Information about Asia and the Pacific Asia y el Pacífico
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Republic of Palau

Author(s):
International Monetary Fund
Published Date:
May 2008
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I. Background

1. Despite relatively high per capita income, Palau faces challenges common to island nations, and self-reliance remains a distant goal. Formidable foreign grants have spurred growth, paved the way for increased private investment and contributed to an improved quality of life. Yet, developmental constraints prevail, including vulnerability to external shocks, geographical isolation, a narrow production and export base, a fragile and climate-dependent environment, as well as diseconomies of scale in the provision of public services. In addition, reaching political consensus on key economic and social issues while transitioning from a traditional tribal system to a modern democracy has often proved elusive for the young nation.

2. Palau is now at a critical juncture. Term limits imply that most policymakers will change following the November 2008 geeral elections, and the scheduled cessation of annual Compact grants in 2009 weighs heavily on the outlook for public finances.1 The government has long recognized that current policies are not sustainable, yet lack of consensus and strong vested interests have stalled much of the reform agenda. There are hopeful signs that this may be changing. However, there is a risk that the reform agenda increasingly take a backseat to ongoing discussions with the United States regarding a possible renegotiation of the Compact.

II. Recent Economic Developments

Since the last consultation economic performance has softened, but inflation remains in check and the external position is stable.2 Revenue weakness has led to a deterioration in the current balance, causing net government wealth to stagnate at about the level of GDP.

3. All indicators point to slowing economic activity. The high growth rates registered in 2004 and 2005 can mostly be attributed to a series of one-off events, such as the hosting of the Pacific Arts Festival, the South Pacific Mini Games, the filming of Survivor Palau and the construction of a new capital on the island of Babeldaob. Since the last consultation, the winding down of two major infrastructure projects, slowing private sector investment and weakening consumer demand have all led growth lower, to near its historical average (Table 1 and Figure 1).

Table 1.Republic of Palau: Selected Economic Indicators, 2001/02–2007/08 1/
2001/022002/032003/042004/052005/062006/07

Estimate
2007/08

Projection
Real sector
Real GDP growth (percent change)-3.5-1.34.95.53.02.52.0
Consumer prices (percent change; period ave.)-1.2-0.65.83.24.83.04.2
Business and tourist arrivals48,15760,73483,45285,00479,72087,14288,885
Public finance(In percent of GDP)
Central government
Revenue42.454.054.152.953.553.146.9
Domestic revenue23.826.026.627.924.823.424.2
Grants18.628.127.625.028.629.722.7
Expenditures66.362.662.753.759.558.051.9
Current48.950.047.444.144.743.939.0
Capital17.412.615.39.614.814.112.9
Current balance 2/-25.0-24.0-20.9-16.2-19.9-20.5-14.8
Overall balance (excluding grants) 3/-47.5-29.5-37.3-27.1-29.9-37.3-27.5
Overall balance (including grants) 3/-28.9-1.5-9.7-2.1-1.2-7.6-4.9
(In millions of U.S. dollars; unless otherwise indicated)
Compact Trust Fund (CTF) balance124.5136.3141.6152.5157.0174.0174.0
Interest income and capital gains/losses-4.719.511.316.810.423.023.0
Investment fees and withdrawals5.87.76.05.95.96.06.0
Government non-CTF financial assets13.716.49.59.811.89.9
Balance of payments
Trade balance-76.4-79.8-101.4-91.8-101.7-81.2
Exports (f.o.b.)20.38.45.913.413.610.1
Imports (f.o.b.)-96.7-88.2-107.3-105.2-115.3-91.3
Tourism receipts57.475.696.997.292.999.4
Current account balance
Including grants-21.2-6.0-6.8-4.7-20.89.8
Excluding grants-41.8-27.0-30.2-25.4-42.5-13.6
Overall balance-34.0-4.9-8.6-4.8-5.3-5.3
External public debt 4/20.019.420.318.617.522.921.5
Debt service ratio 5/0.91.51.82.11.71.6
(In percent of GDP)
Current account balance
Including grants-17.6-4.9-5.2-3.3-13.56.0
Excluding grants-34.6-22.1-23.1-17.8-27.6-8.4
External public debt 4/16.615.915.513.111.414.112.5
Sources: Data provided by the Palauan authorities; and Fund staff estimates.

Fiscal Year ending September 30.

Defined as domestic revenue minus current expenditure.

Including errors and omissions.

Does not include public enterprise debt which is not guaranteed by the government.

In percent of exports of goods and nonfactor services.

Sources: Data provided by the Palauan authorities; and Fund staff estimates.

Fiscal Year ending September 30.

Defined as domestic revenue minus current expenditure.

Including errors and omissions.

Does not include public enterprise debt which is not guaranteed by the government.

In percent of exports of goods and nonfactor services.

Figure 1.Republic of Palau: Real and External Developments

Sources: Country authorities; World Tourist Organization; IMF, Information Notice System ; and Fund staff calculations.

1/ Excludes Compact Trust Fund and Compact Road.

2/ Excludes non-budgetary grants from Japan and Taiwan Province of China.

