- Christopher Browne
- Published Date:
- August 2006
The Federated States of Micronesia (FSM) comprises about 600 islands, stretching 1,800 miles across the central Pacific. The total landmass of about 700,000 square kilometers is spread over a sea area of 1 million square miles, including its exclusive economic zone. With the remote location, small population of 110,000, and narrow resource base, Micronesia has much in common with other Pacific island countries. Economic and social conditions are relatively favorable by regional standards, with per capita GDP of around $2,000, primarily because of very high external grants under the two successive Compacts of Free Association with the United States (Box 11.1). At the same time, there is a need for major adjustment efforts because external assistance will be reduced in coming years.
Micronesia was formed from part of the United Nations Trust Territory of the Pacific countries, which was administered by the United States after the end of World War II. The four states of Kosrae, Pohnpei, Chuuk, and Yap signed a constitution in 1979 and attained independence in 1986. These states had much in common: each was isolated, had poor transportation links and a narrow resource base, and engaged in little trade within or beyond the region. Growth was impeded by a lack of infrastructure, particularly in air, shipping, water, sewer, and power services, as well as by the poor educational and health systems. Formal markets, including financial markets, were underdeveloped; land ownership revolved around customary arrangements; and foreign investment was minimal. Accordingly, subsistence fishing and farming played an important role.
Box 11.1.Micronesia: Compacts of Free Association with the United States
The economic assistance provisions of the original Compact covered 1987–2001. It provided annual cash grants of $97.9 million during 1987-91, $91.1 million during 1992-96, and $79.2 million during 1997-2001. The funds were to cover general government and capital expenditures, with the latter to comprise a minimum of 40 percent of grants. During the 2002-03 interim, while the Compact was being renegotiated, grants were provided at the average level of the initial Compact period (so-called bump-up funds), which represents a sizable increase from immediately preceding years.
The renewed Compact II covers 2004-23 and features declining grant assistance, creation of a trust fund, and enhanced accountability and monitoring:
- Total funding: Total funding of $92.7 million per year comprises primarily grants and trust fund contributions. Grants are $76.2 million during 2004-06, after which they decline by $0.8 million per year in nominal terms, to $62.6 million in 2023. Grants and trust fund contributions are indexed at the lesser of two-thirds the increase in the U.S. GDP deflator or 5 percent.
- Compact Trust Fund: Trust fund contributions are set to rise from $16 million in 2004 to $29.6 million in 2023. In addition, Micronesia made a $30 million contribution in 2004, as required under Compact II. The trust fund cannot be used to finance spending or as collateral for borrowing before 2024. The fund is administered by a five-member committee (three U.S. and two FSM appointees) and can invest in U.S. stocks and bonds and other instruments as approved by the committee.
- Accountability and monitoring: A U.S.-Micronesia Joint Economic Management Committee approves grant allocations and reviews performance outcomes and audits. The committee is composed of three U.S. and two FSM members.
- Sectoral allocations: Funds are to be allocated to six priority sectors— health, infrastructure, education, capacity building, environment, and private sector development. There are no explicit formulas for allocation by sector, but the committee has resolved that infrastructure spending should rise toward at least 30 percent of annual Compact grants by 2006.
- Other provisions: Disaster assistance from the U.S. Federal Emergency Management Agency is to be phased out over time and replaced by assistance administered through the U.S. Department of State. Funding under certain U.S. educational programs is to be replaced by the Supplemental Education Grant (about $12 million in 2005). Immigration provisions are tightened; for instance, visitors now must show a passport, but access to emigration and U.S. jobs remains relatively straightforward.
In other aspects, the four states were highly diverse. They had distinct cultures with individual languages and tribal structures. They were geographically varied, with some comprising low-lying atolls and others featuring high volcanic mountains. Moreover, each state had its own executive, judicial, and legislative branches, as did the new national government. Under this system, although the national government has statutory authority for policy coordination, in practice the states exercise considerable autonomy in economic affairs. The constitution gives the national government the power to levy taxes on income and imports, while reserving for the states the authority to levy sales and other taxes.
Economic Developments: Compact I, 1987-2003
Compact I came into effect in 1987.1 It covered a 15-year period, with a possible two-year extension, and aimed to foster economic development and financial independence. As a main mechanism for achieving this end, the Compact provided block grants that were only partially indexed to inflation and were subject to cuts (step-downs) each five-year period. Micronesia also received earmarked grants and program assistance, mainly for health, education, and welfare. In principle, some conditionality and oversight were attached to the grants. At least 40 percent 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 with the U.S. government were mandated to review the reports. The Compact also allowed citizens of Micronesia to easily migrate to and work in the United States.
