Information about Asia and the Pacific Asia y el Pacífico

10 Marshall Islands

Christopher Browne
Published Date:
August 2006
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Information about Asia and the Pacific Asia y el Pacífico
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Hali Edison and Dan Nyberg

The Republic of the Marshall Islands (RMI) consists of a group of atolls and islands in the central Pacific with a total land area of 20,000 square kilometers and 750,000 square miles of ocean. Two-thirds of the population of about 58,000 live in the two major urban centers, Majuro and Ebeye. Like other small Pacific island countries, the country is remote from major markets, and the economy is highly dependent on U.S. financing provided through the amended Compact of Free Association (covering 2004-23). Economic activity is dominated by the public sector, and a small private sector developed mainly to meet the demands of the government and its workers. Small contributions also come from agriculture, fisheries, and tourism. As a result of large external assistance, economic conditions are relatively favorable by regional standards, with a per capita GDP of around $2,500.

Politics and Government

In 1947, the Marshall Islands became part of the United Nations Trust Territory of the Pacific Islands, under the administration of the United States. Following increasing demands for autonomy, the country became a republic in 1979. The Compact of Free Association with the United States came into effect in 1986, under which RMI has full responsibility for its internal and foreign affairs, while the United States retains responsibility for defense and security. The United States also agreed to provide financial assistance totaling some $620 million over the period 1986-2001 and to create a $150 million Nuclear Trust Fund to compensate the inhabitants of the four atolls affected by U.S. nuclear tests in the 1940s and 1950s.

The government operates under a mixed parliamentary and presidential system, which includes a head of state, the president, and a bicameral parliament. The Council of Iroij (the upper house) is comprised of 12 tribal chiefs who advise the presidential cabinet and review legislation affecting customary law or any traditional practice, including land tenure. Legislative power resides in the Nitijela (the lower house), which consists of 33 senators elected by 24 electoral districts by universal suffrage of all citizens above 18 years of age. The president is elected to a four-year term and appoints cabinet ministers with the approval of the Nitijela. Although there are no restrictions on the formation of political parties, formal political parties do not exist. Instead, there are loosely formed interest groups that have no party headquarters, formal platforms, or party structures.

Human development indicators have lagged behind countries with similar income levels, despite high amounts of foreign aid and high health and education expenditures. Mortality rates for infants and children under age five are high compared to averages for middle-income countries and, according to the Human Development Index, RMI ranks in the bottom half among the Pacific island countries.

Structure of the Economy

Like most other Pacific islands, RMI faces a variety of geographical constraints, including limited land area, poor soil, territorial dispersion, and remoteness from major markets. Other obstacles include the acute shortage of skilled labor and a customary land tenure system, which severely limits the use of land as collateral in financial transactions and deters foreign investment. The outer islands operate on a semi-subsistence basis, while the urban centers of Majuro and Ebeye have a more developed cash economy, based mainly on government services and trade. The domestic production base is limited, consisting primarily of copra production, subsistence farming, fishing, and handicrafts.

The public sector plays a dominant role in the economy, backed by external assistance. Government current expenditure accounts for more than 70 percent of GDP, and about 50 percent of government revenue comes from external grants, mainly from the United States. Consequently, overall economic activity is highly correlated with government expenditure and external grant flows.

The public sector comprises the central government, local governments, trust funds, and nonfinancial public enterprises. The central government continues to be heavily dependent on foreign aid, while the main source of local government revenue is sales taxes. The government acts as trustee for a number of trust funds associated with the Compact, although the receipts and expenditures are largely outside the government budget. The largest of these is the Nuclear Trust Fund, set up to compensate inhabitants of the four atolls affected by U.S. nuclear testing, and the Kwajalein Atoll Trust Fund, which compensates landowners for the use of the atoll as a military base. Nonfinancial public enterprises are concentrated in utilities, transport, telecommunications, and copra production and are important sources of employment, but their financial results have been generally weak.

