COUNTRY ECONOMIC REVIEW - PITI-VITI · Fiscal Year 2015 Economic Review October, 2016. CURRENCY...

Fiscal Year 2015 Economic Review

October, 2016

CURRENCY EQUIVALENTS

Currency unit: United States dollar (US$)

ABBREVIATIONS

ADB — Asian Development Bank

AIP — Airport Improvement Program

Amended Compact — second phase of the Compact, FY2004-FY2023

AusAID — Australian Agency for International Development

BoP — balance of payments

BPS — budget preparation system

BSS — basic social services

c.i.f. — cost, insurance and freight

COLA — cost-of-living adjustment

COM — College of Micronesia

Compact — FSM Compact of Free Association with the

United States

Compact I — first 17 years of the Compact, FY1987-FY2003

CPI — consumer price index

CTF — Compact Trust Fund

CY — calendar year

DEA — Department of Economic Affairs, FSM

DOI — U.S. Department of the Interior

EEZ — exclusive economic zone

EPIC — Economic Policy Implementation Council

ERP — early retirement program

ESC — executive steering committee

FAA — Federal Aviation Administration

FDI — foreign direct investment

FEMA — Federal Emergency Management Agency

FIAS — Foreign Investment Advisory Service

FMIS — financial management information system

f.o.b. — free on board

FPA — Fiscal Procedures Agreement

FSM — Federated States of Micronesia

FY — fiscal year

GDP — gross domestic product

GFS — Government Finance Statistics

GNDI — gross national disposable income

GNI — gross national income

GRT — gross receipts tax

HIES — household income and expenditure survey

iii

ICT — information and communication technology

IDF — investment development fund

IIP — international investment position

IMC — investment-oriented major corporation

IMF — International Monetary Fund

ITF — Investment Trust Fund

JEMCO — Joint Economic Management Committee

LTFF — long-term fiscal framework

MFFF — Macroeconomic and Fiscal Forecasting Frame-

work

MTMF — Medium-Term Macroeconomic Framework

MTN — medium-term notes (Compact-backed bonds)

NGO — nongovernmental organization

OIA — Office of Insular Affairs

PEFA — Public Expenditure and Financial Accountability

PFM — public financial management

PFTAC — Pacific Financial Technical Assistance Center

PIER — Pacific Island Economic Report

PMCB — performance management capacity building

PMO — project management office

PMU — project management unit

PNA — Parties to the Nauru Agreement

PRS — performance reporting system

PSDP — Private Sector Development Program

PSRP — Public Sector Reform Program

RAA — Revenue Administration Act

RIF — reduction in force

SBOC — Office of Statistics, Budget and Economic Man-

agement, Overseas Development Assistance,

and Compact Management

SDP — Strategic Development Plan

SEG — Supplemental Education Grant

SGS — sustained growth strategy

SOE — state-owned enterprise

TA — technical assistance

TRTF — Tax Reform Task Force

TWG — technical working group

URA — Unified Revenue Authority

U.S. — United States

VAT — value added tax

YSPSC — Yap State Public Service Corporation

NOTE: The FSM government’s fiscal year (FY) ends on September 30.

iv

TABLE OF CONTENTS

Page

Table of Contents iv

List of Tables vii

Foreword Error! Bookmark not defined.

I. Background and FY2014 Highlights xvi

1 Background xvi 2 FY2015 Highlights xviii

II. Economic Developments 1

A Growth and Employment 1 1 Developments in the FSM Economy 1 2 The Structure of the Economy 6

3 Industry Developments 8 4 Incomes, Population and Migration 10

5 Employment 14 6 Wages 16

B Monetary Developments and Prices 17 1 Prices 17 2 Money and Banking 18

C Balance of Payments, External Debt, GNI, GNDI and International

Investment Position 21 1 Balance of Payments 21 2 GNI and GNDI 25 3 International Investment Position 27

4 Nominal and Real Effective Exchange Rates 28 5 External Debt 29

D Fiscal Developments 30 1 Fiscal Policy Framework 30 2 FSM Fiscal Performance 34

3 Structural Changes in Key Fiscal Variables 36 4 Structure of the FSM tax system 37 5 Fiscal Performance at the National Government 39

III. Policy Issues 44

A Public Financial Management 44 1 Public Sector Payroll 44 2 Public Expenditure and Financial Accountability 47 3 Financial Management Information Systems and Performance

Management 48

B Fiscal Issues 49

v

1 Tax Reform 49 2 Corporate Tax Policy and the FSM Domicile 49 3 External Debt Management and Policy 53 4 Social Security Sustainability 55

