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p. 47 of 68 BACK | NEXT I. Developing Asia and the World II. Economic Trends and Prospects in Developing Asia East Asia Southeast Asia South Asia Central Asia The Pacific Cook Islands Fiji Islands Kiribati Republic of the Marshall Islands Federated States of Micronesia Nauru Papua New Guinea Samoa Solomon Islands Democratic Republic of Timor-Leste Tonga Tuvalu Vanuatu III. Competitiveness in Developing Asia Statistical Appendix

Asian Development Outlook 2003 : II. Economic Trends and Prospects in Developing Asia

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Federated States of Micronesia

The economy grew in FY2002, albeit more slowly than the past 2 years. Growth was supported by increased government spending using "bump-up" Compact funds. The consolidated fiscal position conceals the need for the national and all four state governments to make significant fiscal adjustments in view of lower Compact funding expected from FY2004. Growth is projected to pick up in FY2003.

Macroeconomic Assessment

GDP increased by 0.8% in FY2002 (year ended 30 September 2002), following growth of 1.1% in FY2001. With the exception of FY2000, growth has been very weak since the mid-1990s following reductions in Compact of Free Association funding. As the private sector and public enterprises did not expand in FY2002, yearly growth was driven by consolidated government expenditures, which increased by 2.3%. Based on employment data, the manufacturing, distribution, financial, and business services were the only sectors to expand.

Economic growth in recent years has been driven by high government spending that follows a period of adjustment to the reduction in Compact funds. The governments of the Federated States of Micronesia (FSM) and the US have been negotiating the extent and nature of continued Compact funds since 1999.

The commitments for the first 15 years ended in FY2001 and additional transitional funds (in excess of transfers for FY2001) became available for a further 2 fiscal years while negotiations continued. This transitional funding level is equivalent to the average of funding for the first 15 years—resulting in an increase equal to $17 million or 7.3% of GDP in FY2002, known as "bump-up" funds.

High government spending continued in FY2002 financed by the contribution to government revenues from bump-up funds and some drawing down of reserves. Despite the fiscal boost, growth has remained weak, reflecting greater fiscal problems in Chuuk and a cautious attitude in the private sector as the Compact is renegotiated.

The consolidated accounts for FSM show an overall budget surplus of 2.4% of GDP in FY2002, following a series of sizable deficits that have averaged 6.8% of GDP since FY1998 (Figure 2.28). Total revenues and grants increased significantly to 69.1% of GDP in FY2002. Tax and nontax revenues (other than grants and fishing access fees) also increased. Total consolidated government expenditures were up to 66.7% of GDP in FY2002, reflecting the dominant role of the public sector in the formal economy.

The Government plays a major role in all states and in the FSM as a whole, though the exact importance of the public sector and its fiscal position vary considerably across the national and state governments. Pohnpei is the only state government where the economy is not dominated by public expenditures, as state government expenditures were 28.7% of total GDP in FY2002. On the other hand, the Government is particularly dominant in Kosrae where total public expenditures were 78% of GDP in the same fiscal year. The private sector continues to be generally characterized by small-scale activities focused on the local market. All four state governments continue to be heavily reliant on grants, although the national Government and Yap have been relatively more successful in raising local revenues.

Exports stagnated in FY2002 and imports declined by about 10%, leading to a narrower trade deficit. The services account also improved slightly, reflecting higher travel receipts and lower payments for freight and insurance. Tourist arrivals increased by 6.7%, following a decline of 18.8% in FY2001. However, fishing access fees (the single most important external income source apart from transfers and travel receipts) declined by 6.7% in FY2002, the third year in a row that a decline has been recorded.

The balance of payments is dominated by official transfers, primarily in the form of Compact receipts, which account for about 70% of all current account payments and indicate the high dependency of the economy on external aid. Official transfers rose by 16.8% in FY2002. Reflecting these developments, the overall current account moved into surplus of 3.7% of GDP, from a deficit of 7.6% of GDP in FY2001. The overall balance of payments also moved into a fairly strong surplus position. Net external debt (adjusted for offshore investments) declined from 17.0% to 15.0% of GDP, continuing a trend that started in FY1993 when net debt peaked at 35.0% of GDP. Debt service costs as a proportion of exports decreased from 36.0% to 8.0%.

Inflation for the country as a whole was negligible in FY2002. Domestic items recorded an overall price decline of 1.4% while imported items showed a rise of only 0.7%. Inflation varied across states with Yap recording a yearly increase of 2.8%, Pohnpei a decrease of 0.5%, and Kosrae a decrease of 4.5% (no data were available for Chuuk). FSM uses the US dollar as its currency, which gives it the advantage of avoiding currency crises and, with its high import dependency, helping keep inflation low.

