Public Information Notice No. 13/06

Federated States of Micronesia: IMF Executive Board Concludes 2012 Article IV Consultation

January 17, 2013

On January 14, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Federated States of Micronesia (FSM).¹

Background

The FSM’s economy is highly dependent on external aid, and private activity contributes little to growth. A new Compact of Free Association agreement (“Compact”) with the United States, effective since Fiscal Year (FY) 2004, steadily lowers transfers to the FSM through FY2023 and has stricter rules on the use of grants. After FY2023, the FSM is expected to complement its domestic revenues with income from its Compact Trust Fund (CTF) and other savings.

Since the last Article IV consultation, the economy continued on a steady growth path. Following a recession in FY2006-2008 due to delay in Compact grants utilization as well as high fuel and food prices, the FSM economy grew by 2–2½ percent for FY2010 and FY2011. The expansion was driven by new construction activities and growth of the fishery sector. Inflation has declined to 4.6 percent in FY2011, after reaching its recent peak of 7.8 percent in FY2009.

The overall fiscal balance of the consolidated government recorded modest surpluses for three straight years through FY2011, with an uneven distribution of outcomes across states. Public debt remains at a relatively low level (below 30 percent of GDP), but underfunding in the CTF assets and a declining balance of the social security fund pose long-term challenges.

Despite some deterioration of the current account balance, external balance is sustained by a stable flow of official transfers. The majority of the overall current account deficit is financed through capital transfers from official sources.

Economic growth will likely slow in the near term, as the private sector falls short of offsetting the declining public sector demand from Compact grants reduction. Growth in FY2012 is estimated at 1.4 percent as recent construction projects are winding down. A modest consolidated fiscal surplus of 1¼ percent of GDP is expected in FY2012, mainly due to a sharp increase in fishing access fee revenue by $7.6 million. While the fishery sector is expected to continue its healthy expansion, lackluster wholesale and retail activities will remain a drag on the private sector growth. Beyond the near-term, growth is weighed down by the scheduled reduction in Compact grants. Medium-term growth is estimated to stay low at about ½ percent, with limited private sector growth failing to offset the effects of a decline in Compact grants.

Executive Board Assessment

Executive Directors noted that the FSM economy continued to grow last year, driven by construction and fishery. Nonetheless, the economy faces important risks, including from a potential deterioration in the external environment and, over the longer term, the scheduled expiration of Compact grants and the continued outmigration of the working age population. In this context, Directors underscored the need to begin addressing the fiscal gap to create fiscal buffers and ensure sustainable public finances, and to accelerate reforms to boost potential growth.

Directors encouraged the authorities to implement a credible fiscal strategy based on a realistic macroeconomic framework and balanced fiscal adjustment. They stressed the importance of swift passage of the comprehensive tax reform bill to enhance revenue, and the need to contain current expenditures, in particular public wages. It will also be essential to improve public financial management to complement tax and expenditure reforms.

Directors cautioned that underfunding of the Compact Trust Fund and a declining balance of the social security fund pose long-term challenges. With the Compact grants scheduled to expire in FY2023, Directors underlined the importance of improving FSM’s capacity to fully utilize the remaining grants. They encouraged the authorities to prepare for the grants’ expiration by developing realistic reform plans with broad support from the state governments and the general public. In this regard, they looked forward to swift approval of the budget to establish the 2023 Planning Committee.

Directors emphasized the importance of advancing investment-friendly reforms to catalyze growth and support fiscal consolidation. In this context, further liberalizing land use and lease and streamlining investment licensing procedures at the national and state levels are important priorities.

Directors noted that the financial system is well capitalized and liquid, but urged careful monitoring of credit quality given the increase in consumer loans in recent years. They welcomed efforts to address issues in loan collateral, which could help unlock commercial lending. Directors agreed that the FSM Development Bank should be brought under appropriate supervision and its activities redirected to helping finance start-ups.

Directors encouraged the authorities to step up production of high quality economic statistics, especially in the fiscal area, to strengthen monitoring and policy analysis.