C State-Owned Enterprises (SOEs) 57 1 FSM Telecom and ICT Reform 58 2 FSM Petroleum Corporation 61

D Compact Issues 63 1 Adjustment to the Amended Compact 63

2 Decrement Management 64 3 Infrastructure Development and Economic Growth 66

E Special Topics 69 1 Sovereign Wealth Management 69 2 Third FSM Economic Summit 71

F Private Sector Development 72 1 The World Bank Doing Business Survey 72 2 Foreign Direct Investment (FDI) 73

G The Policy Score Card 74

IV. The Compact Trust Fund 78

A Performance of the Compact Trust Fund (FY2004-FY2015 and projected

to FY2023) 78 1 Background 78 2 Performance Monitoring 79

B Trust Fund Principles and Market Risk 82 1 Benchmarks and Performance Measures 82

C Trust Fund Simulations 83

D Projected Value of the CTF and distributions in FY2023 and thereafter 84 1 Trust Fund Performance 84

V. State Economic Developments 87

A Chuuk state 87 1 GDP 87 2 Employment and Government Payroll 89 3 Fiscal Performance 91

B Kosrae state 94 1 GDP 94

2 Employment and Government Payroll 96

3 Fiscal Performance 97

C Pohnpei state 101 1 GDP 101 2 Employment and Government Payroll 103 3 Fiscal 105

D Yap state 107 1 GDP 107

vi

2 Employment and Government Payroll 109 3 Fiscal Performance 111 4 Policy Issues 112

VI. Economic Prospects to the end of the Amended Compact and Beyond116

A Economic Prospects 116 1 Assumptions 116

2 Economic Activity 118 3 Fiscal Projections 121 4 Policy Implications 123

Appendix 1 The Macroeconomic Fiscal Forecasting Framework Projection Methodology 125