The private economy remains underdeveloped, primarily providing services to the government. The export sector is small, consisting almost entirely of coconut oil, fish, and reexports of diesel fuel to fishing boats. Nearly all raw materials and consumer and capital goods are imported. With exports amounting to about 20 percent of imports, the trade balance is chronically in deficit. Owing to official transfers, however, the current account balance has generally been in surplus or close to balanced (Figure 10.1).

There is no central bank, as the U.S. dollar is the domestic currency and the sole legal tender. The use of the U.S. dollar has imparted monetary stability, with inflation largely mirroring that of the United States. The real effective exchange rate has remained broadly stable, reflecting the low and stable inflation differential with the United States, RMI’s largest trading partner. RMI is not competitive relative to other countries in the Pacific in terms of the costs of conducting business, especially for tourism, because of its geographical isolation and limited hotel facilities.

The banking sector is characterized by high intermediation costs and low levels of lending. Consumer loans account for the dominant share of loans and are primarily used for construction, travel, and education. Most consumer loans are serviced directly through payroll deductions. Longer-term lending is constrained by the land tenure system, which prevents banks from using land as collateral, as well as by the lack of viable projects. Given the limited opportunities to extend credit domestically, a substantial portion of the total assets of commercial banks is held outside the country.

Employment opportunities have not expanded at the rate of population growth. Continuously reliable data on unemployment are not available. According to the latest official survey, unemployment stood at around 30 percent in 1999, with youth unemployment considerably higher. While access to both primary and secondary education has improved recently, around 30 percent of children do not receive secondary education and dropout rates are high, contributing to the acute skills shortage. Emigration to the United States is relatively easy, and many Marshallese (around 15,000) have emigrated.

Figure 10.1.Marshall Islands: Trade and Current Account Balances

(In percent of GDP)

Source: Marshall Islands authorities.

Economic Developments during Compact I, 1987-2003

The original Compact of Free Association with the United States (Compact I) aimed at fostering economic development over a 15-year period. The Compact provided block grants that were partially indexed to inflation and subject to step-downs in assistance after each five-year period. RMI also received earmarked grants and program assistance, mainly for health and education, with some conditionality and oversight attached to the grants. The limited scope for monetary and exchange rate policies underscored the key role of fiscal policy. Despite the large external aid, real GDP growth in RMI during the first Compact was the lowest among all Pacific island countries except for Papua New Guinea. The two step-downs, after each five years, had substantial impact on real GDP.

Figure 10.2.Marshall Islands: Real GDP

(Index 1987=100)

Sources: IMF, World Economic Outlook database; and IMF staff estimates and projections.

Real GDP grew relatively quickly during 1987-91, averaging 4.5 percent annually, mainly reflecting Compact-related spending (Figure 10.2).1 The public sector, already large as a legacy of the Trust Territory period, expanded further with the release of Compact funds. Capital spending to modernize the infrastructure picked up sharply. The private sector served mainly government demand and the growing ranks of public sector employees. Inflation pressures were generally contained.

In the first five years of the Compact, the government ran sizable budget surpluses, averaging 9 percent of GDP. With the first scheduled decline in grants, fiscal deficits began to appear in the early 1990s, averaging 10 percent of GDP during 1991-95. Although the reduction in U.S. aid was largely foreseen, government expenditures were not adjusted accordingly. The government borrowed sizable amounts abroad through medium-term notes, secured by future Compact flows, to finance deficits and fund public investment. External public debt reached over 150 percent of GDP in 1995 (Figure 10.3). In addition, poor-performing public enterprises, including the national airline and the copra processing company, required subsidies that further drained government finances.

Figure 10.3.Marshall Islands: External Debt

(In percent of GDP)

Source: Marshall Islands authorities.

By the mid-1990s, the level of public expenditures and external debt had become unsustainable. Faced with the second scheduled decline in external grant assistance in 1996, the authorities implemented a public sector reform program. However, this consolidation, together with the impact of a drought, resulted in a large contraction, and real GDP declined by 5 percent on average during 1995-99.

