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p. 56 of 77 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 Republic of Palau Papua New Guinea Samoa Solomon Islands Democratic Republic of Timor-Leste Tonga Tuvalu Vanuatu III. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia

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Federated States of Micronesia

A reduction in foreign grants triggered a large contraction in the economy in 2004. Conditions are expected to improve in 2005, but prospects further out are highly uncertain. Foreign grants available for government expenditures are on a downward trend, and economic growth will be increasingly dependent on expansion of the small private sector.

Macroeconomic assessment of 2004

The economy contracted in 2004 as it adjusted to new arrangements with the US under the Compact of Free Association, as amended. GDP is estimated to have declined by 3.3% in FY2004 (ended 30 September), likely almost all attributable to a contraction in the public sector of 8.4%. Other sectors are also expected to have shrunk, but by less than 1% in aggregate. Dive tourism was firm, with the three main dive hotels reporting occupancy rates of more than 80%. However, other tourism activity was weak and occupancy rates at other hotels were typically less than 40%. Tourist arrivals in 2004 are estimated at more than 10% below the previous year’s level and substantially below recent highs. The high cost of airfares relative to other regional destinations remains a major constraint on tourism. Even though airfares were reduced in the second half of 2004 following the July entry of a new carrier, Air Palau Micronesia, the existing operator matched these lower fares and the new operator had ceased flights by December.

The weak economic environment resulted in a poor revenue outcome for the year. Total tax receipts slipped by 2.3% in 2004, with import duty collection falling by 7% and revenues from the wages and salary tax weakening by 5% (in nominal terms). Improved enforcement led to a slight rise in revenues from the third-largest tax, a turnover tax. The declines in tax revenues were greatest in the states of Chuuk and Kosrae, of 15% and 7%, respectively, from the 2003 levels. In contrast, collection in Yap and Pohnpei rose by 3% and 4%, respectively. This pattern is consistent with the relatively larger fiscal adjustments that were required in Chuuk and Kosrae in 2004.

Grants also fell substantially during the year, stemming primarily from the end of a “bump-up” in funds provided by the US for the final 2 years of the previous Compact. The 27% fall in revenues and grants exceeded a 12% cut in expenditures and net lending, and the consolidated budget moved into deficit (Figure 2.29). This followed 2 years of surpluses, which had been achieved to meet a government commitment to invest in a trust fund, negotiated as part of the amended Compact.

Inflation is estimated to have stayed low in 2004 at 1.5%, as a result of the US dollar’s use as a base currency and the low inflation rates in the country’s main trading partners. Commercial bank lending remained low over the first half of 2004. Total lending was $53 million as of December 2001, but had fallen to $22 million by December 2003 following the closure of the operations of the Bank of Hawaii in the country and a tightening in the lending policies of the two remaining banks. Lending fell by a further 8% by end-June 2004. Commercial loans recorded a 23% rise over the first half, but this was more than offset by a fall in consumer lending. Lending by the other main source of finance, the FSM Development Bank, was stable. Indicative interest rates on business loans from the commercial banks remained close to 7% while interest rates on consumer loans rose slightly to just above 15%. Deposit rates continued to hover around 1%. Deposits at the commercial banks of $110 million as of June 2004 remained well above total lending.

It is expected that exports were stable in 2004, representing about 15% of imports. While the easing in domestic demand is likely to have lowered non-oil imports during the year, higher fuel prices will have countered this, and the trade deficit is forecast to come in at close to recent levels. The large decrease in grants for 2004 is likely to have resulted in an overall deficit on the balance of payments.

Macroeconomic policy developments

The amended Compact with the US will provide $92 million in grants annually until FY2023. This is substantial, at the equivalent of 40% of current GDP, and will underpin the economy over the long run. The grant is only partially indexed to inflation and, what is more important for fiscal management, a portion of the grant is to be saved in a trust fund. Initially $16 million is to be saved each year, but from FY2006 this will rise by $0.8 million a year. The consequence is that grants available for general government expenditures are significantly below the $84 million received toward the end of the previous agreement (excluding the bump-up). The real value of grants available for the budget will continue to decline.

