Public Information Notice No. 10/60

Public Information Notice: IMF Executive Board Concludes 2010 Article IV Consultation with Palau

May 14, 2010

On April 28, 2010, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Republic of Palau.¹

Background

The global financial crisis, compounded by some Palau-specific shocks, has taken a heavy toll on the island nation. Foreign direct investment (FDI) contracted as many foreign firms lost access to financing. Tourism accounting for almost half of GDP fell by a cumulative 17 percent over the last two years owing in large parts to the bankruptcy of a Taiwanese airline. And, foreign capital grants and public investment contracted as major infrastructure projects, like the construction of the Compact road and its feeder roads, were completed.

Monetary conditions have tightened in the wake of the global downturn. Foreign bank branches, which account for about 95 percent of banking sector assets, are flush with liquidity. However, foreign bank branches have tightened credit standards, reflecting a reassessment of risks at headquarters and Palau-specific concerns about household debt. As a result, private credit contracted by 20 percent in FY2009 (October-September).

Palau’s external position deteriorated as oil prices spiked and overseas investments sustained major valuation losses. In FY2008, the current account (including grants) deteriorated by about 10 percentage points of GDP to -18 percent of GDP. While it has recovered somewhat since then, external debt continued to increase and reached a record 38 percent of GDP in FY2009. Palau’s external assets, namely pension funds and the Compact trust fund lost about 15 percent of their value since the financial crisis. Taken together, Palau’s international investment position (foreign assets minus foreign liabilities) fell from 4 percent of GDP in FY2007 to -33 percent of GDP in FY2009.

Fiscal policy continues to be loose and the liquidity situation is becoming serious. Domestic revenue fell and current spending rose over FY2008–FY2009, leading to a further deterioration in the current balance (domestic revenue minus current expenditure). The current balance has been worsening since FY2005, despite the medium-term policy goal of a zero current balance. In addition, revenues and grants have not been sufficient to finance expenditures, as evidenced by a steady drawdown of government deposits.

The short-term outlook remains clouded, with growth projected to turn only slightly positive in FY2010. Tourist arrivals and FDI should pick up in FY2010 along with the recovery in global growth and financial conditions. However, little stimulus is expected from public infrastructure projects and oil prices are projected to rise by 35 percent between FY2009 and FY2010. Downside risks include higher than expected oil prices, fewer grants as donor countries struggle with tighter finances, and a double dip in global growth, which would affect tourism. On the upside, an expansion of flight schedules could lead to an increase in tourism.

Executive Board Assessment

Executive Directors noted that, in the wake of the global crisis, the Palauan economy had been hit by sizable domestic and external shocks, which contributed to a large contraction. Directors commended the authorities for steering Palau through these turbulent times. While near-term prospects have improved, many challenges remain however to be tackled to consolidate the recovery and sustain growth.

Directors observed that ensuring a sustainable fiscal position remains the most important challenge confronting Palau. They welcomed recent steps to strengthen fiscal policy such as the tax measures currently before Congress, and encouraged further efforts to protect the government’s cash position and advance toward the authorities’ goal of self sufficiency.

Directors underscored that gradual fiscal adjustment will be necessary over the medium term to prevent a sharp correction once U.S. Compact grant assistance ends in 2024. This would be achieved through the passage of all the revenue measures currently before Congress and additional spending restraint. They welcomed recent efforts to improve the budget process as a precondition for fiscal discipline. Looking forward, the adjustment would require a comprehensive tax reform as well as civil service reform. Directors recommended a conservative approach to possible future oil and gas revenues in the formulation of fiscal policy. They welcomed the authorities’ work on strengthening the fiscal and legal frameworks for managing such revenues, and encouraged them to continue drawing on technical assistance from the World Bank.

Directors welcomed the authorities’ efforts to streamline the FDI regime, including the FDI bills currently before Congress, to generate new sources of revenues and growth as fiscal consolidation proceeds. They noted that higher labor fees for foreign investors and lower minimum wages for foreign workers continue to impede FDI and employment generation for Palauans.

Directors supported the continued use of the U.S. dollar as legal tender, given Palau’s small size and administrative capacity. They observed that Palau has maintained its external competitiveness, but remains vulnerable to terms of trade shocks. Greater pass-through of global oil prices to contain debt accumulation in public utilities would therefore be desirable. Directors welcomed continued improvements in financial sector oversight, but urged caution in proceeding with the plans to launch a corporate and ship registry, which could pose new challenges in fighting money laundering given Palau’s current oversight capacity.

Directors noted that high-quality data are essential for policy formulation and surveillance. They looked forward to the adoption of the GDP numbers compiled with the help of the Pacific Financial Technical Assistance Center and to the increase in staffing levels at the Bureau of Budget and Planning.