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Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia
Federated States of Micronesia The economy is estimated to have recorded only slight growth in FY2003, with considerable variation in the economic performance of the four states. Another economic downturn is expected in FY2004 as the economy adjusts to the new assistance provisions under the amended Compact of Free Association. A return to moderate expansion is forecast for FY2005. Economic Assessment GDP growth fell to an estimated 0.1% in FY2003 (ended 30 September 2003) following a rise of 0.9% in FY2002. This national average reflected the impact of contraction in the public and financial sectors, but the four state economies displayed considerable economic variation. The Pohnpei economy, which includes the national Government and accounts for 45% of national GDP, contracted by an estimated 2.8% because of declining private sector and public enterprise activity, while the government sector expanded. The smallest state economy, Kosrae (9% of GDP), experienced a broad-based contraction of 4.5%. In contrast, the Chuuk (30% of GDP) and Yap (17% of GDP) economies grew by 2.2% and 7.5%, respectively. In Chuuk, private sector strengthening more than offset the effects of contraction in the public and financial sectors, while in Yap a strong private sector was reinforced by growth in public enterprise activities. Aggregate employment was down by almost 1% in FY2003, as falling employment in public administration, manufacturing, and finance outweighed increases in the trade, hotels and restaurants, and education sectors. The drop in employment was concentrated in Chuuk state, due to a substantial drop in government employment. Two factors that distort the labor market are the high level of public sector wages relative to those in the private sector (about double); and the ease of migration to high-wage locations such as Guam, Commonwealth of the Northern Marianas, Hawaii, and mainland US. In FY2003, the overall budget recorded a surplus of 1.9% of GDP, as consolidated revenues and grants for the national and four state governments went up by 2.1% to $163.7 million, while total expenditures rose by 3.1% to $159.6 million. Most of the improvement in revenues and grants came from higher levels of fishing license fees, dividend and interest income, and external grants, with the last element constituting 70% of total revenues and grants. Two thirds of the rise in total expenditures was attributable to higher capital spending, while the increase in current expenditures stemmed from a higher wage bill. All of the state governments ran budget surpluses in FY2003, but the national Government recorded a deficit for the seventh successive year. Total official external debt outstanding at the end of FY2003 was $54.3 million, or about 24.5% of GDP, with debt servicing equivalent to 6.1% of exports. The debt position was further enhanced by the fact that the five governments held portfolio investments in an External Debt Management Fund. Adjusting for these assets, the unsecured component of external debt was equivalent to about 9% of GDP. Following the November 2002 closure of the Bank of Hawaii, Federated States of Micronesia (FSM) branch, only two commercial banks were operating in 2003. Total deposits in the commercial banks at end-FY2003 were 6.9% higher than at end-FY2002. Commercial loans fell by 52% as the banks restricted lending in response to accumulating arrears on commercial loan repayments, which in turn reflected a deterioration in the timeliness of state and national government payments to private service providers. Consumer lending fell by 23.3% because of a similar arrears problem and declining government employment levels. Prices tend to track those in the US, and in FY2003 estimated deflation was unchanged from the prior-year rate of 0.2%, and was largely attributable to falling food prices. Exports edged up by 2.4% in FY2003, reaching $20.1 million. Imports increased by 8.3% to $108.9 million and the merchandise trade deficit consequently widened. The deficit on the services account remained virtually unchanged at $28.4 million, with tourism arrivals declining by 3.0%, while the surplus on the income account widened on the growth in fishing access fees. Unrequited transfers, primarily Compact and other official transfers, increased significantly to $119.0 million. As a result, the current account surplus rose to $16.3 million, or 7.3% of GDP, while the surplus on the capital account dropped to 31% of its FY2002 level because of a large short-term outflow. The overall balance-of-payments surplus was 12.5% of GDP. Policy Developments The crucial policy development in 2003 was the passage into US law in late November of the Compact of Free Association Amendments Act 2003, which sets out the nature and terms of US financial assistance for the period FY2004-FY2023 (Box 2.5). In order to meet their obligation of contributing $30 million to the start-up capital of the Compact Trust Fund, the national and state governments committed to save $30 million of the $34 million in "bump-up" Compact funding received in FY2002 and FY2003. By the end of FY2003, $27 million had been provided. The deadline for completion of contributions is 30 September 2004, and an initial $16 million US pledge to the Trust Fund is conditional on this deadline being met. Further contributions of $16 million are expected by the US in FY2005 and FY2006. Under the amended Compact, there will be a shift from general budgetary grants to sector grants linked to performance conditions. The sector grant assistance receivable during FY2004-FY2023 is $76.2 million in the first year, rising to $88.4 million in FY2005 