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p. 51 of 69 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions 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. Foreign Direct Investments in Developing Asia

Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia

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Republic of the Marshall Islands

As a result of limited expansion in the public sector and in primary production, the economy grew slowly in 2003. The late-2003 approval of the amended Compact of Free Association, which reaffirms the importance of private sector development, laid a foundation for achieving long-term fiscal sustainability, though this will require an adjustment to lower levels of public spending.

Economic Assessment

After strengthening by an estimated 4.0% in FY2002 (ended 30 September 2002), GDP is likely to have risen by close to 3.0% in FY2003, following recently revised public expenditure figures and analysis of the main local firms' annual reports. Statistical weakness, however, makes it difficult to assess economic performance.

Copra production expanded on account of higher copra prices, continued government subsidies, and intensified frequency of outer island shipping services. Also, the tuna loining plant turned in higher production figures than in 2002. Government spending expanded, though at a much slower rate than in FY2002, which was the first year of a 2-year boost in Compact funding pending finalization of the amended Compact of Free Association between the US and the Marshall Islands. The upturn in government demand, albeit modest, provided some stimulus to activity in other services sectors, particularly transport and communications. In the retail trade sector, increased competition led to faster growth.

Employment edged up in FY2003, primarily due to the filling of some civil service vacancies, and government wages rose from the previous year's level (Figure 2.29). However, growth in labor demand fell short of the annual increase in the labor supply (averaging about 2.4%).

The FY2003 budget forecast an overall surplus equivalent to 14.1% of GDP, compared with an actual surplus of 14.8% in FY2002. Tax revenues were expected to rise by 3.1% from the FY2002 level, largely because of a rise in gross revenues and import taxes. External grants, mostly supplied under Compact provisions, were forecast to remain unchanged, accounting for 50.4% of total revenues (exclusive of loan funds). Total expenditures in FY2003 were forecast to rise by 3.8% from the FY2002 level. The FY2003 budget provided for a 5% limit to the growth of general fund expenditures and continued the public service wage freeze (with the exception of some increases in the Ministry of Education that brought teachers' salaries in line with Public Service Commission pay scales). The actual budget outcomes for general fund activities in FY2003 showed that expenditures were well controlled, coming in just under the budget estimate, and that revenues were slightly above the budget estimate, mainly the result of improved tax collection.

The surplus was allocated as a contribution to the Marshall Islands Intergenerational Trust Fund (MIITF), which at end-FY2003 had a total capital of $31 million that was to be the seed money for the Compact Trust Fund to be established in FY2004. However, prior to the general elections of November 2003, $7 million of this allocation to the MIITF was provided as a deposit to the Marshall Islands Development Bank (MIDB) for onlending at concessional rates to two major retailers, and effectively became unavailable for augmenting Compact Trust Fund capital. External public debt in FY2003 was just over 50% of GDP and was dominated by ADB concessional loans. Debt service was at a manageable level following the 2001 repayment of high-cost commercial debt.

Inflation tends to track that in the US, which supplies 50-60% of imports. The estimated inflation rate in FY2003 was 2.5%, up from 2.0% in FY2002. Commercial banking services are provided by the Bank of Guam and the Bank of the Marshall Islands. Due to persistent defaults on consumer loan repayments, these banks slightly raised their lending rates on consumer loans to 18.5% in FY2003. In contrast, MIDB offered consumer loans at about 14%. The interest rate spread remained in the 7-12% range-with commercial loans at the lower end of the scale, and consumer loans at the upper.

The reexport of diesel fuel associated with the fishing transshipment base in Majuro remained the largest export in FY2003, while domestically generated exports were limited mainly to copra cake and coconut oil. After declining in FY2002, it is estimated that merchandise exports picked up by 12.3% in FY2003, but imports, at about five times the value of exports, rose moderately, and as a result the trade deficit remained substantial. Net income receipts and external transfers ensured another substantial current account surplus. The country's location, small size, and high cost structure continued to be the main obstacles to FDI, despite the possibility of receiving considerable tax and regulatory exemptions of the sort granted to the tuna loining operation.

Policy Developments

The critical 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). The overall annual financial support potentially receivable in this period, prior to inflation and other adjustments, is in the order of $66 million, or about 60% of the current nominal GDP level. Under the amended Compact, there will be a shift from general budgetary grants to sector grants, characterized by enhanced measures for accountability.

