Public Information Notice No. 98/64

Public Information Notice: IMF Concludes Article IV Consultation with the Federated States of Micronesia

August 27, 1998

On June 26, 1998, the Executive Board concluded the Article IV consultation with the Federated States of Micronesia¹.

Background

The economy of Micronesia has a very narrow productive base, mainly in fishing, tourism, and small-scale agriculture, with fish and agricultural products forming the main exports. Primary constraints facing the country include its relatively small size, geographical isolation and dispersion, limited scope for diversification, and low factor endowments. Real GDP growth was stagnant through FY1996 before turning negative in FY1997 reflecting a fall in external grant financing and the introduction of fiscal adjustment measures. Despite migration to the United States, real per capita income has been declining in the past five years. With the use of the United States (U.S.) dollar as legal tender, inflation is largely influenced by developments in the U.S. dollar. The economy is highly dependent on annual grants provided by the U.S. under the Compact of Free Association which became effective in 1986. However, the financial arrangements under the Compact are scheduled to expire in 2001 and negotiations with the U.S. on the continuation of these financial arrangements are expected to begin in 1999.

The U.S. grants to the government were intended to contribute over a 15-year period toward the creation of the needed infrastructure and institutions to enable Micronesia to function as a fully independent state. Attempts to diversify the economy through direct government investment in fisheries, tourism, manufacturing, and agriculture have been unsuccessful and absorbed a sizable amount of the grants. At the same time, the grants also financed a rapid expansion in the size of the government, leading to severe structural imbalances in the fiscal and external sectors. Chuuk and Pohnpei states in particular faced relatively greater financial difficulties. Through FY1995 government expenditures accounted for around 83 percent of GDP and provided more than 50 percent of formal employment. The structure of the state budgets has been unstable and the external current account deficit (excluding transfers) averaged around 52 percent of GDP. Government expenditures were financed in part from external borrowing against disbursements of future Compact grants, leading to a rise in external debt to as high as 72 percent of GDP.

With the imminent expiration of the financial arrangements under the Compact, the authorities began to implement adjustment measures under a reform program in FY1996. The main objectives of the program are to transform the economy from an over-dependence on external financing to a more self-reliant one, reduce the size of the public sector, and establish a favorable environment for promoting private sector growth. The use of the U.S. dollar limits the ability of the authorities in the conduct of independent monetary and exchange rate policies and thus a correction of the fiscal and external imbalances must rely mainly on budgetary measures, particularly in reducing current expenditures in all four states and the national government of Micronesia.

In Micronesia’s political context, the complexity of formulating a coordinated adjustment package that had been agreed upon by individual states and the national government was particularly daunting. Nevertheless, following a series of economic summits held at the local, state, and national levels, Micronesia was able to reach consensus on a coherent program of adjustment measures. These measures included downsizing of government employment, cutting outlays on goods and services, and eliminating subsidies to public enterprises, as well as efforts to increase tax revenue. The reform program is receiving the financial support of the Asian Development Bank.

With a good start in FY1996, large budgetary surpluses have been generated and the external current account deficit has narrowed, but the fiscal and external imbalances continue to be unsustainable. The pace of implementation of fiscal and structural adjustment measures under the reform program has faltered in FY1998, particularly in Pohnpei but also in Chuuk. Planned expenditure and revenue measures, especially the continuation of downsizing of government employment and increases in state taxes, are being delayed. Some states continue to face liquidity problems and the risk of incurring payment arrears. While structural reforms have been implemented, the pace of change has been slow and has inhibited the growth and development of private sector activity and exports.

Executive Board Assessment

Executive Directors welcomed the implementation of a reform program since FY1996 aimed at reducing the size of government and promoting private sector activity in Micronesia, inpreparation for the prospective termination of grant assistance under the Compact with the U.S. Nevertheless, Directors cautioned that fiscal and external imbalances remained unsustainable and that implementation of fiscal measures has faltered. They stressed the need for sustained implementation of fiscal and structural measures to promote private sector-led growth and to attain a sustainable external position over the medium term. A consistent track record of sustained implementation of reform measures also would be important to obtain the support of the international financial community to ease Micronesia’s transition to a more self- reliant economy.

Directors emphasized that Micronesia would need to generate large budgetary surpluses over the next few years as part of efforts to reduce reliance on external assistance. Further reduction in government expenditure will need to bear the burden of this adjustment effort, which would come mainly from additional cuts in government employment and outlays on goods and services, while maintaining adequate allocations for social sectors. In particular, Directors recommended that Chuuk and Pohnpei implement further steps to reduce expenditures through downsizing government employment and raising state taxes without delays, in order to strengthen their budgetary position and avoid the accumulation of additional arrears. They also recommended a rationalization of the numerous layers of national and state government institutions. In the revenue area, Directors welcomed the proposed unified tax authority which should improve tax collection, noting the continued low tax-to-GDP ratio in Micronesia. To improve the tax effort, they recommended the introduction of a broad-based consumption tax, such as a value-added tax, and the elimination of remaining tax exemptions.

Directors underscored the need to continue improving the environment for private sector activities, including by legislation to remove regulatory obstacles affecting investment approval, land use, and commercial contracts. They also urged full support for the Office of the Bank Commissioner to ensure the appropriate supervision of bank operations in accordance with international best practices.

Directors expressed concern about the poor statistical base of Micronesia. They welcomed the proposed efforts to improve statistical information, and urged that core data be submitted to the Fund on a regular and timely basis.