The Third FSM Economic Summit was held in early 2004 in Palikir, Pohnpei to build awareness of the new arrangements with the US and to develop consensus on an overall development strategy. The summit was attended by more than 400 people, representing the traditional leadership, the private sector, national and state governments, NGOs, churches, women’s and youth groups, the civil service, and international donors. A consensus emerged at the summit to pursue a high economic growth strategy based on agriculture, fisheries, and tourism with the objective of achieving self-reliance over the term of the amended Compact. The summit also emphasized the importance of ensuring that Micronesians receive an equitable share of the benefits of growth.

The summit recognized that achieving the strategy would require a major public sector reform program, and agreed that a key element of the program would be the generation of revenues required to protect essential public services and investment. A redirection of expenditures to priority areas was also envisaged, including increased investment in airports, electricity, roads, and health facilities. It was also agreed that performance-oriented planning and budgeting systems would be adopted. The summit endorsed action to generate domestic and foreign investments through revised rules and laws, including the implementation of regulations to facilitate employment of the foreign technicians and managers needed for rapid growth. The overall intention of the public sector reform program will be to create a competitive investment environment to buttress private sector expansion.

Outlook for 2005-2007 and medium-term trends

The amended Compact provides for the adoption of a range of new performance requirements. These include new procedures for the specification, tendering, and contracting of major public works. The FY2004 budget anticipated administrative problems in adjusting to the new procedures and only budgeted for relatively low levels of public investment. However, it was expected that these problems would be overcome by FY2005, when there would be a large expansion in the public works program. This boost in investment is expected to help the economy recover, and growth in GDP of 2.3% is projected in FY2005.

The revenue position is expected to improve in FY2005 as the firmer domestic economy pushes up tax revenues and $13 million is received from a US Special Education Grant (in addition to Compact funds). A small deficit is projected for the consolidated general government sector for the year. Despite a second consecutive year of deficits, gross external public debt is expected to remain low at approximately 26% of GDP, or less than 20% in net terms once offshore financial assets are taken into account.

The consolidated general government sector faces an ongoing need to control operating expenditures. In addition to the decline in grants available for general government spending, transition arrangements require a shift from operating to capital spending. Over the 5 years to FY2009, $6.3 million is to be redirected from operating expenditures. While the required correction is small relative to total expenditures and net lending, it is large relative to the expenditure base from which compensating cuts could be made. In the case of the state governments, the cut in locally funded operating expenditures would range from 16% to 37% if all the adjustment is to be made on the expenditure side.

The economic summit favored the pursuit of revenue reform to help alleviate fiscal constraints. A commitment was made at the summit to a revenue-neutral shift to a modern tax system within 2 or 3 years. Adjustment to existing taxes could cover the $6.3 million revenue shortfall--most of it, for example, by an increase in the gross revenue tax from 3% to 5% and in the general import duty rate from 4% to 10%. The introduction of a VAT to replace the gross revenue tax is also being considered. A VAT is also recognized as having the advantage of providing a sound basis for raising overall revenue collection.

A quick buildup in private sector activity is unlikely given its current low level. The economy is heavily consumption oriented, and export activities have been slow to establish themselves. Most families meet their own needs with regard to locally produced items, and consequently local trade in agricultural products is limited and agricultural exports are few. Attempts to establish export-based fishing operations have met with little success--any exports are almost entirely attributable to the efforts of distant-water fishing nations.

Tourist arrivals are now low at around 10,000 people a year, and there seems to be no ready solution to the hurdle imposed by a monopoly airline. This low base of private sector activity highlights the major effort required to raise the standard both of infrastructure and of the policy environment, if high growth is to be achieved.

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