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p. 46 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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Republic of Marshall Islands

The economy continued to recover in 2002 after a long period of weakness. It benefited both from a temporary boost in Compact funding (while negotiations were under way for new Compact arrangements) and much lower debt service commitments. The outlook for 2003 is similar to the outcome for 2002, but prospects will be driven by the level and nature of future Compact funding.

Macroeconomic Assessment

Economic growth accelerated somewhat to 4.0% in FY2002 (ended 30 September 2002) from around 2.0% in FY2001 (Figure 2.27). This followed a period of weakness related to fiscal contraction in 1996-1997 and adverse weather conditions. Copra production increased with the support of higher prices and significant subsidies. The primary sector also benefited from higher income from fish exports generated from a tuna processing plant. Construction was supported by sizable public investment projects. Government expenditures rose by around 4.0% of GDP in FY2002 (ended 30 September 2002), reflecting a much stronger fiscal position and providing general support to the economy. With a general wage freeze in place, the rise in such expenditures reflects the filling of vacant positions, creation of new positions, and capital spending. The transport, communications, and trade subsectors benefited from a general strengthening in economic activity. Inflation increased slightly to about 2%.

The fiscal position improved substantially in FY2002 as debt service commitments were greatly reduced following the repayment of outstanding commercial loans and bonds in FY2001. Principal repayments peaked in FY1999 but still amounted to around $25 million in FY2001. Debt service commitments relative to exports of goods and net services and net income receipts declined to a manageable 8.0% in FY2002. The high level of these commitments in recent years has meant that the Government had to achieve substantial budget surpluses and draw down on its financial assets to meet the principal repayments. The fiscal position also benefited from a temporary boost in Compact of Free Association funding while a new agreement was being negotiated.

The Government receives considerable direct budget support and other forms of assistance from US federal government programs under Compact provisions. In FY2002, for example, grant funding amounted to 70.4% of total government revenues and grants. Nearly a third of the annual funding is earmarked for development spending on Kwajalein atoll and for rent payments to landowners on the atoll, in return for land use by the US. Separate compensation payments related to past US activities are made to families and communities of several atolls from a US-financed trust fund. The trust fund has dwindled in recent years, reflecting a combination of mounting claims and low returns.

The first 15-year phase of the Compact expired in September 2001 and the provisions for the next phase were being negotiated in FY2002 with expectation of finalization by September 2003. The Compact provides for 2 years of interim financing. These funds, known as "bump-up" funds, are equivalent to the average of funding for the first 15 years and will be available for both FY2002 and FY2003.

Local revenue generation has been relatively poor in recent years, reflecting the weak state of the economy. However, FY2002 saw some recovery with total domestic revenues strengthening by 7.8%. Income taxes declined but revenues from gross revenue taxes, import duties, and fees from fishing rights rose significantly. Total expenditures increased from around 65% to 70% of GDP but, as the Government met its commitment to contain wage rises, an overall surplus of about 9% of GDP was realized. The Government used the surplus, plus some financial assets, to make a significant contribution to the Marshall Islands Intergenerational Trust Fund of $15.5 million, or around 14% of GDP in FY2002, and made a commitment to allocate a similar amount to the Fund in FY2003.

Local conditions are the major factors in determining interest rates, despite the use of the US currency and absence of exchange controls. Interest rate margins have been around 7-12% for many years. Real interest rates for loans continued to be very high in 2002 at around 17% for consumers and 9% for businesses. The Bank of Hawaii closed its operations in late 2002, leaving only the Bank of Guam and the Bank of the Marshall Islands providing commercial banking services.

The country's export base is very limited, with estimated exports of only $10 million in FY2001 compared with imports of nearly $50 million. In addition, reexports of diesel fuel associated with Majuro's fishing base constitute the single biggest export and accounted for 70% of total exports in FY2000. Proximity to a major tuna fishing area, good harbor facilities, duty-free fuel supplies, reliable power and airline services, and ready availability of supplies in Majuro have led to the establishment of a fishing transshipment base in the town. In 1999, the facilities were expanded with the opening of a local tuna processing plant. Net income receipts, including fees from fishing rights, generate a significant income amounting to about 20% to 22% of GDP and, together with external transfers, have meant that the overall current account has been in substantial surplus for the past 3 fiscal years. Copra still provides the main source of export income on the outer islands.