After a five-year fiscal consolidation period, the economy rebounded, with real GDP growth averaging 3 percent annually in 2000-03. Adding to the rebound, during the 2002-03 negotiation of the amended Compact, the U.S. government provided so-called bump-up grants at the average level of the first Compact, a sizable increase over 2001. These funds helped to sustain the economic expansion and brought about an improvement in the overall fiscal position, even as some of the earlier progress in government consolidation was reversed.

Looking back, Compact I brought limited results in terms of real GDP growth, while fiscal and structural adjustment remained incomplete. A 2000 U.S. General Accounting Office report reviewed the effectiveness of Compact funds in promoting economic self-sufficiency and found that such expenditures had led to little improvement in economic development. In particular, real per capita income, adjusted for inflation, had fallen since the beginning of the Compact. The report also noted that funds were mainly spent to maintain high government wages and a high level of public employment that discouraged private sector growth.

In comparison with other Compact countries, RMI grew more slowly than Federated States of Micronesia and lagged well behind Palau. Tax revenue remained low due to long-standing weaknesses, and the wage bill was high. Public sector wages, set high to attract qualified personnel, were increasingly out of line with private sector pay and spurred migration from the outer atolls. Moreover, there were slippages in the administration of Compact funds, including shortcomings in accountability and oversight on the part of both the RMI and U.S. governments.

Economic Prospects during Compact II, 2004-23

The amended Compact came into effect in 2004 and will expire in 2023. U.S. funding will remain constant in nominal terms, with annual declines in grants fully offset each year by progressively higher contributions to a trust fund. The Compact grants target six specific sectors: education, health care, public infrastructure, the environment, public sector capacity building, and private sector development, with priority given to education and health. The Compact Trust Fund will be built up with installment contributions from the United States, RMI, and Taiwan Province of China. The main objective of the trust fund is to help achieve budgetary self-sufficiency in the post-Compact era, and no drawdowns or collateral borrowing are permitted until 2024.

Compact II also contains enhanced measures of accountability and monitoring (Box 10.1). A U.S.-RMI Joint Economic Management and Financial Accountability Committee was established to approve grant allocations and review performance outcomes and audits. Compact II allows for the possibility that the U.S. government could withhold funds in the case of noncompliance with grant terms and conditions. Adjusting to this enhanced accountability and monitoring is posing near-term challenges because capacity constraints have already led to delays in the disbursement of some Compact grants. Other provisions of the amended

Box 10.1.Marshall Islands: Comparison of Compacts I and II

The original Compact of Free Association (Compact I) came into effect in 1986. The three goals for RMI were to (i) secure self-government, (ii) ensure certain national security rights, and (iii) assist in efforts to promote economic self-sufficiency. The United States provided $640 million in grants during 1986-2001, with declining block grants every five years. These funds were provided to cover general government and capital expenditures. At least 40 percent of the total grants were to be devoted to capital projects, although this was a cumulative requirement that did not have to be satisfied in any particular year. Annual reports were required on economic performance and grant usage, and consultations were held to review the reports. Compact I also contained provisions allowing citizens of RMI to easily migrate and work in the United States. A provision specified that, if a new funding agreement was not in place by the time of expiration of the original Compact in 2001, aid would be given for an additional two years at the average level of the first 15 years ($42 million) (the so-called bump-up grants).

The amended Compact (Compact II) came into effect in 2004 and continues economic assistance during 2004-23. The total amount of $42.7 million per year (roughly 40 percent of GDP) includes grants, audit funds ($0.5 million), and trust fund contributions.

Grants target six specific sectors: education, health care, public infrastructure, the environment, public sector capacity building, and private sector development, with priority given to education and health. In addition to providing sector grants, the amended Compact provides for the establishment of a Compact Trust Fund that is intended to become a sustainable source of revenue to replace grant assistance beginning in 2024. RMI is required to provide $30 million to set up the trust fund, and the United States is to make an initial contribution of $7 million and then to further augment that by $0.5 million annually. Sector grants decline by that same $0.5 million per year in nominal terms.

