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p. 46 of 81 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia South Asia Central Asian Republics The Pacific Cook Islands East Timor Fiji Islands Kiribati Marshall Islands Federated States of Micronesia Nauru Papua New Guinea Samoa Solomon Islands Tonga Tuvalu Vanuatu III. Preferential Trade Agreements in Asia and the Pacific

Asian Development Outlook 2002 : II. Economic Trends and Prospects in Developing Asia

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Federated States of Micronesia

The economy grew at a modest 0.9% in 2001, helped by a temporary increase in funding from the Compact of Free Association with the US. Prospects depend largely on future funding under the Compact and on how these funds are used to increase economic efficiency and production in the private sector.

Macroeconomic Assessment

Fishing is the primary industry in the Federated States of Micronesia (FSM), followed by tourism and a modest level of manufacturing and construction. However, the economy has been highly dependent on funds from the US under the Compact of Free Association. In recent years, the Compact has provided a total of around $80 million annually in budget support for the national and four state governments (Figure 2.32). US funding reached almost $85 million in 2001, compared with an estimated GDP of $240 million for the year. The level of funding provided under the Compact has been stepped down twice since 1986, and this has required a contraction in the size of the public sector. The adjustment to the second step-down in the mid-1990s was a key factor behind 3 years of falling GDP at that time.

Current levels of Compact funding were to have ceased in September 2001 and to be replaced by a new negotiated level. In anticipation of a potentially protracted negotiation and approval process, the current agreement was extended for a further 2 years, during which time funding was set at the average rate of the 15 years of the agreement. This amounted to a temporary increase of about $17 million a year, known as “bump-up” funds. The additional funds allowed for an increase in government expenditures, mainly on development projects and wages. This helped boost economic activity over the last quarter of 2001, leading to marginal GDP growth for the year estimated at 0.9%.

Marine products generate almost all export revenues. Foreign fishing companies, operating mainly offshore, dominate the fishing industry. While fish exports have grown considerably, the industry has created relatively few jobs or profitable business opportunities for locals. The main impact of the fishing industry is via the payment of fish license fees to the national Government. With a small export base, the private sector is dominated by production for domestic consumption. Most nongovernment market activities are in services and the retail and wholesale trade, which are substantially dependent on the demand generated by government spending.

Within the private sector, the tourism industry has the best potential. However, visitor arrivals declined from 16,500 in 2000 to 15,250 in 2001, with the fall concentrated among visitors from Japan and other parts of Asia. For the full year, the number of visitors from the US (accounting for around half the total) increased slightly, but this includes a decline immediately after the September 11th events.

In 2001, total formal employment (employing only about 16% of the population) fell by around 7%. Most of the decline came from cutbacks in the government sector. The annual inflation rate (for Pohnpei only) was estimated at 2.6% as of end-June 2001. The low rate reflects both the stagnant economy and low inflation in the US—the major source of imports.

Total loans from commercial banks amounted to just over $50 million at end-June 2001, or equivalent to about one fifth of GDP. Reflecting the low level of private sector activity, only $18 million were lent for commercial purposes, and the volume of these loans had declined over the 12 months to June 2001. This led to a high level of excess liquidity in the commercial banking sector.

Policy Developments

The availability of the bump-up funds has tested the fiscal credentials of the national and the four state governments. The state governments of Pohnpei and Yap, and the national Government, committed themselves to putting 50% of the additional funds into a special stabilization account of the FSM Trust Fund. This was intended to promote fiscal discipline by avoiding an increase in expenditures to likely unsustainable levels after September 2003. In contrast, Chuuk state government proposes to save the bump-up funds only for 2003, while fully spending the funds for 2002 on additional development projects and higher wages. Kosrae state government intends to use the funds to increase its wages by 20%. The risk, though, is that these two states may find it difficult to cut back the public sector if Compact funding declines after September 2003.

The Government has the potential to raise more revenues domestically, and one option is to replace an existing turnover tax. Improved tax administration is also required.

The external debt-to-GDP ratio was estimated at 24% in 2001. The national Government is committed to maintaining the debt at no more than this level through 2004. This represents a substantial reduction from a peak of 66% in the early 1990s. Given the prospect of declining revenues once Compact support is renegotiated, it is important that current debt levels remain manageable.

Outlook for 2002-2003

Given the uncertainty of the amount of future Compact funding, it is difficult to judge how fast the economy will grow after September 2003. However, it is projected to strengthen by 3.3% in 2002, supported by the temporary increase in Compact funding, before falling to 0.7% growth in 2003. The uncertainty over the future size of the public sector is deterring private sector investment and the potential for economic expansion. It is difficult to expect much new activity prior to the finalization of negotiations with the US. Over time, national and state governments will be required to reduce expenditures or introduce new revenue-raising measures (or a combination of the two), either of which would tend to have an adverse impact on the private sector.

The international donor community has extended considerable support to strengthen fiscal management and improve the enabling environment for private sector development. Some achievements have been realized, but these need to be consolidated in Pohnpei and Yap states, while fiscal responsibility is not yet ensured in Chuuk and Kosrae states.

One consequence of large external flows has been that public sector pay rates have risen substantially above (to around double) those of the private sector. The resulting high reservation wage causes labor market distortion in the form of an excessively high cost of domestic labor to the private sector. It is very difficult to see this sector substantially reducing its dependence on the public sector as a source of demand. This factor will tend to continue to influence the prospects for private sector development over the medium term.

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