1 Production and GDP 125 2 Price and wage projections 126

3 GDP at current prices and the generation of income account 127 4 The household sector account 127

5 Gross domestic expenditure and demand 128 6 Government Finance 129 7 Balance of Payments 130

8 Banking Survey 131

vii

LIST OF TABLES

Page

Table 1 Population by state and annual average growth rates 10

Table 2 Employment growth rates by sector and state 14

Table 3 Real wages and differentials by sector and state 16

Table 4 Balance of payments: current account 22

Table 5 Balance of payments: capital and financial account 24

Table 6 FSM international investment position 27

Table 7 U S. annual Compact grants and contributions to the Trust Fund 31

Table 8 Payroll reduction performance: PSRP targets, actual performance

as at loan close out in FY1999 and FY2015 44

Table 9 Social Security Valuation, 2011 56

Table 10 FSM: Ease of doing business, World Bank ranking 73

Table 11 Summary of FSM Policy Reforms 75

Table.12 FSM Compact Trust Fund Simulated Results and Performance 85

LIST OF FIGURES Page

Figure 1 GDP, constant prices 2004 1

Figure 2 Contribution to economic growth by major industry (percent) 3

Figure 3 FSM constant price GDP by sector 3

Figure 4 Contribution to GDP growth by Industry between FY2003 and

FY2013 6

Figure 5 The institutional structure of the FSM economy 7

Figure 6 Net migration and employment change 11

Figure 7 GDP per capita, migration and population growth 11

Figure 8 GDP and GNDI per capita 12

Figure 9 GDP per capita in Chuuk, Kosrae, Pohnpei and Yap 13

Figure 10 Employment by sector 15

Figure 11 Nominal and real wages private and public sectors 17

Figure 12 Change in CPI - food and energy sections 18

Figure 13 Commercial bank loans and deposits 20

Figure 14 Commercial bank credit by sector (less lending in Saipan) 21

Figure 15 Primary and secondary incomes 25

Figure 16 GDP, GNI and GNDI 26

viii

Figure 17 Nominal and real effective exchange rate 28

Figure 18 FSM external debt ratios 30

Figure 19 FSM consolidated revenues and expenditures 34

Figure 20 Fiscal balance state and national government 36

Figure 21 FSM tax effort and grants, percent GDP 36

Figure 22 FSM current and capital expenditures, percent GDP 37

Figure 23 National government tax collections by type 40

Figure 24 National government major revenue items 41

Figure 25 National government payroll and employees 42

Figure 26 National government consolidated revenues and expenditures 43

Figure 27 FSM government employees and wage Bill 46

Figure 28 FSM Public Sector average wage costs by Fund Type 47

Figure 29 Social Security Fund balance, contributions and benefits 56

Figure 30 FSM Telecom net operating income and cash flow 59

Figure 31 FSM PetroCorp net operating income and return on assets 62

Figure 32 LTFF three yearly adjustment cycle 65

Figure 33 Impact on GDP of major economic drivers 69

Figure 34 National and state government domestic revenues 70

Figure 35 Comparison of the Third Summit dismal scenario with

performance 72

Figure 36 Projected FSM Trust Fund Value through FY2023 81

Figure.37 Probability Distribution of FSM Compact Trust Fund in FY2023 84

Figure 38 Chuuk state constant price GDP by sector 87

Figure 39 Chuuk state contribution to GDP growth by industry 89

Figure 40 Chuuk state employment in private and public sectors 90

Figure 41 Chuuk state government payroll and wage bill 91

Figure 42 Chuuk State consolidated revenues and expenditures 92

Figure 43 Kosrae State constant price gdp by sector 94

Figure 44 Kosrae State contribution to GDP growth by industry 96

Figure 45 Kosrae State employment in private and public sectors 97

Figure 46 Kosrae State government payroll and wage bill 98

Figure 47 Kosrae State consolidated revenues and expenditures 99

Figure 48 Pohnpei State constant price GDP by sector 101

Figure 49 Pohnpei State contribution to GDP growth by industry 103

Figure 50 Pohnpei State employment in private and public sectors 104

Figure 51 Pohnpei State government payroll numbers and wage bill 104

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Figure 52 Pohnpei State consolidated revenues and expenditures 105