4. Inflation has receded and the external position is stable. Inflation rose to about 4½ percent in FY06—somewhat higher than that of the United States, whose currency Palau uses as legal tender—owing to the impact of rising fuel costs on transportation. In FY07, it came down to around 3–3½ percent, reflecting a temporary easing in oil prices. The real effective exchange rate has remained broadly stable as dollar weakness has been offset by Palau’s inflation differential. The current account deficit (excluding grants) has averaged about 18 percent per year in FY06–FY07, half its FY02 level, despite rising fuel prices (Table 2).3

Table 2.Republic of Palau: Balance of Payments, 2000/01–2006/07 1/(In thousands of U.S. dollars)
2000/012001/022002/032003/042004/052005/062006/07

Est.
Trade balance-83,302-76,367-79,833-101,398-91,765-101,690-81,206
Exports, f.o.b.16,56720,3458,4115,88213,41413,59410,081
Imports, f.o.b.-99,869-96,712-88,244-107,280-105,179-115,284-91,287
78,68485,322104,562112,272107,966111,324
Services account47,88946,00568,23987,69886,53979,59487,262
Receipts59,53758,33976,91198,68098,85894,372101,242
Travel58,53157,35475,61296,94097,22092,91399,360
Other1,0069861,3001,7391,6381,4591,882
Payments-11,648-12,334-8,672-10,982-12,319-14,778-13,980
Transportation-10,682-11,129-7,697-9,457-10,790-13,184-12,493
Passenger’s service-1,032-1,302-1,095-1,761-1,766-1,656-1,805
Freight and insurance-9,650-9,827-6,602-7,696-9,024-11,528-10,688
Travel-966-1,205-975-1,525-1,529-1,594-1,487
Income5,9855,4504,4586,0194,2922,1572,215
Investment income5,1634,8543,9115,6053,733445297
Pension Fund Investment Income605595566309432840740
Social Security Investment Income9177136857927921,5291,798
Income and interest payment-700-712-704-687-665-657-620
Current transfers3,8373,6791,124892-3,799-8921,532
Private-17,576-17,525-20,366-23,497-25,869-23,367-22,864
Inflows5,6867,4944,1233,0221,1242,7562,301
Outflows-23,262-25,019-24,489-26,519-26,993-26,123-25,165
Official21,41321,20421,49024,38922,07022,47524,396
Business licenses and fees1,3801,1481,0621,0771,6341,6011,358
Budget grants20,33420,56120,96623,38320,67821,64223,398
Other-301-505-538-71-242-768-360
Current account (includes official grants)-25,591-21,233-6,012-6,789-4,733-20,8319,804
Current account (excludes official grants)-45,925-41,794-26,978-30,172-25,411-42,473-13,594
Capital and financial account26,61619,58224,75237,00141,63927,48350,597
Public sector13,64510,62218,42823,48522,91425,92749,297
Capital grants1,0641,88813,24313,88214,97922,42424,800
Off-budget capital grants12,5818,7345,7568,7469,5784,64612,140
Gross borrowing 2/0002,0000013,500
Loan repayments00-571-1,143-1,643-1,143-1,143
Private sector12,9728,9606,32413,51618,7251,5561,300
Foreign direct investment12,9728,9606,32413,51618,7251,5561,300
Other private flows/errors and omissions 3/-11,554-32,329-23,670-38,763-41,689-11,988-65,737
Overall balance 4/-10,528-33,980-4,931-8,550-4,783-5,336-5,336
Memorandum items:
Current account as a percent of GDP
Including official grants-20.7-17.6-4.9-5.2-3.3-13.56.0
Excluding official grants-37.2-34.6-22.1-23.1-17.8-27.6-8.4
Service receipts as a percent of GDP48.248.363.175.469.461.462.4
Return on the Compact Trust Fund-26,794-5,54316,79910,31715,8969,45722,011
Sources: Data provided by the Ministry of Finance and Palau Visitors Authority, Banks; and Fund staff and Ministry of Finance estimates.

Fiscal year ending September 30.

Gross borrowing in FY07 includes a $7 million soft loan to Palau Public Utility Corporation.

Private bank flows, profit repatriation of so-called front businesses, and errors and omissions.

Increase in the government’s gross foreign assets minus return on the Compact Trust Fund, which is not covered in the BOP.

Sources: Data provided by the Ministry of Finance and Palau Visitors Authority, Banks; and Fund staff and Ministry of Finance estimates.

Fiscal year ending September 30.

Gross borrowing in FY07 includes a $7 million soft loan to Palau Public Utility Corporation.

Private bank flows, profit repatriation of so-called front businesses, and errors and omissions.

Increase in the government’s gross foreign assets minus return on the Compact Trust Fund, which is not covered in the BOP.

5. Deteriorating revenue performance has undermined the authorities’ expenditure cutting efforts. Under the Cost Reduction Plan current spending has shown welcome restraint, but domestic revenue declined across the board over the last two years, reflecting weaknesses in tax administration (Table 3 and Figure 2). As a result, the current deficit deteriorated by some 4 percentage points of GDP since FY05, moving the authorities farther from their long-term objective of current balance, and leading to a breach of the budget target in FY07.