The Bank of Hawaii closed its operations in the country on 30 November 2002, as part of a broader corporate restructuring. The transfer of the customer base to the other two commercial banks (Bank of the FSM and Bank of Guam) appears to have occurred in an orderly fashion. However, the exit of what was regarded as the most profitable commercial bank in the country could only have impacted adversely on business confidence in 2002 and may raise concerns about future competitive influences.

Policy Developments

The budget surplus for FY2002 masks a deterioration in consolidated government finances reflected in sizable deficits since 1998 and variation in fiscal performance across states. The national Government alone has recorded fiscal deficits in the range of 4-6% of GDP in each year from FY1997 to FY2001 and a smaller but still sizable deficit is expected in FY2003 despite the boost from bump-up funds. The deficits have been financed by using reserves of the national Government. However, unreserved balances are now near zero or negative for the national Government and all state governments, except Yap, where unreserved balances were about $41 million in FY2002, equivalent to about 105% of state GDP. In recent years, Yap, the only state government in a strong fiscal position, has been able to achieve an impressive fiscal record and high standard of public sector management.

According to official government reports, part of the arrangements to secure further Compact funding is for FSM to establish a Compact Trust Fund and contribute $30 million of the additional $34 million in bump-up funds to this Trust Fund. The national Government, as well as the states of Pohnpei and Yap, have set aside adequate funds though Chuuk and Kosrae have failed to do this, with the result that there is currently a net shortfall of around $3.2 million. With the prospect of continuing Compact funds, some sinking fund assets, a proposed ADB private sector development loan, and expenditure restraint, it should be possible to finance the Trust Fund requirements. However, over the medium to longer term, there will be a need to raise more local revenues, further restrain government expenditures, and promote the development of a much larger role for the private sector in the economy to achieve fiscal sustainability.

The Government faces a daunting challenge in implementing policies and measures that will improve the international competitiveness of private business on a scale and in a time frame that will have a meaningful impact on productivity and living standards. The formal private sector is very small scale, inexperienced, isolated from international pressures and opportunities, and further constrained by a low level of human resource development and poor public infrastructure.

Outlook for 2003-2004

Given the heavy reliance on Compact funding and the low level of private sector development, medium-term prospects depend critically on the availability and use of future Compact funding. The proposed Compact II arrangements are supposed to remain in force for 20 years, by which time the Trust Fund should have grown to an adequate level to provide revenue equivalent to the annual grant level for the final year of the agreement in FY2023.

Under the most recent proposals, GDP per capita is projected to grow in the range of 0.1-0.3% on average over the life of the new agreement, depending on the final scale of transfers that are agreed to, with the higher growth rate corresponding to the higher end of contributions.

To achieve a better performance, a challenge for the FSM is to develop some high-performing export activities, as the local economy is too small and dispersed. There are prospects for this in agriculture, fisheries, as well as tourism and a key ingredient for more immediate success is to attract significant foreign investment to help organize production, distribution, and marketing in these industries. Given the current environment, this will require three critical components for policy direction: an open foreign investment regime, a competitive and economically efficient tax system, and easier access to land and other natural resources.

The national Government can play a key role in promoting private sector investment and private sector-led growth. To this end, it can pursue a policy and foster an environment aimed at improving the competitiveness of the private sector in the short to medium term. Specific activities should include (i) securing a stable fiscal situation to engender business confidence and avoid the costs of dealing with fiscal crises; (ii) clarifying the role and scale of government in private sector development to ensure that interventions are effective; (iii) improving the efficiency of public expenditures and public enterprise activities to lower the tax burden and the costs of doing business; and (iv) establishing an approach that reduces the transaction costs of starting and operating a business.

Across the economy as a whole, one of the factors that is critical in restricting private sector development emanates from existing customary land ownership arrangements. Multiple ownership is common and land cannot readily be used as collateral. While it is possible to lease land, the process is difficult and time consuming. Improvements in land titling at the state level have been slow. Foreign ownership of land is prohibited and some states do not even allow ownership by citizens from the other states. This severely restricts mortgage-secured lending. The FSM Development Bank is able to use land as collateral because it is locally owned; however, commercial bank lending is restricted and foreign investors are unlikely to be interested in incurring the substantial transaction costs in securing leases unless there is very good profit potential. Land lease and mortgage draft laws allowing land leasehold mortgage have been developed, but are yet to be passed.

Over the longer term, continued efforts to improve human resource capacity will have an important impact on productivity and competitiveness and need to be pushed through with vigor by both the public and private sectors.

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