New procedures were introduced to enhance financial accountability and economic management. A U.S.-RMI Joint Economic Management and Financial Accountability Committee was established to approve grant allocations and review performance outcomes and audits. Compact II allows the U.S. government to withhold funds in the case of noncompliance with grant terms and conditions.

  • Other provisions of the amended Compact include:
  • Rental payments for U.S. military use of the Kwajalein Atoll through 2066, with the United States having the option to either terminate payments as early as 2030, with advance notice of seven years, or extend its use through 2086.
  • An extension through 2023 of some education and disaster management services received by RMI under Compact I.
  • A slight tightening of immigration provisions, with visitors to the United States from RMI now required to show a passport.

Compact include rental payments for U.S. military use of the Kwajalein atoll and an extension through 2023 of some education and disaster management services provided under the original Compact.

Real output growth remained modest at the beginning of the Compact II period. Economic activity was hampered by delays in implementing an upgraded public works program. However, civil service employment appears to have increased, primarily as a result of increased spending on education and health in line with Compact II. The government made large contributions to the Compact Trust Fund in 2003 and 2004, amounting to around 10 percent of GDP each year, in line with Compact II requirements.

The outstanding external debt remains high, although about 60 percent is on concessional terms and is owed primarily to the Asian Development Bank. The remaining 40 percent is mainly owed by two utility companies in telecommunications and energy. Against the background of declining Compact grants, servicing the external debt will absorb increasing levels of fiscal resources.

Policy Challenges Ahead

The major policy challenges are to achieve stable economic growth and financial independence. The 20-year Compact II agreement provides an opportunity to promote budgetary self-reliance and lessen RMI’s dependence on foreign aid. At this point, the medium-term outlook remains uncertain and hinges on the authorities’ commitment to structural and fiscal reform. In the absence of structural reform to promote fiscal consolidation and private sector activity, growth is likely to falter in the medium term, owing to declining Compact grants and increasing external debt repayments. However, if fiscal consolidation and structural reform are undertaken, RMI can grow sustainably and on a par with other Pacific island countries, even after the expiration of Compact II in 2023.

Fiscal Reforms

Budgetary surpluses are needed annually to ensure fiscal sustainability over the medium term. Achieving consolidation will require revenue-enhancing measures in combination with a substantial reduction and reorientation of current expenditure. Policies need to be implemented to reduce the payroll and to focus increases in development projects in the priority sectors identified in the Compact. Subsidies to public enterprises need to be curtailed, with a view to increasing economic efficiency. On the revenue side, measures should be taken to broaden the tax base, bolster tax administration, simplify the tax structure, and eliminate the cascading effects of sales taxes. A more comprehensive reform of the tax system could be considered in the medium term, perhaps through the introduction of a VAT or consumption tax.

An alternative scenario, without implementation of a medium-term fiscal adjustment, would lead to low economic growth and lack of budgetary self-sufficiency by the end of Compact II. In these circumstances, RMI would likely draw heavily from the trust fund after 2023, causing the fund to decline in real terms. By contrast, the adjustment scenario would be designed to ensure that only limited withdrawals are needed from the trust fund to maintain its real value after 2023 with economic self-sufficiency.

Structural Reforms

Structural reforms need to complement the fiscal reforms to encourage private sector development. The focus should be on clarifying property and land tenure rights, changing existing minimum-wage legislation to increase wage differentiation among skill levels, trimming extensive state involvement in business through privatization, and reducing constraints on foreign investment.

Development of the tourism sector continues to be hampered by RMI’s distance from major markets, competition from lower-cost destinations, limited tourism infrastructure, and infrequent air service. The minimum wage is high by regional standards, which skews competition for jobs in the private sector and encourages migration from the outer atolls. The government has repeatedly launched public enterprises in areas such as fisheries and outer island shipping that have lost money and competed directly with private firms. Bank lending continues to be limited by the difficulties of using land as collateral and of foreclosing. In order for the banking system to play a full role in the development of the economy, longer-term bank lending needs to be facilitated by improvements in the newly established land registry.

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