Table 3.Republic of Palau: National Government Budgetary Operations, 2001/02–2007/08 1/
2001/022002/032003/042004/052005/062006/072007/08
BudgetActualBudgetEstimateBudget
(In thousands of U.S. dollars)
Total revenue and grants51,22565,86670,81975,35291,20282,23985,98686,22280,943
Domestic revenue28,77631,65734,76439,69537,86338,17339,49838,02441,782
Tax revenue22,04222,70626,13130,08629,64729,37631,32929,75134,068
Nontax revenue4,5205,7137,6226,2766,7716,6416,7365,8255,857
Local Trust Funds2,2143,2381,0111,3331,4452,1571,4332,1981,856
Capital revenue0002,0000002500
Grants22,44934,20936,05535,65753,33944,06646,48848,19839,161
Total expenditure80,03276,29182,09376,46698,45291,50690,60594,21089,644
Current expenditure58,99460,94662,06662,83069,43268,77866,94571,36167,297
Capital expenditure21,03815,34520,02713,63629,02022,72823,66022,84922,347
Errors and omissions,
Accounts Payable/Receivables-6,1488,651-1,467-1,89607,4020-4,310328
Current balance (excl. grants)-30,218-29,289-27,302-23,135-31,569-30,604-27,447-33,337-25,515
Overall balance-34,955-1,774-12,741-3,010-7,250-1,865-4,619-12,298-8,373
Financing34,9551,77412,7413,0107,2501,8654,61912,2988,373
Net long-term borrowing0-571857-1,643-1,143-1,1437575,357-2,000
New borrowing002,0000001,9006,5000
Principal repayments05711,1431,6431,1431,1431,1431,1432,000
Change in NTF assets29,955-2,6556,884-3473,393-1,992-1381,9415,373
Withdrawals from Trust Fund5,0005,0005,0005,0005,0005,0005,0005,0005,000
(in percent of GDP)
Total revenue and grants42.454.054.152.959.353.553.053.146.9
Domestic revenue23.826.026.627.924.624.824.323.424.2
Tax revenue18.318.620.021.119.319.119.318.319.7
Nontax revenue3.74.75.84.44.44.34.13.63.4
Local Trust Funds1.82.70.80.90.91.40.91.41.1
Capital revenue0.00.00.01.40.00.00.00.20.0
Grants18.628.127.625.034.728.628.629.722.7
Total expenditure66.362.662.753.764.059.555.858.051.9
Current expenditure48.950.047.444.145.144.741.243.939.0
Capital expenditure17.412.615.39.618.914.814.614.112.9
Errors and omissions,
Accounts Payable/Receivables-5.17.1-1.1-1.30.04.80.0-2.70.2
Current balance (excl. grants)-25.0-24.0-20.9-16.2-20.5-19.9-16.9-20.5-14.8
Overall balance-28.9-1.5-9.7-2.1-4.7-1.2-2.8-7.6-4.9
Memorandum items:
GDP (tousand US$)120,755121,909130,852142,461153,818153,818162,370162,370172,574
Off-budget grants (percent of GDP) 2/7.24.76.76.73.07.5
Sources: Data provided by the Palauan authorities; and Fund staff estimates.

Fiscal year ending September 30.

Off-budget grants finance infrastructure projects.

Sources: Data provided by the Palauan authorities; and Fund staff estimates.

Fiscal year ending September 30.

Off-budget grants finance infrastructure projects.

Figure 2.Republic of Palau: Fiscal Developments

Sources: Country authorities; Datastream; and Fund staff estimates.

1/ Return before fees. Average annual return for CTF was 10.1 and Benchmark was 8.2.

6. The government’s net financial assets have stagnated at about the level of GDP. External debt stands at 14 percent of GDP. The Compact Trust Fund (CTF) recovered the sharp losses incurred in 2001–02, and stood at $174 million at end-FY07. The annual average return of the CTF over the last three fiscal years was in line with its benchmark, but this was insufficient to increase the fund’s value relative to GDP after deficit financing (Figure 2).4

7. Deposits have partly recovered following the failure of Pacific Savings Bank (PSB) in late 2006.5 However, credit growth has virtually halted as banks have become more cautious in extending credit, and credit quality is low as households are already highly leveraged. Commercial lending rates of the largest banks are at Prime plus 0.5–4 percent.

8. In February 2008 the long delayed amendments to the Financial Institutions Act (FIA) were signed into law, paving the way for more effective bank supervision. These amendments allow the Financial Institutions Commission (FIC) to issue prudential regulations without legislative approval; require all banks to have an annual audit; and grant the FIC’s staff legal immunity in carrying out official acts. They also empower the FIC to examine for anti-money laundering (AML) issues. Amendments to AML legislation were put in place in late December.6

Outlook and risks

9. The near-term outlook is broadly favorable, with risks tilted to the downside. Growth is projected to moderate further to about 2 percent. Donor-financed capital spending will continue to fund unmet infrastructure needs and tourism would remain strong, while prospects for large private investment projects continue to be clouded by uncertainties surrounding Compact renewal. Downside risks include higher oil prices and the global economic slowdown which may affect tourism. On the upside, a possible expansion of scheduled flights could lead to increased arrivals of high-end tourists.

III. Issues for Discussion

Prudent management of foreign grants has delivered improved infrastructure, growth and a higher standard of living. However, current fiscal policy is not sustainable, even if the Compact were to be renewed. Moreover, the predominance of the public sector in the economy limits growth potential going forward. Thus, the discussions focused on policies and structural reforms aimed at achieving fiscal sustainability and long-term growth—key elements of self-reliance.

A. Fiscal Policy

10. The authorities recognize that current fiscal policy is not sustainable. Grants amount to nearly 37½ percent of GDP and tax revenue has been falling.7 The staff estimates that even if the Compact were renewed—a best case scenario—current spending would need to be cut by about 10 percentage points of GDP to be sustainable (Scenario B, Box 1; and Table 4).8 If the adjustment were to occur gradually, or if the Compact were not renewed, the needed adjustment would be larger. To the extent that domestic revenue can be increased, the required spending cuts would be smaller.9 The authorities noted that these estimates are in line with those of other IFIs and private consultants.

