Countries and Regions

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p. 2 of 5 BACK | NEXT I. Country Strategy II. Current Development Trends and Issues III. Implementation of the Country Strategy and Program IV. Portfolio Management Issues V. Country Performance and Lending Levels

Country Strategy and Program Update 2003-2005: Federated States of Micronesia

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II. Current Development Trends and Issues

A. Recent Political and Social Developments

6. The current national government administration was elected to office in the FSM in May 1999. Midterm elections for the 10 2-year members of the 14-member FSM National Congress were held in March 2001, resulting in the seating of one new senator in the May session and one in the August session of the 12th Congress, both replacing deceased senators. During the second regular session in October 2001, the FSM Congress passed bills authorizing the FSM to borrow from ADB for the PSDP and BSS.

7. The FSM is a stable democracy with actively contested national, state, and local government elections. Since gaining self-government in 1979, all transitions have been consistent with constitutional provisions and free and fair elections. National elections are scheduled for March 2003, subject to constitutional amendments that may result from the August 2002 referendum (para. 10). A new administration and a reorganized Congress will begin in May 2003.

8. The Economic Policy Implementation Council, created at the recommendation of the 2nd FSM Economic Summit in September 1999, has been established as an effective element of nationwide economic policy coordination. At the 5th council meeting in May 2002, the FSM leadership developed a strategy to identify resources, in addition to those bump-up funds already committed, to meet a US Government demand that at least $30 million be deposited into the proposed Compact trust fund prior to the start of new economic provisions.

9. State elections will be held in Kosrae and Yap in November 2002, while Pohnpei’s elections will be held in November 2003. Chuuk State’s governor was elected by a wide margin in March 2001; however he now faces impeachment investigations by the state legislation. Chuuk is also facing a major financial crisis that, if unaddressed in the coming few months, will have serious ramifications for the entire country. Chuuk will hold midterm elections for the 28- member lower house in March 2003.

10. As a result of the 2001 Constitutional Convention, some major revisions and amendments have been proposed. Among the 14 amendments that will be considered in the August referendum, four specific proposals may have an impact on ADB’s working relations, strategy, and assistance program. One would result in the president and vice-president being elected directly by popular vote, with the presidency rotating among the four states. Another three-part proposal would add 4 members to the 14-member FSM Congress; each senator’s term would be increased from 2 to 4 years, and a term limit of 12 years would be imposed. On the economic management front, one proposal would provide for concurrent powers at the state and national levels for a value-added tax; and another would increase the share of national taxes distributed to the states from 50% to 80%. These will have a significant impact on how the tax reform program is designed and implemented under ADB technical assistance (TA).

B. Recent Social Developments

11. In FSM, no consensus or even acknowledgment of the significant level of poverty exists in the country. Considerable inequality exists in terms of gross domestic product (GDP) per capita among the four states. Of serious future concern are the implications of population growth continuing to exceed economic growth, and the increasingly unequal standards of living between the population of the outer islands⁵ and migrants to Pohnpei and Chuuk.

12. Based on the latest household income and expenditure survey, an estimated 40% of households could fall under the national poverty line. With a human poverty index of 26.7, the FSM has a low ranking status in the Pacific. The incidence of economic inequality varies widely among the four states, and the lowest-income households are on the outer islands where the lack of opportunity for formal sector employment is chronic, caused by sluggish economic growth. Second, with a human development index of 0.569, the FSM scores poorly on social development goals. During 1980–2000, life expectancy increased from 65 to about 68 years, showing a moderate overall success in health care. Third, the FSM faces several environmental issues related to inadequate access of the population to safe water, inadequate solid waste management, and loss of biodiversity. As shown in the report prepared by the US Department of Interior (USDOI), the needs of rehabilitating deteriorated infrastructure facilities in the 4 states are intensive. The OID loan will focus on the most vital sectors for rehabilitation, and address the most urgent needs of the FSM that would help improve the living conditions of the local population and the deteriorating environment.

13. Maternal mortality of 122 deaths per 100,000 live births is a serious health issue, and illustrates the poor quality of the health services. The total fertility rate ranges from 3.7% in Yap to 5.6% in Chuuk, and the contraceptive prevalence rate is 30% in Chuuk and 45% in the other states. While the crude birth rate and fertility rates remain high, the number of children born per woman has decreased from 8.2 in 1973 to 4.7 in 1997. However, the high population growth adversely affects health indicators and also offsets economic growth.

14. Only 30% of those in paid employment are women. Women hold disproportionately fewer managerial positions (15% of the total), with only one elected woman in the national and state legislature bodies (1%). Gender inequalities are also significant as shown by lower female literacy and lower educational enrollment ratios. Education expenditure needs to be more effectively targeted, especially at girls in the elementary level. The BSS and OID loans will address many of these population, health, and education issues, specifically as they affect women.

