Countries and Regions

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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. FSM is a stable democracy with actively contested national, state, and local government elections. General elections were held in March 2003 for the FSM National Congress, and approximately half of the 14 senators were newly elected. The new president was appointed in May 2003 from among the four members-at-large of the congress. The new president formed the Cabinet in July 2003.

3. The 3^rd Economic Summit was held in March-April 2004 under the new leadership with the theme, “The Next 20 Years: Achieving Economic Growth & Self-Reliance”. More than 400 participants attended the summit, representing such stakeholder groups as the national government, the four state governments, traditional leaders, representatives of the private sector, nongovernment organizations (NGOs), and donors. The summit’s main objectives were: (i) to build awareness on the structure and projected impact of the Amended Compact²; (ii) to achieve consensus on an overall economic strategy, including an FSM-wide strategic development plan (SDP) and an infrastructure development plan (IDP); and (iii) to improve monitoring mechanisms to enhance implementation of policies and programs such as a strategic planning matrix, directly linked to annual budget performance, and quantifiable outcomes for sector strategic goals.

4. Three scenarios³ of economic growth were presented during the summit, of which the government decided to adopt the high-growth scenario. While details of the above three scenarios were not known, the high-growth scenario requires the country's continuous efforts in major structural reforms. A positive outcome of the summit was the government's commitment to continuing economic policy reform to cope with the transition of the Amended Compact and to maintain long-term sustainable economic growth.

5. The available data on poverty and social indicators show slow progress toward achieving the Millennium Development Goals (MDGs), although there is very limited reliable data. A recent analysis⁴ shows that approximately 30% of households in 1998 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 the 20% of households with the lowest incomes receive less than 4% of total income, while the highest quintile received more than 50% of income. This suggests unequal income distribution.

6. Basic literacy is both high and equitably distributed between gender and states. However, neither the quality of education nor students’ attainment levels has improved significantly in recent years. Health indicators are unimpressive. 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 a rapidly increasing incidence of noncommunicable diseases. Only 41% of the population has access to improved water sources and about 45% to improved sanitation. Table A2.1 in Appendix 2 shows the country's progress toward the Millennium Development Goals and Targets.

7. With a human poverty index of 26.7, FSM ranks ninth among the 13 PDMCs in terms of poverty. This largely reflects the poor social services in the rural and outer islands, caused by factors including insufficient institutional capacity, an inefficient public sector that captures a disproportionate share of resources, and dispersed geographical locations.

B. Economic Assessment and Outlook

8. Real gross domestic product (GDP) growth fell by an estimated 0.1% in FY2003 (ended 30 September 2003) following growth of 0.9% in FY2002. This national average reflected the impact of contraction in the public and financial sectors. Aggregate employment was down by almost 1% in FY2003 as falling employment in public administration, manufacturing, and finance outweighed increases in trade, hotels, restaurants, and education. The drop in employment was concentrated in Chuuk state, where the 2001-2002 financial crisis substantially curbed government employment.

9. In FY2003, FSM recorded a budget surplus of 1.9% of GDP. Consolidated revenues and grants for the national and four state governments increased by 2.1% to $163.7 million, while total expenditure rose by 3.1% to $159.6 million over FY2002 levels. Two-thirds of the increase in total expenditure was attributable to higher capital spending, while the increase in current expenditure mostly involved higher wages and salaries. Some state governments ran budget surpluses in FY2003, while the national government recorded a deficit. Total official external debt outstanding at the end of FY2003 was $54.3 million, or about 24% of GDP, with debt servicing equivalent to 6.1% of exports of goods and services. The debt repayment position was enhanced as the five governments held portfolio investments in an external debt management fund. Adjusting for these assets, unsecured external debt was equivalent to about 9% of GDP.

10. Real GDP is projected to decline by 1.5% in FY2004 because of an anticipated fiscal shock of approximately 10% of GDP. This fiscal shock is the combined result of a 7.3% reduction in Compact transfers into national and state government budgets, and the delayed availability of infrastructure sector grant funding. The reduction in transfers will be partially offset by spending of reserves, as well as spending under the US Federal Emergency Management Agency programs for typhoon relief in Yap and Chuuk. The delay in infrastructure spending means that $17 million, or 24% of the planned $76 million Compact transfers is effectively frozen in FY2004. The latter funds will become available in FY2005⁵ and, with a rise in sector grant assistance under the Amended Compact, is expected to contribute to an economic recovery. Growth in real GDP is projected to be 2.2% in FY2005.

11. The five FSM 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% of GDP. A comprehensive reform of taxation and tax collection is required but faces strong opposition. Sizeable 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.

12. The critical policy development in 2003 was the passage into US law in late November of the Compact of Free Association Amendments Act of 2003, which revised the original 1986 Compact of Free Association between the US and FSM. Under the Amended Compact, the US will provide a $76 million sector grant and a $16 million contribution to the Compact Trust Fund during the first year. The annual sector grants under the Amended Compact will be administered through six sector grants for (i) education, (ii) health care, (iii) private sector development, (iv) environment, (v) capacity building in the public sector, and (vi) public infrastructure, with priorities in education and health care. The contribution to the trust fund will increase by $0.8 million annually, while the grant will be reduced annually by a similar amount. The fund will remain untouched until FY2023, at which time it is expected to yield an annual income in perpetuity that could replace the Compact’s annual contributions to the budget. Contributions to the FSM budget represent a reduction of approximately 7% from the 2001 Compact grant level, and the further step down every year will entail a prolonged period of adjustment. The government needs sound fiscal management to mitigate the immediate and progressive reductions in contributions under the Compact to the FSM budget.

13. The Compact funds will be managed through a Joint Economic Management Committee (JEMCO). The FSM will establish the secretariat for JEMCO. Among JEMCO’s responsibilities will be reviewing government planning and budget documents, monitoring progress toward sustainable economic development and budgetary self-reliance, reviewing and approving grant allocations and performance objectives, and reviewing quarterly trust fund investment reports. The government, and JEMCO in particular, will require timely economic advice and assistance in a number of priority tasks, including formulation of a new economic strategy, expenditure cutting, tax reform, and adjustments in the structure and delivery of public services. A JEMCO meeting is planned in August 2004 for FY2005 budget appropriations.

C. Implications for Country Strategy and Program

14. The fundamental issues have remained since the last country strategy and program update (CSPU) for 2003-2005. The FSM continues to rely heavily on foreign aid—particularly from US Compact funds—and will be affected by any reduction in the external inflows. It is therefore necessary to promote the private sector to achieve sustainable socioeconomic growth. Poor quality social services and limited access to them remain a problem, as do governance and capacity in the public sector. ADB’s current country strategy and policy remains relevant and valid: it supports good governance, social sector development and reforms, and pro-poor economic growth led by the private sector. ADB’s current strategy is even more relevant with the reductions in grant funding under the Amended Compact.

15. ADB continues to support FSM with its three-pillar country strategy of promoting good governance, inclusive social development, and pro-poor economic growth. ADB's country strategy for 2005-2006 will further emphasize these underlying themes: (i) promoting participation of civil society in development; (ii) addressing poverty issues more explicitly; and (iii) providing assistance with a long-term perspective. Such emphasis on these themes will increase the effectiveness of ADB assistance to FSM through broader community participation, enhanced government accountability, and sustainable long-term development for the poor.

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