Table 4.Republic of Palau: Medium-Term Fiscal Scenarios(Percent of GDP, unless otherwise specified)
FY2002FY2003FY2004FY2005FY2006FY2007FY2008FY2009FY2010FY2011FY2012FY2013FY2014FY2015FY2016FY2017FY2018FY2019FY2020FY2021FY2022FY2023FY2024FY2025 1/
Projections
A. No compact renewal; immediate adjustment to generationally equitable fiscal path
Revenue and grants42.454.054.152.953.553.146.443.038.038.038.038.038.038.038.038.038.038.038.038.038.038.038.038.0
Domestic revenue23.826.026.627.924.823.423.423.423.423.423.423.423.423.423.423.423.423.423.423.423.423.423.423.4
Grants18.628.127.625.028.629.723.019.614.614.614.614.614.614.614.614.614.614.614.614.614.614.614.614.6
Expenditure66.362.662.753.759.558.041.141.141.141.141.141.141.141.141.141.141.141.141.141.141.141.141.141.1
Current48.950.047.444.144.743.928.528.528.528.528.528.528.528.528.528.528.528.528.528.528.528.528.528.5
Capital17.412.615.39.614.814.112.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.6
Current balance-25.0-24.0-20.9-16.2-19.9-20.5-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1-5.1
Overall balance 2/-28.9-1.5-9.7-2.1-1.2-7.65.31.9-3.1-3.1-3.1-3.1-3.1-3.1-3.1-3.1-3.1-3.1-3.1-3.1-3.1-3.1-3.1-3.1
CTF stock 3/97.9109.3100.0100.998.499.2106.0112.0112.0112.0112.0112.0112.0112.0112.0112.0112.0112.0112.0112.0112.0112.0112.0112.0
B. Compact renewal; immediate adjustment to generationally equitable fiscal path
Revenue and grants42.454.054.152.953.553.146.443.090.450.050.050.050.050.050.050.050.050.050.050.050.050.050.038.0
Domestic revenue23.826.026.627.924.823.423.423.423.423.423.423.423.423.423.423.423.423.423.423.423.423.423.423.4
Grants18.628.127.625.028.629.723.019.667.026.626.626.626.626.626.626.626.626.626.626.626.626.626.614.6
Expenditure66.362.662.753.759.558.046.046.046.046.046.046.046.046.046.046.046.046.046.046.046.046.046.046.0
Current48.950.047.444.144.743.933.433.433.433.433.433.433.433.433.433.433.433.433.433.433.433.433.433.4
Capital17.412.615.39.614.814.112.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.6
Current balance-25.0-24.0-20.9-16.2-19.9-20.5-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0-10.0
Overall balance 2/-28.9-1.5-9.7-2.1-1.2-7.60.4-3.044.44.04.04.04.04.04.04.04.04.04.04.04.04.04.0-8.0
CTF stock 3/97.9109.3100.0100.998.499.2101.1102.0149.2157.4165.8174.5183.4192.5201.9211.5221.5231.7242.2253.0264.0275.4287.2287.2
C. No compact renewal; gradual adjustment to generationally equitable fiscal path
Revenue and grants42.454.054.152.953.553.146.743.638.939.239.539.840.140.440.741.041.341.641.942.242.242.242.242.2
Domestic revenue23.826.026.627.924.823.423.724.024.324.624.925.225.525.826.126.426.727.027.327.627.627.627.627.6
Grants18.628.127.625.028.629.723.019.614.614.614.614.614.614.614.614.614.614.614.614.614.614.614.614.6
Expenditure66.362.662.753.759.558.055.554.553.552.551.550.549.448.447.446.445.444.443.442.442.442.442.442.4
Current48.950.047.444.144.743.942.941.940.939.938.937.936.835.834.833.832.831.830.829.829.829.829.829.8
Capital17.412.615.39.614.814.112.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.6
Current balance-25.0-24.0-20.9-16.2-19.9-20.5-19.2-17.9-16.6-15.3-14.0-12.6-11.3-10.0-8.7-7.4-6.1-4.8-3.5-2.2-2.2-2.2-2.2-2.2
Overall balance 2/-28.9-1.5-9.7-2.1-1.2-7.6-8.8-10.9-14.6-13.3-12.0-10.7-9.4-8.0-6.7-5.4-4.1-2.8-1.5-0.2-0.2-0.2-0.2-0.2
CTF stock 3/97.9109.3100.0100.998.499.291.984.672.361.150.841.633.426.220.215.411.79.28.08.08.08.08.08.0
D. Compact renewal; gradual adjustment to generationally equitable fiscal path
Revenue and grants42.454.054.152.953.553.146.743.691.351.251.551.852.152.452.753.053.353.653.954.254.254.254.242.2
Domestic revenue23.826.026.627.924.823.423.724.024.324.624.925.225.525.826.126.426.727.027.327.627.627.627.627.6
Grants18.628.127.625.028.629.723.019.667.026.626.626.626.626.626.626.626.626.626.626.626.626.626.614.6
Expenditure66.362.662.753.759.558.055.955.354.754.253.653.052.451.851.250.650.049.448.848.248.248.248.248.2
Current48.950.047.444.144.743.943.342.742.141.641.040.439.839.238.638.037.436.836.235.635.635.635.635.6
Capital17.412.615.39.614.814.112.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.612.6
Current balance-25.0-24.0-20.9-16.2-19.9-20.5-19.6-18.7-17.8-16.9-16.1-15.2-14.3-13.4-12.5-11.6-10.7-9.8-8.9-8.0-8.0-8.0-8.0-8.0
Overall balance 2/-28.9-1.5-9.7-2.1-1.2-7.6-9.2-11.736.6-2.9-2.0-1.1-0.30.61.52.43.34.25.16.06.06.06.0-6.0
CTF stock 3/97.9109.3100.0100.998.499.291.583.3122.2122.7124.1126.4129.7134.0139.3145.6152.9161.4171.0181.8192.9204.3216.0216.0

2004 and 2005 data incorporate revisions in GDP. Projections exclude several megaprojects such as the Moatize coal mine project, Cahora Bassa transfer, and petroleum exploration.

Minus sign indicates depreciation.

Includes the issuance of government securities for the central bank recapitalization in years 2005–07.

