Republic of Palau

Country Information

Location and People

The Republic of Palau is located in the Western Pacific on the western end of the Caroline Archipelago, and about 900 kilometers east of the Philippines. Situated in the Micronesian group of islands, the Caroline chain consists of six island groups totaling more than 300 islands. The islands vary geologically from the high, mountainous main island of Babelthuap to low, coral islands usually fringed by large barrier reefs. Only 9 of the islands are inhabited.

Babelthuap is the largest island and accounts for 78% of the country's total land area of 458 square kilometers. A bridge links Babelthuap to the capital of Koror. Koror is the largest urban area in Palau and home to more than 70% of the population of 19,000. Palauans account for 70% of the population, with Asians---mainly Filipinos, followed by Chinese, citizens from Taipei,China, and Vietnamese---accounting for nearly all of the balance.

Historical Background

Palau was for three decades a part of the United Nations Trust Territory of the Pacific under the administration of the United States (US). In 1978, Palau opted for independence rather than join the Federated States of Micronesia. A Compact of Free Association with the US was approved in 1986, but was not ratified until 1993. The Compact, which covers the 15-year period 1994-2009, entered into force the following year, when the islands gained independence.

Socio-Economic Conditions

The economy consists primarily of tourism, subsistence agriculture, and fishing. The government is the major employer of the work force, relying heavily on financial assistance from the US, including grants for direct budget support and disbursements for the creation of a Compact Trust Fund (CTF). Palau has the highest income per capita in the Pacific and the highest level of aid per capita.

Tourism is Palau's main source of income. Visitor arrivals grew to a record of nearly 80,000 in 2004. Tourism infrastructure is well advanced, with accommodation facilities ranging from fully integrated resorts to small guesthouses. Hotels, transportation and communication systems, and public utilities are being expanded to accommodate expected additional growth. Long-run prospects for the sector have been bolstered by the expansion of air travel in the Pacific, the rising prosperity of leading East Asian countries, and the willingness of foreigners to finance infrastructure development.

Beyond subsistence fishing and a small local market, Palau's main source of income from fishing is from the sale of licenses to fishing vessels from Japan, China, the US, and Taipei,China that catch tuna in Palau's extensive exclusive economic zone. Revenue from fishing license fees in 2004 remained at the fairly low level of recent years. Tuna harvesting failed to produce the catch levels characteristic of the late 1980s.

Palau has a small manufacturing sector producing mainly handicrafts and garments for the local market and for tourists. Relative to its size, Palau has a well-developed infrastructure. There is a well-maintained road network connecting Koror with Palau's largest island, Babelthuap, and a number of major new road projects are currently underway.

Palau enjoys a relatively high standard of living, the result, primarily, of support from the Compact of Free Association with the US. Fiscal deficits in recent years, however, have been the highest among Pacific island economies. They have been a major drain on the CTF, which has also been adversely affected by trends in international equity markets.

Country Outlook

Grant disbursements under the Compact are expected to decline over the remainder of the Compact period. A medium-term fiscal strategy that ensures long-term fiscal sustainability needs to be formulated and implemented. This strategy will involve a reprioritization of a reduced level of government expenditures, and augmentation of the CTF as a source of sustained revenues.

Over the medium to long term, the Government faces the twin economic challenges of managing the fiscal adjustment to a decline in sector grants, and encouraging broad-based private sector development. At present, there is over dependence on aid and tourism. Prospects for sustained growth in the post-Compact period are consequently uncertain. Economic activities with greater output and employment multiplier effects need to be promoted through structural reforms, including the creation of a leaner, results-oriented civil service, tax and tariff reform, and public enterprise reform.

Palau's comparative advantages lie in tourism, fisheries, small-scale manufacturing, and facilitating service industries. Government policies and institutions should provide a framework and supporting infrastructure to focus economic activity in these sectors. The economy needs to expand through increased private sector participation. The costs of doing business in Palau are generally high by international standards, and are especially high for closing a business. Bringing these costs down is an essential component of an improved environment for the private sector.