Figure 53 Yap State constant price GDP by sector 107

Figure 54 Yap State contribution to gdp growth by industry 108

Figure 55 Yap State employment in private and public sectors 110

Figure 56 Yap State government payroll and wage bill 110

Figure 57 Yap State consolidated revenues and expenditures 111

Figure 58 FSM economic prospects 118

Figure 59 Sources of rrowth during the remainder of the amended Compact 119

Figure 60 Economic prospects at the state level 120

Figure 61 State government revenues and expenditures 122

Figure 62 National government revenues and expenditures 122

Figure 63 Projected Trust Fund values with national government

contributions 124

LIST OF APPENDIX TABLES Page

Table 1a FSM: Income measures in current prices and real terms, FY2003-

FY2015 S5

Table 1b FSM and states: Current and constant price GDP, GDP per capita,

FY1981-FY2015 S6

Table 1c FSM: Constant price GDP by industry, FY2003-FY2015 S7

Table 1d FSM: Constant price GDP by industry sector, annual percent

growth, FY2003-FY2015 S8

Table 1e FSM: Constant price GDP by industry sector, contribution to

percent growth, FY2003-FY2015 S9

Table 1f FSM: Current price GDP by industry, FY2003-FY2015 S10

Table 1g FSM: Implicit GDP price deflators by industry, FY2003-FY2015 S11

Table 1h FSM: Share of GDP by industry, current prices, FY2003-FY2015 S12

Table 1i FSM: Constant price GDP by institutional sector and income

components, FY2003-FY2015 S13

Table 1j FSM: Current price GDP by institutional sector and income


Table 1k FSM: Share of GDP by institutional sector, current prices,

FY2003-FY2015 S15

Table 1l FSM: GDP by income component, current prices, FY2004-

FY2015 S16

Table 2a Chuuk: Constant price GDP by industry, FY2003-FY2015 S17

x

Table 2b Chuuk: Constant price GDP by industry sector, annual percent


Table 2c Chuuk: Constant price GDP by industry sector, contribution to %


Table 2d Chuuk: Current price GDP by industry, FY2003-FY2015 S20

Table 2e Chuuk: Implicit GDP price deflators by industry, FY2003-FY2015 S21

Table 2f Chuuk: Share of GDP by industry, current prices, FY2003-FY2015 S22

Table 2g Chuuk: Constant price GDP by institutional sector and income


Table 2h Chuuk: Current price GDP by institutional sector and income


Table 2i Chuuk: Share of GDP by institutional sector, current prices,

FY2003-FY2015 S25

Table 2j Chuuk: GDP by income component, current prices, FY2003-

FY2015 S26

Table 3a Kosrae: Constant price GDP by industry, FY2004-FY2015 S27

Table 3b Kosrae: Constant price GDP by industry sector, annual percent


Table 3c Kosrae: Constant price GDP by industry sector, contribution to


Table 3d Kosrae: Current price GDP by industry, FY2003-FY2015 S30

Table 3e Kosrae: Implicit GDP price deflators by industry, FY2003-FY2015 S31

Table 3f Kosrae: Share of GDP by industry, current prices, FY2003-

FY2015 S32

Table 3g Kosrae: Constant price GDP by institutional sector and income


Table 3h Kosrae: Current price GDP by institutional sector and income


Table 3i Kosrae: Share of GDP by institutional sector, current prices,

FY2003-FY2015 S35

Table 3j Kosrae: GDP by income component, current prices, FY2003-

FY2015 S36

Table 4a Pohnpei: Constant price GDP by industry, FY2003-FY2015 S37

Table 4b Pohnpei: Constant price GDP by industry sector, annual percent


Table 4c Pohnpei: Constant price GDP by industry sector, contribution to


Table 4d Pohnpei: Current price GDP by industry, FY2003-FY2015 S40

xi

Table 4e Pohnpei: Implicit GDP price deflators by industry, FY2003-

FY2015 S41

Table 4f Pohnpei: Share of GDP by industry, current prices, FY2003-

FY2015 S42

Table 4g Pohnpei: Constant price GDP by institutional sector and income


Table 4h Pohnpei: Current price GDP by institutional sector and income


Table 4i Pohnpei: Share of GDP by institutional sector, current prices,

FY2003-FY2015 S45

Table 4j Pohnpei: GDP by income component, current prices, FY2003-

FY2015 S46

Table 5a Yap: Constant price GDP by industry, FY2003-FY2015 S47

Table 5b Yap: Constant price GDP by industry sector, annual percent


Table 5c Yap: Constant price GDP by industry sector, contribution to


Table 5d Yap: Current price GDP by industry, FY2003-FY2015 S50

Table 5e Yap: Implicit GDP price deflators by industry, FY2003-FY2015 S51

Table 5f Yap: Share of GDP by industry, current prices, FY2003-FY2015 S52

Table 5g Yap: Constant price GDP by institutional sector and income


Table 5h Yap: Current price GDP by institutional sector and income


Table 5i Yap: Share of GDP by institutional sector, current prices, FY2003-

FY2015 S55

Table 5j Yap: GDP by income component, current prices, FY2003-FY2015 S56

Table 6a FSM: Visitor arrivals by year (sum of four FSM states): , FY2003-

FY2015 S57

Table 6b Chuuk: Visitor arrivals by year, FY2003-FY2015 S58

Table 6c Kosrae: Visitor arrivals by year, FY2003-FY2015 S59

Table 6d Pohnpei: Visitor arrivals by year, FY2003-FY2015 S60

Table 6e Yap: Visitor arrivals by year, FY2003-FY2015 S61

Table 6f Total fish catch in FSM EEZ, by method, CY1998-CY2015 S62

Table 6g Total fish catch, by FSM and domestically based vessels, CY2001-

CY2015 S62

Table 6h License fees collected, FY1999-FY2015 S63

Table 7a Employment by industry, FSM and states, FY2004-FY2015 S64

xii

Table 7b Employment by institution, FSM and states, FY2004-FY2015 S69

Table 7c Average nominal wage rates by institution, FSM and states,

FY2004-FY2015 S72

Table 7d Average real wage rates by institution, FSM and states, FY2004-

FY2015 S75

Table 7e Employee earnings by institution, FSM and states, FY2004-

FY2015 S78

Table 7f Employment by industry, FSM and states, private sector, FY2004-

FY2015 S81

Table 7g Earnings by industry, FSM and states, private sector, FY2004-

FY2015 S86

Table 8a FSM commercial banking survey, FY2004-FY2015 S91

Table 8b Interest rates of domestic money banks, CY2004-CY2015 S92