2004 and 2005 data incorporate revisions in GDP. Projections exclude several megaprojects such as the Moatize coal mine project, Cahora Bassa transfer, and petroleum exploration.

Minus sign indicates depreciation.

Includes the issuance of government securities for the central bank recapitalization in years 2005–07.

Box 1.Toward a Sustainable Fiscal Policy

This box explores fiscal sustainability in Palau using the government’s intertemporal budget constraint. Four scenarios are presented. The first two scenarios—mainly for illustrative purposes—show the impact on key variables of an immediate adjustment to a sustainable current balance under different assumptions about future Compact grants. The next two scenarios show the impact of a gradual adjustment to a sustainable current balance over 15 years. 1/

Immediate Adjustment

Scenario A: No compact renewal (bold solid line). To achieve sustainability, the current balance would adjust from minus 20½ percent of GDP in FY07 to minus 5 percent of GDP in FY08, and remain at that level thereafter (Figure 1). In FY08 and FY09, grants would continue after the adjustment had taken place; therefore, Palau would run budget surpluses (Figure 2) and the Compact Trust Fund (CTF) would increase (Figure 3). After FY09 budget deficits would be financed from CTF returns and the CTF would remain constant at about 100 percent of GDP.

Figure 1.Sustainable Current Balance, FY2007-FY2030

(percent of GDP)

1/ Actual.

Figure 2.Sustainable Overall Balance, FY2007-FY2030 1/

(percent of GDP)

1/ Inverse of sustainable withdrawals.

2/ Actual.

Figure 3.Stock of Trust Fund, FY2007-F Y2030

(percent of GDP)

1/ Actual. CTF plus other government net worth.

Scenario B: Compact renewal (solid line). With an assumed Compact extension until FY24, adjustment to a sustainable current balance would be smaller than under Scenario A (10½ percentage points of GDP). Overall budget balances would be much higher in the years of additional grant assistance and the assets of the CTF would rise to about 270 percent of GDP.

Gradual Adjustment

Scenario C: No compact renewal (bold broken line). An adjustment in the current balance of 1.3 percentage points of GDP each year would achieve sustainability by FY21. The gradual adjustment would necessitate withdrawals from the CTF, which would be depleted by FY20.

Scenario D: Compact renewal (broken line). An adjustment of the current balance by 0.9 percentage points of GDP each year would achieve sustainability by FY21. After FY09 assets of the CTF would rise to about 200 percent of GDP in FY24 before stabilizing.

In sum, even with Compact renewal, a sizable fiscal adjustment is required to achieve fiscal sustainability and future Palauans would have to live with current spending that is 1012 percentage points of GDP lower than today. To the extent that revenue measures are possible, the cuts in spending would be lower. Without Compact renewal, an annual adjustment of 1.3 percentage points of GDP for 15 years would still leave the CTF depleted by FY20.

1/ All 4 scenarios assume: Real GDP growth of 3 percent and inflation of 2 percent after FY09. A real rate of return on the Compact trust fund of 6 percent. Capital spending to GDP at historical levels. Under the scenarios that assume no Compact renewal, U.S. Compact grants drop to zero after FY2009, while U.S. non-Compact grants and grants from other countries remain at historical levels (14½ percent of GDP). Under the Compact renewal scenarios, U.S. (current) Compact grants remain at historical levels (12 percent of GDP) for another 15 years and drop to zero after FY2024. In addition, the U.S. is assumed to replenish the Compact Trust Fund to the originally envisaged FY2010 value. Off-budget grants and corresponding capital spending are not considered, as they do not affect the sustainability analysis.

11. There was broad agreement that an adjustment of the required magnitude could not be made immediately, given its impact on public service delivery. The mission recommended an average annual adjustment of 1–1⅓ percentage points of GDP over the next 15 years, with about one third of this coming from the revenue side. Without Compact renewal this fiscal policy path would result in a balanced budget by 2020, however, the CTF would be depleted (Scenario C, Box 1). With Compact renewal the trust fund would stabilize at 200 percent of GDP around 2025, and finance a budget deficit of 6 percent of GDP (Scenario D, Box 1). This consolidation path is in line with the authorities’ view that they could adjust by about 5 percentage points of GDP over the next 5 years, with some front-loading possible, although they envisioned somewhat more scope for revenue measures.

12. Recognizing that improvements in tax administration are key to reversing revenue weakness, the authorities have taken measures. These include suspending business licenses for non-filers, making cash registers mandatory, and conducting a greater variety and audits. The team noted that removing exemptions would likely be the single most effective measure. Additional measures should include establishing a large taxpayer unit, legislating self-assessment, and making audit selection computer-based. The authorities concurred and noted that a large taxpayer unit is being established, but given that the 50 largest tax payers were already paying, they did not expect large revenue gains.

13. On tax policy, there was shared broad endorsement of the measures in the 1998 report of the Tax Reform Advisory Committee. Eliminating exemptions under the import tax and abolishing refunds under the salaries and wage tax would facilitate administration and increase the tax base. Over the medium term, distortions could be reduced by moving from a gross revenue tax to a net profit tax, by taxing in-kind payments under the salaries and wage tax, and by replacing the import tax with a VAT and excises.10 The mission called for a simplified tax system, and cautioned against the introduction of nuisance taxes.11 The authorities are looking closely at moving to a net profit tax, but consider a VAT too difficult to administer. Taxation of in-kind payments may be considered further down the road.

