Public Information Notice No. 05/37

Public Information Notice: IMF Executive Board Concludes 2004 Article IV Consultation with the Federated States of Micronesia

March 22, 2005

On February 25, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Federated States of Micronesia.¹

Background

Economic developments in the Federated States of Micronesia (FSM) remain dominated by external assistance, particularly sizable U.S. grants under the Compact of Free Association. In FY2004 (ending September 30), a fall in Compact grants, along with a typhoon, precipitated a contraction in real output. Employment has been stagnant this year, and the public sector continues to account for half of formal employment. Wage growth has been modest, with a persistent wide differential between public and private pay. Inflation remained low despite higher oil prices.

The fiscal position swung sharply to deficit in FY2004, due to both a scheduled drop in Compact grants and delays in disbursements. With softening economic activity, domestic revenues continued to fall relative to GDP. Reflecting a loose federal system, the states' budgetary performances varied, with Chuuk state accumulating arrears. The fiscal deficit contributed to a decline in usable government financial assets to 8¼ percent of GDP.

The external position also worsened, as the trade deficit widened due to rising oil prices as well as the typhoon's effects on agricultural exports. External debt has remained low, and debt service is around 6 percent of exports. With the U.S. dollar the official currency, the real exchange rate has depreciated modestly in recent years.

Domestic credit continued to shrink in FY2004. While the FSM's two commercial banks are sound, they mainly channel deposits overseas, rather than lending domestically. As a result, the loan/deposit ratio has reached record lows. This situation reflected continued uncertainty about economic prospects and shortcomings in the legal framework for lending, both of which continue to restrain private sector development.

Executive Board Assessment

Directors welcomed signs that the economy is recovering from the effects of the recent reduction in grants under the Compact of Free Association with the United States, and that inflation remains low. Directors noted with concern, however, that employment has been stagnant, the external and fiscal positions have recently worsened, and domestic credit has been contracting. Against this backdrop, limited private sector job opportunities have fostered steady emigration, undercutting the development of human capital within the country. Directors recognized that the Federated States of Micronesia's geographic remoteness and small size pose challenges to economic development. At the same time, they were of the view that following a prudent fiscal policy aimed at reducing reliance on grant assistance, combined with the implementation of structural reforms to foster private sector development and raise employment, would be the most effective way of confronting those challenges.

Directors observed that growth is likely to be sluggish over the medium term without fiscal and structural adjustments to promote stability and growth. Given the coming further reductions in Compact funding, the costs of the large government sector will be increasingly unsustainable, and the fiscal situation will deteriorate further. Directors therefore urged the authorities to make every effort to promote medium-term economic and fiscal sustainability and to build the needed political consensus for adjustment through greater outreach efforts.

Directors welcomed efforts by the authorities to restrain spending through a continued wage freeze and other means, but further efforts are needed to reduce the fiscal deficit, including cuts in the still-high wage bill and in other current expenditures. Directors stressed the need to deal with the unfunded liability of the social security system, including through cutbacks in benefits, if necessary. Comprehensive and timely reforms of the public enterprises could yield budgetary savings and improve prospects for private businesses. Directors encouraged the authorities to further strengthen budgetary management to meet the Compact's accountability and oversight requirements.

Directors emphasized the need to protect core expenditures on health, education, and infrastructure to underpin growth. Given the difficulties of making further spending cuts beyond those envisaged in other areas, and in light of fiscal adjustments previously undertaken by the authorities, the primary focus must be on raising revenues. In particular, greater efforts are needed to boost tax revenues, including through improvements in tax administration. Directors encouraged the authorities to move expeditiously in the context of the Task Force on Tax Reform to design and implement a comprehensive tax reform strategy. Some Directors saw a Value Added Tax as the best option for tax reform, especially if related constitutional issues can be resolved, but noted that it will need to be carefully designed and well-coordinated among the states.

A few Directors expressed concern about the passage of tax haven legislation by the Congress, which they viewed as harmful for the transparency of the tax system. They urged the authorities to work closely with relevant international groups to ensure that the tax haven scheme is not subject to abuse.

Directors stressed that structural reforms are needed to encourage private sector development and employment. In that connection, they broadly endorsed the authorities' priorities of enhancing infrastructure, easing restrictions on the use of land, and streamlining the foreign investment regime. They urged that measures to reach these objectives be accelerated. The authorities should also move ahead to develop the tourism, fisheries, and agriculture sectors, which could also help to improve the external imbalance. Directors considered appropriate the authorities' pursuit of regional trade liberalization as a prelude to broader liberalization.

Directors noted that domestic lending continues to decline, notwithstanding the banks' strong capital and liquidity positions. Enhancements to the domestic lending environment can help the private banking system to better support the domestic economy. In this connection, the Development Bank should avoid competing with commercial banks, and the budgetary impact of its operations should be limited. Directors commended the authorities for strengthening their effort to prevent money laundering and counter the financing of terrorism by establishing a financial intelligence unit.

Directors called on the authorities to strengthen economic statistics to improve their usefulness for economic monitoring and policy analysis. Domestic statistics-gathering capacity in particular needs to be enhanced. They encouraged the authorities to participate in the General Data Dissemination System.