The country joined the African, Caribbean, and Pacific States grouping and is receiving assistance under the Cotonou Agreement from the EU Center for Development Enterprises. In 2002, it was one of the main beneficiaries of the EU program in the Pacific with support for several activities to establish and promote exports.

In April 2002, OECD designated the country an uncooperative tax haven along with several other jurisdictions. The country was also on FATF's List of Non-Cooperative Countries and Territories. Later in the year, however, the country was removed from the list when the authorities took various steps to improve the transparency of the financial and monetary system.

Policy Developments

In the initial 15-year phase of the Compact, the Government and the economy became very dependent on US funding. However, public investments failed to deliver expected returns and the public sector became bloated and inefficient. The Government also borrowed heavily, using all future funds from the initial phase of the Compact as collateral. This led to a major financial crisis in 1996.

The new Compact provisions are reported to include measures to link funding to fiscal and public sector performance and long-term sustainability. It is also likely that the new Compact will stress accountability. An Intergenerational Trust Fund is supposed to receive Compact and government contributions with the aim of eventually replacing Compact budgetary support.

As a result of the financial crisis in 1996, a major public sector reform program was implemented with the support of ADB. Under the program, the civil service was reduced by about 35% between 1995 and 2000 and other measures were put in place to try to prepare for the possibility of lower assistance under a new Compact. In 2001, another reform program was agreed with ADB with a focus on fiscal and financial management, economic strategy advice, and improvement in the policy environment for private sector development. Budget reforms include the introduction of performance-oriented budgeting, which should start in the Ministry of Education and in the Ministry of Health and Environment in FY2003. In addition, a medium-term budget and investment framework has been developed in conjunction with the preparation of the FY2003 budget.

The reform program is also addressing a number of deficiencies in the structure and administration of the tax system. The income, social security, and health insurance tax systems are highly regressive. With social security and health insurance taxes only applying up to an income level of $20,000 or higher, the overall effective tax rate peaks at around 20% at that income level and then declines. In addition, nonwage incomes and fringe benefits are untaxed. A gross revenue tax of 3% on sales above $10,000, a separate wholesale sales tax of 4% levied by local governments, and a general tariff of 8% all need to be recognized as part of the overall tax system. There are also major enforcement and tax collection problems and anomalies associated with these taxes, including a lack of coordination among various bodies in identifying taxpayers and sharing information. This has led to a public perception of inequity in enforcement and the development of widespread incentives to evade taxes.

In response to these weaknesses, significant efforts were made to strengthen the administrative and enforcement capacity in the Tax Division of the Ministry of Finance in 2002 with more staff, computers, and new accounting systems. In addition, legislation is being drafted to reduce the highly regressive nature of the existing tax system. With nonwage income and fringe benefits not being taxed there is scope to raise more income tax revenues while meeting equity and economic efficiency objectives. The adoption of a broad-based sales tax also offers the potential to increase local revenues. This option is worth considering, particularly in light of the eventual adoption of PICTA.

Outlook for 2003-2004

Economic growth is forecast to slow slightly to 3.0% in FY2003, reflecting the impact of government spending restraint.

Total government expenditures are expected to rise as a proportion of GDP by 1.4 percentage points in FY2003; however, with total domestic and grant revenues to increase by a similar proportion, an overall surplus of 8.8% of GDP is projected. A freeze on general salaries remains in place but an increase has been approved for teachers; they have been left far behind in the pay league as they have been outside the Government's wage-setting regime since 1994.

The future level of Compact funding will continue to drive the economy over the medium term. Negotiations over the level of US funding beyond FY2003 are currently under way and due for completion by September 2003. Should Compact and other external funding be maintained in FY2004 at a similar or slightly lower level than the current one, some weakening in economic growth might be seen. The opportunity to emigrate to the US under the Compact provides an important adjustment mechanism for the economy.

The new Compact funding arrangements are considered to be more performance oriented than in the past and direct the Government's level and pattern of expenditures. However, continued long-term reliance on external funding represents a risk, unless the fundamentals for private sector development are greatly improved. Besides fiscal stability and tax system reform, key structural changes needed to facilitate private sector development are improving general access to land and adopting a more open and streamlined approach to foreign investment. Although actions have been taken to address these constraints, continued efforts are required to ensure that the regulatory environment is as attractive as possible for foreign investors.

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