14. The authorities should build on their success to date in curtailing current expenditure. The measures in the Cost Reduction Plan have contributed to a reduction in current spending of 6 percentage points of GDP since FY03. There was agreement that further cost cutting will require some bold steps as maintenance costs of the new capital building and the Compact Road create new spending pressures. The mission recommended to (i) avoid duplication of government offices by closing those in Koror, (ii) commercialize water and sewage services, and (iii) eventually privatize all public utility companies. The authorities maintained that it was never the intention to move public service oriented government offices out of the population center. They are attempting to establish a Maintenance Trust Fund for the up keep of the Compact Road and the capital building; new funds of about 3 million dollars may become available, but given that prospective funds appear insufficient, spending pressures would remain.

15. There was broad agreement that a reduction in the current deficit of at least 2½ percentage points of GDP was feasible in FY08, assuming revenue measures are approved. This would require the government and the legislature to agree on credible measures to underpin the FY08 budget. The enacted changes to the hotel room tax and the fish export tax are insufficient to achieve the revenue target, and forced expenditure cuts could kick in. The authorities are preparing a supplemental budget for the April legislative agenda which includes revenue measures in line with staff recommendations. Proposed measures include eliminating import duty exemptions and moving to a c.i.f. valuation basis; further increasing the specific minimum hotel room tax; unifying the foreign labor fee for Palauan and non-Palauan employers; increasing the currently notional water charge to near cost recovery levels; and commercializing water and sewage services. The latter was considered unlikely to pass this round. Staffs recommendation to raise the fuel excise tax was deemed to impose too large a burden on cash strapped consumers.

B. Financial Sector

16. The mission team applauded the recent signing into law of the amendments to the FIA and encouraged prompt issuance of implementing regulations. The authorities noted that these are being prepared with MCM technical assistance and could be in place by end-summer. The FIC has demonstrated its commitment to a well-regulated financial sector, and the team urged it to take action against the smaller private banks identified as problems. While these banks are not systemic in size, with only about 3 percent of deposits and 7 percent of assets, all three have poor accounting, governance and operational practices which could potentially damage financial sector integrity in the wake of the PSB failure. Early adoption of information sharing agreements with other jurisdictions would enhance cross-border supervisory efforts. Looking forward, off-site supervision would be enhanced through better Call Reports and improved reporting.

17. The FIC stressed that it must be given adequate resources to carry out effective supervision. The mission team commended the FIC for effectively placing PSB in receivership despite a vacuous legal framework, repeated efforts by vested interests to delay regulatory forbearance, and limited resources. The FIC noted that some resources will be freed for day-to-day supervision activities as the PSB case winds down. However, the transfer of the Financial Intelligence Unit to FIC—without the required staff and budget to make it operational—places an additional load on already inadequate resources. As provided for under the law, the FIC should formulate and adopt a budget financed by industry charges. This will serve to further increase autonomy by mitigating the risk of legislative underfunding.

C. Exchange Rate Regime and Trade Policies

18. The current exchange rate regime—the U.S. dollar is legal tender—remains appropriate given Palau’s small size and predominance of U.S. grants and trade flows. The authorities stressed that Palau does not have the administrative capacity to conduct an active exchange rate and monetary policy, and its close ties to the U.S. (running through 2044) make dollarization an appropriate framework. In the event of sharply lower grants, a flexible exchange rate could, in principle, redirect domestic demand from tradable to nontradable goods. However, given Palau’s narrow production base, the scope for such demand switching seems very limited. Over the near term, external stability is not at risk given the current level of net financial assets; however, over the long term insufficient fiscal adjustment would eventually lead to a depletion of the CTF and possibly mounting external debt.

19. The authorities observed that key indicators point to preserved competitiveness. The real effective exchange rate (REER) has remained broadly stable since 2002, despite a drop in government consumption and a deterioration in the terms of trade. However, the current account excluding grants has improved steadily since FY2000, suggesting that Palau’s level of competitiveness is broadly appropriate. Wage pressures are kept at bay through the hiring of foreign labor, and price pressures are held down in part by the open trade regime.12 In addition, Palau’s main exports—tuna and tourism—tend toward the higher end with lower price elasticity; as a premium and unique dive destination, it does not compete primarily on price. Palau ranks above average in more than half of the World Bank’s Doing Business indicators, with room for improvement within the areas of access to credit, protecting investors and enforcing contracts (Figure 3).

Figure 3.Republic of Palau: Indicators of Investment Climate, 2007

Source: World Bank, Doing Business, 2008.

1/ Ranked among 178 economies; lower number indicates better environment.

20. High export concentration in water-based tourism exposes the economy to external shocks. The authorities are looking for areas of possible export diversification. Authorization for investment in two golf courses is in progress, and aquaculture is beginning to take hold. The government has also been approached by firms wishing to carry out oil exploration and seabed mining activities. The authorities recognize the potential revenue streams such activities could bring, but place a high priority on preserving Palau’s pristine environment. Many environmental protection initiatives are in the works in collaboration with other island countries and IFIs, and the government is a key player in the discussions on the impact of climate change (Box 2).

D. Structural Reforms

21. The authorities concurred that the private sector should be the source of sustainable growth, but noted several obstacles. Tourism and domestic agri- and aquaculture hold the greatest potential. Given Palau’s small size, foreign investment could lead to higher growth, broaden the tax base and aid in knowledge transfer. Still, significant impediments to foreign investment remain, and land-use disputes and contract enforcement issues have reportedly delayed foreign investment projects. Moreover, restrictions on foreign investment have led to a proliferation of “front” businesses, operating outside the law.13 The mission team emphasized that addressing the outdated legal framework, cumbersome foreign investment regime, and weak property rights should be given priority, as improving the investment climate and removing incentives to circumvent the law are key to private sector led growth.