The country registered satisfactory real GDP growth of 3.6 percent annually during 1987-95, reflecting two related developments. First, the public sector, already large as a legacy of the Trust Territory period, swelled in tandem with the sizable grants provided under the Compact. Public sector real output rose by a cumulative 27 percent over this period, while employment increased by 15 percent in the public sector (including national, state, and municipal governments plus public enterprises). As part of this trend, capital spending to modernize the infrastructure picked up sharply. Second, resources were drawn out of the informal sector into the market economy. This development was related closely to the growth of the public sector, because the formal private sector served mainly to support the burgeoning government and the swelling ranks of public sector employees. Although the growth of the public sector had beneficial spillovers to the private sector, it brought difficulties as well. Public sector wages were high, in order to attract qualified personnel, and were out of line with private sector pay, making it difficult for the private sector to compete for skilled workers. In addition, the government launched public enterprises in such areas as pepper, fisheries, and coconut processing, and these lost money and competed directly with private firms. In some instances, notably the case of the Development Bank, the existence of public enterprises was rationalized by impediments to private sector activity, such as restrictions on land ownership. However, the failure to tackle these impediments directly served to further dampen private sector activity, which grew only very modestly.
The sizable investment in infrastructure did make services more accessible and reliable. However, the heavy expenditure on government administration and business ventures failed to foster economic development. Moreover, there were slippages in the administration of Compact funds, including misuse of funds and shortcomings in accountability and oversight on the part of both the FSM and U.S. governments.
On the positive side, macroeconomic stability was broadly maintained. In the early years of the Compact, the government ran sizable budget surpluses, partly because capacity limitations acted to restrain spending. Inflation pressures were contained, and use of the U.S. dollar as the domestic currency and the sole legal tender imparted much-needed monetary stability, with no adverse impact on competitiveness. However, the limited scope for monetary and exchange rate policies underscored the crucial role of fiscal policy in meeting the burden of economic adjustment.
Fiscal deficits began to appear in the early 1990s, averaging about 3 percent of GDP during 1992-93. The government borrowed considerable amounts abroad through medium-term notes secured by future Compact flows, in order to finance the deficits and fund public investment, and external public debt reached 72 percent of GDP in 1993. In addition, exports remained weak, at less than a quarter of imports, and comprised mainly fish and agricultural products. With only modest tourism receipts, the external current account, excluding grants, was in deficit. Nevertheless, Micronesia smoothly weathered the first step-down in Compact funds that occurred in 1992 despite the weaker budgetary and external positions, mainly because of limited spending capacity and its external borrowing.
Figure 11.1.Micronesia: GDP Growth and Inflation
Sources: Micronesia authorities and IMF staff estimates.
With absorptive capacity improving and external borrowing already large, adjusting to the second step-down in Compact funding in 1997 proved more difficult. Real GDP declined by 3.5 percent annually during 1996-99, offsetting the gains in the earlier five-year period (Figure 11.1). Faced with reduced external assistance, the national government decided to scale back its workforce. It launched a public sector reform program, under which two years’ salary could be paid to employees to induce early retirement. The reform program also involved cutbacks in working hours, which had been rising substantially. As a consequence of these steps, the wage bill was reduced by 29 percent by 1999. Public enterprise reforms were also initiated, and outlays for subsidies were reduced by about a third. However, these measures were only partly successful and the fiscal situation remained difficult, with the budget moving from near balance in 1995-97 to deficits of over 7 percent of GDP in 1998-99. Moreover, private sector activity remained sluggish, even though the external current account had moved to surplus by 1999 (Figure 11.2).
Figure 11.2.Micronesia: Current Account and Fiscal Balances
Sources: Micronesia authorities and IMF staff estimates.
Growth rates varied considerably among the four states, as well as between urban areas and outer islands within each state. Fiscal discipline also was uneven across the states, and slower growth tended to increase the fragility of their respective financial positions, particularly when tax measures and expenditure cuts were postponed. This was most notable in Chuuk, where fiscal mismanagement triggered a crisis in the mid- 1990s. Specifically, persistently high expenditures exhausted the state’s cash reserves, leading to arrears that in 1996 peaked at 30 percent of state GDP. Subsequently, the Chuuk government embarked on a stabilization program with conditional financial support from the national government and also launched an early retirement program to bring the wage bill under control. By 2000, most or all of recorded arrears had been cleared. Pohnpei also faced a liquidity crisis in the late 1990s because of inadequate controls on spending.
