Regions and Countries

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p. 2 of 6 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 Appendixes

Country Strategy and Program Update 2005-2006: Federated States of Micronesia

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II. Current Development Trends and Issues

A. Recent Political and Social Developments

2. The FSM is a stable democracy with actively contested national, state, and local government elections. General elections were held in March 2005 for the FSM National Congress, and most of the incumbents returned to the Fourteenth Congress, except two from Chuuk. In addition, new secretaries of the national Government were appointed for Department of Health, Education and Social Affairs; Department of Justice; Department of Economic Affairs; and Department of Transportation, Communication and Infrastructure. In the larger context, the complexity of Government with five distinct national and state governments, and the multitude of municipal governments, is not only expensive to operate, but has contributed to inefficiency and incapacity to formulate and implement sound development policies and strategies. Given the federal structure adopted against the backdrop of distinct cultures coming together to form the nation, there is an extra burden imposed in terms of intergovernmental cooperation and coordination.

3. A third nationwide economic summit was convened in March 2004 with the theme, The Next 20 Years: Achieving Economic Growth & Self-Reliance. Both the first and second economic summits stressed the need for private sector development (PSD) to replace large Government entities as the engine of growth for the economy. The main constraints to PSD include (i) weak commitment to economic reforms, (ii) lack of access to land, (iii) labor market inefficiencies, and (iv) an unfavorable policy environment. These constraints still remain despite years of summit discussions.

4. During the third summit, the Government made a firm commitment to continuing economic policy reform to cope with the transition of the Amended Compact and to maintain long-term sustainable economic growth. An infrastructure development plan (IDP) was approved at the Joint Economic Management Committee (JEMCO) meeting in March 2005. An FSM-wide strategic development plan (SDP) was finalized in July 2005 in preparation for the JEMCO Meeting in August 2005. This will build awareness of the anticipated structural and projected impact of the Amended Compact including a strategic planning matrix, directly linked to annual budget performance, with quantifiable outcomes for sector strategic goals.

5. Basic literacy is both high and equitably distributed between genders and states. However, neither the quality of education nor students’ attainment levels have improved significantly in recent years. Health indicators are also unimpressive. The FSM still has one of the highest maternal mortality rates among the Pacific developing member countries (PDMCs)— although maternal mortality rates have fallen significantly—and there is a rapidly increasing incidence of noncommunicable diseases. Only 41% of the population has access to improved water sources and about 45% to improved sanitation. Improved water sources may not actually be safe, and supply may be limited during droughts. Sanitation may improve household conditions but pollute adjacent areas. These services are often provided from Government funds or by heavily subsidized utilities, and so are often neither operated nor maintained in a sustainable fashion, with Pohnpei state as the notable exception. Poor solid waste management is evidenced by the lack of engineered waste disposal facilities in all states. Collection of wastes varies. Tables A2.1 to A2.4 in Appendix 2 show the country’s progress toward the millennium development goals (MDGs) and targets.

6. The very limited reliable data on poverty and social indicators show slow progress toward achieving the MDGs. A recent analysis¹ reveals that approximately 30% of households in 1988 had incomes below the estimated basic needs poverty line of $768 per capita per year ($5,693 per household per year). It also suggests that 20% of households with the lowest incomes receive less than 4% of total income, while the highest quintile receives more than 50%.

7. With a human poverty index of 26.7, the FSM ranks ninth in poverty among the 14 PDMCs. This ranking largely reflects the extremely poor social services in rural areas and outer islands, caused by factors including insufficient institutional capacity, an inefficient public sector that captures a disproportionate share of resources, lack of community ownership, and dispersed geographical locations.

B. Economic Assessment and Outlook

8. The Government continues to dominate the economy. The formal private sector is small, inexperienced, locally focused, and relatively isolated from international opportunities. The economic environment is characterized by inadequate public infrastructure, a deficient collateral framework, poor skills, ineffective and often inconsistent investment policies for both local and foreign investors, and state-owned enterprises (SOEs) that provide unreliable, expensive services while crowding out private-sector initiatives.