and FY2006, and declining thereafter by $800,000 annually. As noted, this annual decrement will be matched by contributions to the Trust Fund, so that US financial contributions will be $104.9 million annually from FY2005 (prior to adjustment for inflation and inclusive of annual audit grants of $500,000). Given the more rigorous accountability provisions under the amended Compact, the FSM Economic Policy Implementation Council endorsed an Accountability Improvement Project aimed at ensuring that future grant assistance is not jeopardized by inadequate public expenditure management and reporting. The planned reduction in Compact grant assistance from $99 million in FY2003 to $76.2 million in FY2004 (exclusive of Trust Fund contributions) was reflected in the formulation of the FY2004 budget, which primarily involved expenditure cuts to produce an overall budget surplus estimated at 1.9% of GDP. It was also recognized that an increased revenue effort was required at national and state levels. Following a national revenue symposium in early FY2003, key reform elements included a move to a broad-based consumption tax, the establishment of an Autonomous Unified Customs and Tax Administration to replace current national and state authorities, and a rationalization of current revenue-sharing arrangements. However, little progress in implementation was made subsequently. A constitutional amendment to enable simultaneous national and state jurisdiction of a VAT failed to gain the required level of voter support, and no progress was made in establishing an autonomous tax administration. Changes to revenue-sharing arrangements in late 2003 effectively reduced, rather than raised, the revenue share of the state governments, which bear most of the responsibility for service delivery. Following the election of the 13th FSM Congress in 2003, the new President called for a third FSM Economic Summit to be held in April 2004 as part of the formulation by consensus of a strategic development plan. An amended Compact requirement, the plan is expected to incorporate a private sector development strategy initiated in 2003. At the same time, a long-term infrastructure development plan will be formulated to guide public investment in a manner that is consistent with the sector priorities identified in the amended Compact. Remittances are not an important macroeconomic variable at present, but there is potential for them to grow and sustain FSM income levels as external grants decline over time. Outlook for 2004-2005 A decline of 1.5% in GDP is projected for FY2004 because of an anticipated fiscal shock of approximately 10% of GDP (Figure 2.30). The major risk to the above scenario is that the national or state governments may fail to meet the accountability requirements of the amended Compact, in which case cash transfers to one or more of the governments could be suspended. Growth could exceed expectations if improvements in the private sector enabling environment pull in greater volumes of domestic and foreign investment in agriculture, fishing, and tourism. Such improvements would result from land tenure reform, streamlined investment approval and licensing procedures, and improved management of public utilities and of physical infrastructure. Inflation is forecast to remain low, rising to 0.5% in FY2004 and 1.2% in FY2005, in line with the US inflation rate. The balance-of-payments profile is forecast to stay fundamentally unchanged in the medium term. The limited base of primary product exports is not projected to expand significantly, while import expansion will remain in line with aggregate economic growth rates. Accordingly, the merchandise trade deficit is projected to narrow in FY2004 before returning to about the FY2003 level the following year. The current account surplus, inclusive of official transfers, is forecast to decline as amended Compact funding drops in FY2004, offsetting any increases in tourist arrivals and fishing access fees. The external debt is primarily concessional and will remain manageable. Over the long term, the five FSM governments face the major fiscal challenges of managing the adjustment to the decline in sector grants and of placing government revenues on a sustainable basis. In FY2007, the reduction in real official transfers is estimated to be equivalent to 0.6% of GDP, and the national Government's economic modeling suggests that during the amended Compact period a compensatory rise in taxation revenues from the present level of about 12% of GDP to over 16% is needed. A comprehensive reform of taxation and tax collection is required but faces strong opposition. Sizable budget surpluses will be needed into the future to build up the Compact Trust Fund to the required level, with the completion of contributions to the Fund scheduled for 2004 representing a major initial test of the national and state governments' commitment.
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This fiscal shock is the combined result of a 7.3% reduction in Compact transfers to national and state government budgets, and the delayed availability of infrastructure sector grant funding. The reduction in transfers will be partially offset by spending of reserves and, in Yap and Chuuk, spending under US Federal Emergency Management Agency typhoon-relief programs. The delay in infrastructure project spending means that $18 million, or 24%, of the planned $76 million Compact transfers are effectively frozen in FY2004. The latter funds will become available in FY2005 and, with a rise in sector grant assistance under the amended Compact, are expected to contribute to an economic recovery. Growth in GDP is forecast at 2.2% in FY2005.
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