against postponing fiscal adjustment and structural reforms until after a decision is made on future grants. In view of this uncertainty, they encouraged the authorities to target a pace of fiscal consolidation consistent with a gradual decline in future grants to reduce the risk of social strains from a sharp and sudden adjustment.

Directors endorsed the government's long-term objective of covering current spending from domestic revenue generation, but saw a need for greater expenditure containment to achieve this goal, particularly on goods and services. Over the medium term, downsizing the public sector, including through maintaining the hiring freeze and outsourcing services, would help reduce spending to a sustainable level. Directors also encouraged further strengthening of tax collection efforts and eliminating exemptions in the near term, and later considering a comprehensive overhaul of the tax system centered on a non-cascading consumption tax, and a more efficient and broader-based corporate and personal income tax.

Directors supported the continued use of the U.S. dollar as the domestic currency and the maintenance of an open trade regime. They agreed that the exchange rate regime provides an appropriate nominal anchor, and emphasized that a continuation of cautious fiscal and wage policies would help preserve external competitiveness in the context of an open trade regime.

Directors stressed the importance of adequately regulating and supervising Palau's relatively large financial system. They noted that the Financial Institutions Commission (FIC) lacks sufficient authority or resources to issue regulations and exercise effective supervisory oversight. They urged the authorities to pass the necessary amendments to the Financial Institutions Act and anti-money laundering legislation, and to ensure adequate authority, budget, and staffing of the FIC and the Financial Intelligence Unit. Directors also welcomed ongoing efforts to strengthen the National Development Bank of Palau.

Directors underscored the need to improve the investment climate and labor and land policies to establish a sound foundation for sustained growth. They welcomed progress made on land titling and leasing and were encouraged by the ongoing debate over reducing investment restrictions. Directors cautioned against raising the minimum wage in order to safeguard employment opportunities for Palauans.

Directors encouraged the authorities to improve the coverage, reliability, and timeliness of national accounts and banking statistics and supported the authorities' request for more technical assistance in these areas.

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.