Given the dominant economic role of the public sector and the role of the Compact in financing it, the step-downs and concomitant adjustments have had a major adverse impact on economic activity. This has prompted emigration, and, accordingly, population growth slowed from 2 percent to about ¼ percent per year. By 1999, an estimated 12,000 Micronesian citizens, or more than 10 percent of the population, had emigrated, mainly to Guam and Hawaii, while an unknown but probably large number had emigrated to the continental United States.
With the country’s economic performance deteriorating and viable investment opportunities scant, one commercial bank decided to cease operations in Micronesia, prompting a prolonged decline in outstanding credit. The bank offered to sell its loan portfolio to the remaining two commercial banks, but they expressed little interest, mainly because of a perceived excessive level of risk.
By the turn of the century, the effects of fiscal adjustment were waning and the economy was rebounding, with real GDP growth averaging 3.7 percent annually in 2000-03. During the 2002-03 renegotiation of the Compact, the U.S. government provided so-called bump-up funds, with grants set at their average level since 1987, which was significantly more than the 2001 level. These extra funds helped to sustain the economic expansion during the next two years and brought about an improvement in the overall fiscal position, even as earlier progress in government retrenchment was partially eroded. However, private sector activity continued to be sluggish, and the structure of the economy remained little changed from the beginning of the Compact period.
During the life of Compact I, real GDP growth averaged only 1.9 percent annually, and fiscal and structural adjustment remained incomplete. Micronesia enjoyed higher growth than the Marshall Islands, but both lagged well behind Palau, the third Compact country, especially in creating private sector employment (Box 11.2). Tax revenue remained low due to long-standing weaknesses, and the wage bill was high. Poorly performing public enterprises put a continual drag on public finances. The autonomy of the states and the absence of collective objectives compromised the formulation of fiscal and development objectives at the national level.
Yet these years also provided a hopeful message: effective policies can pay dividends in terms of growth and stability. The evidence came from Yap state, which had a record of both fiscal propriety and a relatively fertile environment for private enterprise. Yap achieved the strongest growth in the nation, with output rising by almost 50 percent cumulatively over 1987-2001, twice the average rate in the other three states. This suggested that, while the barriers to macroeconomic stability and economic development in the country might be sizable, they are not insurmountable.
Box 11.2.Micronesia: Comparison with Other Compact Countries
Micronesia, Marshall Islands, and Palau (all formerly part of the Trust Territory of the Pacific Islands) currently have Compacts of Free Association with the United States. The three countries have similar characteristics, with heavy reliance on official grants and dollarization. Nonetheless, cross-country comparisons highlight notable differences among them.
Compared with Marshall Islands, Micronesia has experienced higher GDP growth and enjoys higher GDP per capita at present. However, both countries have lagged behind Palau in terms of economic development, and a large part of their population is still in the subsistence sector. Furthermore, growth in paid private sector employment has been modest. The differences in economic performances may be partly attributed to geography: Palau is closest to large Asian countries and receives the most international visitors. All three countries have enjoyed price stability during recent years, thanks to use of the U.S. dollar as the domestic currency.
Private Sector Employment1
Sources: Micronesia authorities and IMF staff estimates.
1 Data for Palau are for calendar year.
Regarding fiscal performance, all three countries are characterized by low domestic revenue, high dependence on grants, and large current expenditures. As a share of GDP, Micronesia has the lowest domestic revenue, the highest grants, and the largest wage expenditures. That said, like Palau, Micronesia’s government debt is at comfortably low levels, thanks to the large grants.
Fiscal Indicators (FY2003)
Sources: Micronesia authorities and IMF staff estimates.
Sources: Micronesia authorities and IMF staff estimates.
Figure 11.3.Micronesia: U.S. Compact Grants
Sources: FSM authorities and IMF staff estimates.