The FY2004 budget was the second formulated within a medium-term and investment framework context, and the phased introduction of performance-based budgeting. It estimates that total revenues and grants will rise by 5.2% from the level estimated in the FY2003 budget. The amended Compact contribution is $57.7 million, including a $7 million US contribution to the Compact Trust Fund. External grants will fund 51.4% of the budget, with tax revenues projected to rise by 3.0% in FY2004. Total expenditures are estimated to rise by 16.4% from the FY2003 figure, so that the budget surplus falls to $7.0 million from $16.0 million in FY2003. The education, health, and environment sectors are to receive substantial increments in their budget allocations.

The Government was returned to office in the November 2003 election and remained committed to the implementation of structural reforms, including the creation of a leaner, results-oriented civil service, tax and tariff reform, SOE reform, and enhancement of the environment for private sector activities. In 2003, a review of management systems and pay scales in the civil service was under way and several initiatives to facilitate private sector development were introduced. These included the amendment of the Development Land Registry Act, increased provision of business development services, streamlining of company registration processes, and the start of a process of strengthening land management and administration. However, transaction costs for foreign investment licensing remained high and no discernible progress was made in reforming the regressive taxation system. The financial performance of most SOEs remained poor in 2003, and the Government had still to follow through on its stated intention to divest itself of unprofitable businesses.

Outlook for 2004-2005

It is highly unlikely that there will be a significant medium-term expansion in the private sector, independently of public sector developments. It is accepted that the key to generating such an expansion is foreign investment in export-oriented ventures, but pilot projects in outer island tourism as well as farming seaweed, black pearls, and fish have not resulted in commercially viable outcomes, and there has been no notable foreign investment since the 1997 establishment of the tuna loining plant. Consequently, the public sector will continue driving the economy over the medium term.

The FY2004 budget provides for a boost to public expenditures, particularly in the health and education sectors, in line with the amended Compact. This is expected to create a demand-side stimulus to the economy, which is forecast to grow by 2-3% in FY2004. Major capital projects will probably only start in late 2004, and this will provide a stimulus in the years to come. In addition, there will be a one-off increase in Compact sector grant assistance in FY2005 of $5.6 million, prior to the phased $0.5 million annual reduction planned for subsequent years. Growth in FY2005 is expected to be around 3%. Cyclones and drought, which have had major impacts on subsistence agriculture and fishing in the past, as well as on physical infrastructure, could cause output volatility in the medium term. Inflation is forecast to remain in the 2-3% range in FY2004 and FY2005, in line with trends in the US economy.

The balance-of-payments profile is forecast to remain fundamentally unchanged in the medium to long term. The performance on the trade account will depend crucially on diesel reexports, which in turn will be a function of the transshipment business and thus the tuna catch and price. Copra production may be stimulated by a possible liberalization of the buying arrangements, but the copra processing plant is heavily subsidized and makes a negative contribution to GDP. The large trade deficit is expected to continue to be more than covered by net income from remittances and official transfers.

Over the long term, the Government faces the major fiscal challenge of managing the adjustment to a decline in Compact funds and placing government revenues on a sustainable basis. A promising start was made with the initial allocation of the bulk of "bump up" Compact funding in FY2002 and FY2003 to the MIITF, but the diversion of $7 million to MIDB in late 2003 is a fiscal governance concern, and sizable budget surpluses will need to be run into the future, in order to build up the Fund to the required level. The medium-term budget and investment framework for FY2004 and FY2005 projects surpluses in the $7 million-10 million range, which at under 6% of GDP may prove to be insufficient to build up the Fund. A comprehensive reform of taxation and tax collection is needed but faces strong opposition from groups with vested interests in maintaining the current tax arrangements. In addition, budget pressures could arise in the long term if sea-level rise causes accelerated coastal erosion, greater risk of storm surges, and excessive saltwater intrusion into fragile freshwater resources.

The Government is committed to poverty reduction and is planning to implement projects aimed at improving transport and basic social services to the outer islands, where hardship is somewhat higher. However, the prospects are that the numbers of unemployed and disadvantaged in Majuro and Ebeye, where two thirds of the population live, will rise. The rate of increase in the labor force is expected to outpace the rate of job creation by a wide margin, making emigration an even more important means of relieving population pressures and placing private sector development as a main item on the government agenda for future economic growth.

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