22. The authorities lamented that until consensus is reached on key issues, the legislative agenda to improve the business climate will likely sit idle. They agreed with the thrust of the team’s recommendations,14 and noted some progress on land titling.15

Box 2.Republic of Palau: Managing Climate Change

Palau is one of the Pacific island countries most vulnerable to global climate change. Its marine and land biodiversity provide subsistence living as well as a world-renowned diving destination. Recent climate change threatens the survival of its inhabitants and poses immense costs. A 2000 World Bank study for Kiribati places potential economic losses at 17–34 percent of its 1998 GDP by 2050.

Key effects of climate changes include:

  • El Nino/Enso phenomenon. Several months of drought in 1997–1998 resulted in a taro crop loss of $0.74 million and fishery production became more volatile.
  • Rising sea level and salt water intrusion already damage taro paddies and freshwater resources, and cause extensive soil erosion and loss of coastal infrastructure. The sea level is projected to rise further, as much as 0.09 to 0.88 meters by 2100, rendering some islands uninhabitable.
  • Rising temperatures threaten Palau’s ecosystems and lead to the bleaching of coral reefs.

In recognition of this threat, the authorities have actively collaborated with other Pacific island countries and international organizations. In 2000, they conducted climate change assessments as a member of the United Nations Framework Convention on Climate Change (UNFCC). In 2002, Palau acceded to the 1995 Vienna Convention on Protection of the Ozone Layer, and jointly initiated the Micronesian Challenge, whereby it placed 30 percent of its geographic area into marine protected areas (MPAs) or marine managed areas (MMAs). It held a nation-wide workshop in 2006 to explore the impact of changing climate conditions and joined the Alliance of Small Island States (AOSIS) to actively contribute to global climate discussions.

They recognize that the current legal framework is inadequate for doing business.16 Yet, on foreign investment, despite the fact that several proposals to change and even abolish the foreign investment law have been tabled, they are being held up by the lack of consensus on how to make the most of foreign investment and labor while protecting citizen opportunities. Much will be decided by the new government.

E. Statistical and Other Issues

23. Data are adequate for surveillance but several serious deficiencies remain in nearly all areas of economic statistics. The authorities willingly share all available data. Notwithstanding, the team expressed concern that data provision has worsened over time. The team strongly urged the authorities to allocate sufficient resources, both human and financial, to ensuring adequate statistics for policy formulation and assessment. In this regard, a small team of trained staff dedicated to compiling core GDP and balance of payments statistics is key. The authorities agreed that quality statistics are required to underpin policy formulation—they have followed up to the best of their ability on much appreciated TA and continue to work toward producing consistent and reliable numbers. The authorities noted some issues related to the introduction of a new data compilation system in Customs.

IV. Staff Appraisal

24. Sizable foreign grants continue to support growth and lay the groundwork for private sector development. Prudent management of these funds has preserved their effectiveness, which has led to an improved quality of life. However, since the last consultation economic performance has weakened somewhat. Growth has returned to its historical average as major projects have wound down and inflation is moderate, but fiscal performance has been mixed, with significant expenditure cutting efforts undermined by revenue weakness.

25. Near-term prospects are broadly favorable but self-reliance remains a distant goal. Sustainability depends critically on fiscal consolidation and structural reforms. Uncertainty regarding the future level of grants is heightened by the scheduled cessation of Compact grants in 2009, and private investment faces challenges in securing property rights and contract enforcement.

26. Current fiscal policy is not sustainable, even if the Compact agreement were renegotiated. The required adjustment is formidable, and delays in adopting required measures only serve to further increase the adjustment down the road. Therefore, fiscal consolidation should not be postponed while Compact discussions are ongoing. Tax measures will be a key complement to continued progress on the expenditure side, while efforts to strengthen tax administration would help reverse the recent falloff in revenue. Consolidation should be front-loaded, with a medium term pace of adjustment aimed at preserving the trust fund over the long term.

27. The government and legislature need to agree on credible measures to underpin the FY08 budget. The tax measures contained in the supplemental budget are appropriate, and a reduction in the current deficit of at least 2½ percent of GDP is feasible, assuming the revenue measures are approved. Going forward, distortions could be eliminated by moving from a gross revenue tax to a net profit tax, while privatization of public utilities would eliminate subsidies and strengthen public finances.

28. The staff recognizes the government’s commitment to a well regulated financial sector. We commend the FIC for effectively placing the second largest bank in receivership in 2006 despite a vacuous legal framework and limited resources. Moreover, the recent signing into law of the amendments to the Financial Institutions Act paves the way for more effective supervision, while the amendments to the AML legislation strengthen the AML framework. The FIC should issue implementing regulations without delay and begin to take action against the three smaller banks identified as problems. Limited supervision and enforcement capacity, lack of resources, and tepid political support are constraints. Capacity building efforts should continue, while use of industry charges, as provided under the law, would ensure adequate funding of supervision and enforcement, and serve to increase autonomy.

29. Use of the U.S. dollar remains an appropriate monetary and exchange rate regime given Palau’s small size and continued close ties to the United States over the longer run. Moreover, the benefits of a flexible exchange rate are constrained by Palau’s narrow production base and limited scope for demand switching. Competitiveness has been preserved, with the real effective exchange rate broadly stable since 2002 and wage pressures kept at bay through increased hiring of lower-cost foreign labor.

30. Establishing a foundation for private sector led growth is key to achieving self-reliance. Policies to encourage high value added tourism and export diversification would help sustain living standards while preserving Palau’s pristine environment. Such policies need to be underpinned by a strong legal framework which facilitates contract enforcement and secures property rights. Foreign investment could play a role by contributing to growth, broadening the tax base and aiding in information transfer. The citizens of Palau will need to come to consensus on the extent of foreign participation in the economy, which will have implications for longer run growth.