9. The economy contracted in 2004 as it adjusted to new arrangements with the United States (US) under the amended Compact of Free Association. Real gross domestic product (GDP) fell by an estimated 3.3% in FY2004 (ended 30 September 2004) following a modest growth of 3.2% in FY2003. The decline was mostly attributable to an 8.4% contraction in the public sector. Other sectors also declined, but by less than 1% in aggregate. Tourist arrivals in 2004 are estimated at more than 10% below the previous year’s level and substantially below recent highs. Recent growth continues the long-term trend of poor growth outcomes.

10. In FY2004, the FSM recorded a budget deficit of 6.7% of GDP, as opposed to a surplus of 5% in FY2003. The weak economic environment resulted in a poor revenue outcome for the year. Some state governments improved their tax collection (Yap’s rose by 3% and Pohnpei’s by 4%) in FY2004, while the national Government, together with the states of Chuuk and Kosrae, recorded declines in tax revenues. Total tax revenues 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). Grants also fell substantially during the year, stemming primarily from the end of the “bump-up” in funds provided by the US for the final 2 years of the previous Compact. Total official external debt outstanding at the end of FY2004 was $60 million, or about 26% of GDP, with debt servicing equivalent to 5.6% (5.2% in 2003) of exports of goods and services.

11. 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 Amended Compact also provides for the adoption of a range of new procedures and performance requirements for the specification, tendering, and contracting of major public works. The FY2004 budget anticipated administrative problems in adjusting to the new procedures, hence last year’s relatively low levels of public investment. However, with the Amended Compact, a large expansion in the public works program is expected in FY2005. This boost in investment is expected to help jump-start the economy, with real GDP projected to grow by 2.3% in FY2005. The revenue position is expected to also 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 budget deficit is still projected for the consolidated general Government sector for the year. Despite a second consecutive year of deficits, the 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.

12. The five state governments face the long-term challenge of adjusting to a decline in sector grants and making their revenues sustainable. 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 a compensatory rise in taxation revenue is needed during the Amended Compact period from the present level of about 12% of GDP to over 16%. A comprehensive reform of taxation and tax collection is required but faces strong opposition. Sizable budget surpluses will need to be run to build up the Compact Trust Fund to the required level. Completion of contributions to the fund scheduled for 2004 will be a major initial test of commitments. Presidential Order No. 27 established a Tax Reform Task Force, headed by the vice president, for possible implementation of a value-added tax (VAT) system based on the approach recommended by several technical assistance missions. A VAT would replace the customs duties and the state sales taxes. A major advantage of VAT in the case of the FSM is that it would replace two taxes that are inefficient and distorting in their effects on the economy.

C. Implications for Country Strategy and Program

13. The FSM country strategy and program update (CSPU) was last updated in July 2004, with the three pillars: (i) promote good governance, (ii) support inclusive social development, and (iii) promote pro-poor economic growth led by the private sector. The fundamental issues for the country—public sector dominance, weak private sector, heavy reliance on foreign aid, weak capacity in civil services, and deteriorating social conditions—have remained the same since the last CSPU. After intensive discussions and consultation with state and national Government officials, traditional leaders, private sector groups, civil society organizations, and key funding agencies, the Mission and the Government agreed that ADB’s current FSM country strategy with the above three pillars remains relevant and valid, but that effectiveness could be increased by further prioritizing state, sector, and issue focus under each pillar. The US Government, through the Amended Compact, provides substantial resources to the education and health sectors. The major challenge will be to apply these resources in a manner that will build sustainable local capacities. Under ADB’s strategy and program, special attention will be given to result-oriented implementation of ongoing projects, performance-based allocation among the states, and continued support for capacity-building in close coordination with the US Government. This niche conforms to the Pacific Strategy 2005–2009² and the Government’s SDP, and complements the Amended Compact with the US.

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