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Driven by an increase in tourist arrivals (Figure 3.34.18) and expansion in construction, economic growth accelerated to 5.7% in 2007. Tourism received a fillip from the weakening US dollar, which is also Palau's currency. Arrivals from the Republic of Korea rose by 21% and from Europe by 13%, providing welcome diversification from the main tourist sources of Japan and Taipei,China. The hotels and restaurants, and transport and communications subsectors, both related to tourism, grew by about 15% and 7%, respectively. Investment in tourist accommodation remained strong, with the construction of two resorts and a hotel, and renovation of other hotels and restaurants.
Inflation decelerated to 3.8% in 2007, primarily due to the decline in prices of clothing, footwear, and housing (Figure 3.34.19). On the fiscal side, domestic revenue collection rose by 2.5%, but growth in current expenditures quickened to 9.6%, and capital spending grew by 20.3%. As a result, the budget deficit in FY2007 (ended 30 September 2007) widened sharply to 7.0% of GDP from 1.0% in FY2006. External grants continued to dominate government revenues, providing 56% of the total.
With the ending in 2009 of the 1994 Compact of Free Association with the US, alternative financial sources will be needed to sustain public spending if negotiations for an extension of the Compact are unsuccessful. Tax reforms proposed by a Tax Review Task Force last year included increasing existing tax rates and introducing new taxes and fees. However, the FY2008 budget made provision for only two out of 19 proposed tax measures, while still providing for a 2.8% increase in public spending. It is likely that future infrastructure maintenance will be inadequately funded, given the completion of projects in 2007, including a major Compact-funded road. Palau's external debt was low, in the order of 10% of GDP, in FY2007.
The business environment improved in 2007 as a result of greater competition in telecommunications, which reduced costs, and regulatory reform, which somewhat strengthened the rights of foreign investors. In August 2007, new legislation extended land leaseholds by non-citizens from not more than 50 years without right of renewal to 99 years, consisting of 50-year leases with an option of renewal for another 49 years. Another new law removed a restriction that only Palauan citizens could register a ship and operate it within the country's territory. New legislation was also introduced to combat money laundering.
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Further growth in tourism is expected in 2008 after favorable publicity in the international media about Palau's strong stance on environmental protection and from the filming in the country of a new series of the US "Survivor" television show. Benefits of growth in visitor arrivals will again be spread over a range of services and in construction. The new land leasehold regulations, if implemented effectively, should complement recent improvements in economic infrastructure and encourage long-term investment, especially if foreign investment restrictions are eased.
Little fiscal adjustment is expected, at least until Compact renegotiations are further advanced. GDP growth is nonetheless forecast to slow to around 2% this year (Figure 3.34.20), because construction activity will decline from a peak reached last year, when the sector accounted for 17% of GDP, and because uncertainty about the outcome of Compact renegotiations could damp investor confidence. Inflation is expected to remain at 3–4%.
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