31. Data provision, while adequate for surveillance, has deteriorated and constrains effective policy evaluation. The authorities willing share all available data. Yet, data deficiencies remain in nearly all areas of economic statistics. Sufficient resources, both human and financial, should be allocated to ensure adequate statistics for policy formulation and assessment.

32. It is recommended that the next Article IV Consultation take place on the 24-month cycle.

Appendix I: Palau: Summary of Annexes

Fund Relations

Palau joined the Fund in December 1997, and has no outstanding purchases or loans. The U.S. dollar is legal tender. The 2005 Article IV consultation was concluded by the Executive Board on February 15, 2006 (IMF Country Report, No. 06/108).

Relations with PFTAC

Assistance to Palau has been substantial, including 27 advisory missions. Palauan officials have participated in 26 seminars and 10 secondments, mostly in the area of tax administration. PFTAC technical assistance has been provided in the areas of public financial management, tax administration and policy, financial sector regulation and supervision, and economic and financial statistics.

Relations with the World Bank Group

Palau became a member of the World Bank Group in December 1997. Since that time, the Bank has provided technical assistance in the areas of natural resource management and the health sector. While Palau is IBRD-eligible there are no outstanding loans or credits. The Pacific Regional Strategy directs the Bank’s work in the region from 2006–09. It focuses on creating an environment conducive to generating sustainable economic growth and employment, while recognizing the development challenges facing small island economies. The Bank plays a selective role in Palau. It is currently aiding Palau in the valuation of natural resources; providing assistance to the National Oil and Gas Task Force; and, together with the AsDB, supporting the development of a National Development Plan.

Relations with the Asian Development Bank

Palau joined the AsDB in December 2003. A pre-Country Programming Mission was undertaken in November 2005; Palau is classified as a Pacific developing member country. Current work priorities are guided by the AsDB’s Pacific Strategy entitled Priorities of the Poor: A Pacific Strategy for the Asian Development Bank (2005–09). A private sector assessment was carried out in 2007. Current AsDB technical assistance is through Pacific Regional Technical Assistance Activities (RETAs) in the areas of secured transactions legislation and aiding the government in updating its National Development Plan.

Statistical Issues

Although data provision to the Fund is generally adequate for surveillance, several serious deficiencies remain in nearly all areas of economic statistics. There are presently no official statistical publications at the aggregate level, and data provision has weakened over time. The latest compiled GDP data is from 2001, and monthly data used to estimate GDP (fiscal operations, tourist arrivals, and trade data) are no longer being reported. The authorities’ capacity to produce consistent official estimates of the national accounts is very weak, and GDP growth rates reported in the staff report are based on preliminary estimates from sector indicators. Difficulties experienced by Custom’s with a new database have impaired import data starting in 2006.

1Under a 50 year Compact of Free Association with the United States signed in 1994, Palau will receive $450 million in “Compact grants” over the first 15 years.
2Real activity estimates are based on tourism, investment, employment and other indicators used to extrapolate GDP. Palau has not had official national accounts data since 2001. Balance of payments figures are sketchy.
3Preliminary import data for FY06 and FY07 show a very large decrease in imports in FY07. A possible explanation is the front-loading of imports for a major investment project which would argue for an averaging of imports over these two years.
4The CTF is managed according to international best practice by Merrill Lynch and is among the better governed among Pacific Islands, with regular reporting requirements to its board and congress.
5PSB was the second largest bank in Palau with 20 percent of deposits. The bank was placed in receivership in November 2006, and performing assets are in the process of being sold. The process is expected to be wrapped up by end-2008.
6The March 2008 joint mission of the IMF and the Asia Pacific Group on Money Laundering found that the amendments strengthen Palau’s AML/CFT framework, but several legislative deficiencies remain. Moreover, enforcement is insufficient due to lack of human and financial resources.
7Includes both on- and off-budget grants (Table 3); average FY05-FY07.
8A Selected Issues paper explores fiscal sustainability using an intertemporal budget framework.
9Inclusion of the unfunded liabilities of the pension fund and fiscal arrears would only serve to increase the required adjustment. The unfunded liabilities of the civil service pension fund exceed 25 percent of GDP, and are poised to increase given its negative annual cash flow. Fiscal arrears, mostly to public enterprises, have declined but remain above 2½ percent of GDP.
10A Selected Issues paper explores options for revenue enhancing tax reform.
11The 2007 Tax Review Task Force proposed 8 new taxes, which in staff’s view would overburden tax administration and create distortions.
12The tariff structure has five nonzero bands, with most imports subject to a 3 percent rate. The unweighted average tariff is just under 3 percent.
13The negative list includes tour operators, as well as all retail and wholesale businesses. Foreign investors seeking to operate in these fields must have a local partner, but there is widespread circumvention of the law, with locals (so-called “fronts”) selling the use of their name to foreign businesses.
14Specific recommendations—in line with the AsDB’s 2007 Private Sector Assessment—include: (i) securing property rights by accelerating land titling and dispute resolution, and introducing secured transactions legislation; (ii) harmonizing labor laws to remove the bias against local labor; (iii) reducing the negative list for foreign investment to encourage high value added tourism and eliminate the use of transfer pricing to avoid taxation; and (iv) strengthening the legal framework to ensure contract enforcement.
15Under the law, titling should be completed by February 11, 2009. At present, just over 5,100 land title certificates have been granted, of an expected 15,000–20,000 lots. There is a backlog of over 2,000 cases waiting to be heard by the land court. Disputes over ownership or demarcation of boundaries delay about one- fourth of all cases.
16The current legal framework is based on pre-1953 U.S. Common Law. Key legislative priorities include a uniform commercial code, bankruptcy law, and privacy protection law, as well as arbitration.

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