Economic Prospects during Compact II, 2004-23
The amended Compact (Compact II) came into effect in 2004. Despite the periodic step-downs since 1987, grants remain sizable, amounting to one-third of GDP, or about $700 per capita. The grants will steadily decline until the Compact expires in 2023 (Figure 11.3). During this period, a trust fund will be built up with payments from Micronesia and the United States, and initial contributions have already been made by both parties. Throughout the period, total U.S. funding will be partly adjusted for U.S. inflation, with programmed declines in grants to be fully offset each year by progressively higher contributions to the Compact Trust Fund. The main purpose of the trust fund is to secure economic self-sufficiency in the post-Compact era, and no drawings or collateral borrowing is permitted until 2024.
There are two major features that differ markedly from Compact I. First, the amended Compact incorporates enhanced accountability, monitoring, and conditionality. A U.S.-Micronesia Joint Economic Management Committee has been established to review allocations and review performance outcomes and audits. Grant disbursement can be held up if requirements are not satisfied. In addition, resources are to be directed to six priority sectors: health, infrastructure, education, capacity building, environment, and private sector development. There are no explicit formulas for allocations by sector, but the committee has resolved that infrastructure spending should rise toward at least 30 percent of grants by 2006. Second, Compact II incorporates steady annual declines in grants (rather than discrete step-downs), with only partial indexation for inflation.
Making the adjustment to these two changes will be a major challenge, as will the ultimate goal of attaining stable economic growth and financial independence. In the near term, the challenge will be to adapt to the tighter conditionality. In 2004, a third of programmed grants, equivalent to 11 percent of GDP, could not be absorbed due to capacity constraints in meeting Compact requirements, although these funds were subsequently released, and a 2005 U.S. Government Accountability Office report found that there had been improvements in both accountability and monitoring. The larger challenge, and the main one facing Micronesia over the medium term, is achieving fiscal and economic sustainability in the face of a continuous decline in external assistance. Moreover, under existing arrangements, the trust fund may suffice only to replace expiring grants for a few years after the Compact expires.
To help promote longer-term sustainability, Micronesia will need to undertake sustained fiscal consolidation, as well as structural reforms to foster a more vibrant private sector. Early action toward these ends is vital to forestall major and disruptive adjustments later in the Compact period.
To ensure fiscal sustainability over the medium term, the government must realize budgetary surpluses annually. There are two major issues that must be addressed to achieve this degree of consolidation. First, tax revenues are low by regional standards at only about 11 percent of GDP, compared with over 15 percent in Marshall Islands and over 20 percent in Palau and the larger Pacific islands. There are persistent weaknesses in administration and compliance that need to be corrected. Beyond this, the system must be modernized and streamlined, including by removal of distortions created by cascading taxes through which goods are taxed at multiple stages (e.g., as imports, during production, and at final sale). One option for reform is introduction of a VAT similar to that adopted by a number of other Pacific island countries in recent years, and as recommended by the Presidential Task Force on Tax Reform. Implementation of a VAT would require the cooperation of the states, which have constitutional jurisdiction over consumption taxes.
On the expenditure side, despite continued wage and hiring freezes, the wage bill remains high compared with other Pacific island countries at about 25 percent of GDP. This is several percentage points above the levels in Marshall Islands and Palau, and far above the level in the larger Pacific island countries, including Fiji, Papua New Guinea, Samoa, and Solomon Islands. A lower wage bill is essential to meet Compact requirements for enhancing spending in key sectors, such as health, education, and infrastructure, as well as to support long-run growth. Public enterprises should be reformed to reduce their continuing burden on the budget. This sector remains significant in size, accounting for 5 percent of employment, roughly the same as all the main export-oriented sectors combined. Reducing the size of this sector would be consistent with the authorities’ strategy to facilitate private sector development.
Fiscal reforms need to be complemented by structural reforms to encourage private sector development and employment. Issues that should be addressed include the high cost of doing business; poor infrastructure, with periodic power outages; obstacles to foreign ownership of land and to the use of land as collateral for loans; and an opaque and lengthy application process for foreign investment. The commercial banking system is sound, and the two private banks benefit from U.S. Federal Deposit Insurance Corporation (FDIC) oversight provided under the Compact. However, the banks invest primarily abroad, in view of the domestic risks associated with shortcomings in the legal framework and uncertain economic prospects. Their strong liquidity provides scope for greater lending, which would be stimulated by structural reforms. The present trade regime is relatively unrestrictive, and the commitment of the authorities to further liberalization under the regional trade arrangements is indicative of their intention to enhance private sector competitiveness.