C. Economic Assessment and Outlook

15. Over the past 3 years, the FSM economy has stabilized and returned to a level of growth nearer to its long-run average real growth rate of approximately 1.5% per annum. Stabilization followed a significant reduction of Compact funding at the onset of the third 5-year period of the Compact. The reduction amounted to the equivalent to 7.1% of GDP in FY1997. Following 4 years of economic decline from FY1996 to FY1999, the economy recorded positive real growth of 2.5% in FY2000, but declined to 0.9% in FY2001. The growth potential was significantly constrained due to the effects of worldwide recession, reduced capital expenditures, and uncertain investment climate, resulting from the looming threat of significantly reduced assistance under the Compact beyond FY2004.⁶ However, the economy is projected to grow by 3.3% in FY2002, supported by the temporary increase of about $16 million a year for FY2002 and FY2003 in the Compact funding level. One-half of these “bump-up” funds were reserved in FY2002 and a still greater proportion will be reserved in FY2003 in a stabilization account of the FSM trust fund. Projections for economic activity in FY2003 indicate a decline of 0.7%, largely as a result of fiscal tightening in advance of reduced Compact assistance anticipated in FY2004 and continued uncertainty curtailing investment. Inflation in the FSM remains moderate. The estimated national annual inflation rate (which is based on Pohnpei estimates) is 2.6% as of end-June 2001. The low rate reflects both the stagnant economy and low inflation in the US, the major source of imports.

16. The partial use of the “bump-up” Compact funds by Chuuk and Kosrae, in particular, allows for an increase in government expenditure on capital projects and wages. However, a stepdown in revenue is expected for FY2004, which may trigger a reduction in the size of the public sector. The public sector provides the core of the economy. It directly accounted for 34% of GDP in FY2000 and has typically employed around half of the formal workforce. The national Government maintained a large structural surplus; however, cyclical revenue shortfalls due to reduced fishing fees and low investment returns put significant pressure on the national fiscal position in the short term. In Pohnpei and Yap, which maintained medium-term fiscal balance by constraining recurrent expenditure, fiscal management remained sound over 2001 and 2002. Chuuk faced a cash flow crisis toward the end of FY2001 due to an overestimation of revenue and a rush of capital expenditure in the lead-up to an election. Their fiscal position has deteriorated in FY2002 due to continued lack of discipline; a financial crisis is looming unless rapid and rigorous reforms are put in place immediately. Kosrae has a medium-term fiscal imbalance, and during 2001 could not fully service recent loans to facilitate economic reform. Starting in FY2002 with a fiscal deficit, the executive and legislature have recently passed a “deappropriation” bill to meet the fiscal balance conditions of the PSDP loan. Resulting from a moderate structural imbalance a more difficult adjustment is anticipated for Kosrae in FY2004.

17. Based on recent negotiations, the FSM can now anticipate a package of new Compact economic assistance to be in place for FY2004. Even in the event of a delay in US Congressional approval, indications from the US Government are positive that FY2004 funding—consistent with negotiated terms—will be provided beginning 1 October 2003. Thus, there is little or no threat of a major, destabilizing adjustment at that time or anytime in the foreseeable future. As of May 2002, the difference between the US and FSM proposals has narrowed considerably. While both proposals would result in a moderate shock in FY2004, the latest economic analysis indicates that the FSM would benefit from a 20-year period of substantial funding followed by a smooth transition to support from a trust fund created during that period. The latest US proposal includes a $76 million grant and a $16 million contribution to the trust fund for 20 years. The contribution to the trust fund will increase by 0.8 million annually, while the grant will be reduced by a similar amount. All payments are inflation-indexed to two thirds of prevailing US inflation. While there is no predetermined sectoralization, a certain portion must be used for infrastructure investment and a fixed amount is set aside for maintenance to ensure long-term sustainability of those investments.

C. Implications for the Country Strategy and Program

18. In designing any future intervention, the implications of the federal structure of the FSM Government must be taken into account. Project designs cannot assume a uniform level of acceptance by all five governments and therefore must allow for differentiated project design. Possible changes in taxing powers and revenue sharing among the national and state governments arising from the referendum will also need to be factored into the future program.

19. Special attention will be given to ensuring no duplication and/or conflict with Compact assistance and assistance from other funding agencies. During the Country Programming Mission, the latest offer from the US was reviewed for its implications for ADB’s strategy. The latest information indicates an offer that will require further fiscal adjustment of a small to moderate magnitude during FY2004–2006 and reduction in funding for infrastructure projects.

20. The emphasis for public sector reform needs to be shifted to the state level. Recognizing the four states as key players, long-term improvement in terms of efficiency, effectiveness, and accountability in government must be directed at the state level, and adequate capacity to sustain such efforts needs to be built. Assistance directed to these outcomes will be through TA for capacity building at state levels and coordination with other assistance agencies.

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