Table 9a FSM: CPI index, FY1999 to FY2015 S93

Table 9b FSM: CPI index, domestic items, FY1999 to FY2015 S94

Table 9c FSM: CPI index, imported items, FY1999 to FY2015 S95

Table 9d Chuuk: State CPI index, FY1999 to FY2015 S96

Table 9e Kosrae: State CPI index, FY1999 to FY2015 S97

Table 9f Pohnpei: State CPI index, FY1999 to FY2015 S98

Table 9g Yap: State CPI index, FY1999 to FY2015 S99

Table 10a FSM and states: Imports by major category, FY2004-FY2015 S100

Table 10b FSM Balance of Payments (summary) FY2004-FY2015 S102

Table 10c FSM Balance of Payments (detail), FY2004-FY2015 S104

Table 10d FSM international investment position, FY2004-FY2015 S107

Table 10e FSM external debt, FY2004-FY2015 S108

Table 10f External debt, original value, and outstanding principle by loan S109

Table 11a FSM consolidated summary government finances (GFS format),

FY2004-FY2015 S110

Table 11b National government summary finances (GFS format), FY2004-

FY2015 S111

Table 11c Chuuk State government summary finances (GFS format),

FY2004-FY2015 S112

Table 11d Kosrae State summary government finances (GFS format),

FY2004-FY2015 S113

Table 11e Pohnpei State government summary finances (GFS format),

FY2004-FY2015 S114

Table 11f Yap State government summary finances (GFS format), FY2004-

FY2015 S115

xiii

Table 11f FSM consolidated detailed government finances (GFS format),

FY2004-FY2015 S116

Table 11g National government detailed government finances (GFS format),

FY2004-FY2015 S118

Table 11h Chuuk State detailed government finances (GFS format), FY2004-

FY2015 S120

Table 11i Kosrae State detailed government finances (GFS format), FY2004-

FY2015 S122

Table 11j Pohnpei State detailed government finances (GFS format),

FY2004-FY2015 S124

Table 11l Yap State detailed government finances (GFS format), FY2004-

FY2015 S126

Table 11m FSM Compact grants awarded, FY2004-FY2015 S128

Table 12a Population growth by state and outer islands, 1980 to 2010 S131

Table 12b Age and sex distribution, and households, by state and outer

islands, 2010 S132

Table 12c Labour force indicators, by state and outer islands, 2010 S133

Table 12d Net air passengers from the USA, FY1991 to FY2011 S134

xiv

DISCLAIMER

The views, thoughts, and opinions expressed in this Review are those of the authors, and

represent an independent assessment of the FSM’s FY16 economic performance. This

document does not necessarily represent the views of the Government of the Federated

States of Micronesia, the Graduate School USA, nor any other organization, committee,

group or individual, real or implied.

FOREWORD

This review has been prepared to assist the government of the Federated States of Micro-

nesia (FSM) and the U.S. Department of the Interior to fulfill their respective reporting

obligations under the Compact of Free Association with the United States. The FSM is

required, under Title One, Section 214, to report to the U.S. president on the use of sector

grant assistance and on progress in meeting mutually agreed program and economic

goals. The president, under Title One, Section 104.h, is required to submit a similar re-

port to Congress concerning developments in the FSM.

This review has been prepared under a grant from the Department of the Interior and ad-

ministered by Graduate School USA. However, it is not intended to directly fulfill the re-

porting requirements of the FSM and U.S. governments, but rather to provide an inde-

pendent assessment of the FSM’s economic performance and policy environment as well

as a set of economic statistics. Much of the material will be directly relevant to the two

reports. However, the reporting requirements of the two governments are different; thus,

not all the material will be relevant to both reports.

This review consists of five chapters: (i) a descriptive chapter on economic performance

in the FSM; (ii) a discussion of policy developments and issues; (iii) a chapter on the

Compact Trust Fund, performance and simulations; (iv) a chapter on state economic per-

formance; and (v) a chapter on prospects over the long term. The descriptive chapter

takes a standard macroeconomic approach and includes economic growth and employ-

ment, monetary developments and prices, the external sector, and fiscal developments.

The policy discussion does not attempt to provide a comprehensive policy review. In-

stead, it focuses on key topical areas, which include public financial management, and

fiscal and Compact issues. The Compact Trust Fund (CTF) chapter has been abbreviated

from last year’s review and the reader referred to a new paper on “Trust Funds in the

Three Freely Associated States: Mechanics and Stochastic Projections” for a full descrip-

tion and analysis. The state chapter reviews and examines economic performance at the

state level, covering economic growth, employment, payroll, and fiscal developments.

The prospects chapter provides projections of the economy and fiscal position through

the end of the amended Compact under the current policy environment, and examines po-

tential adjustments thereafter.

This review was prepared by the Graduate School USA, working closely with the Office

of Statistics. The authors wish to express special thanks to Mathew Chigiyal and Sharon

xv

Pelep, who provided invaluable support to the exercise. Additional discussions were held

with Fredy Perman of FSM Telecommunications Corporation; Eugene Pangelinan of the

National Oceanic Resource Management Authority (NORMA); Lam Dang and Patrick

Mackenzie, legal counsel and staff of the FSM Congress; Bob DeCourtnay, CEO of Bank

of the FSM; Steven Baker of the Micronesian Registration Advisors; and many others.

A digital copy of this—and previous—reviews is available online at the EconMAP web-

site at http://www.econmap.org.

http://www.econmap.org/

xvi

I. BACKGROUND AND FY2014 HIGHLIGHTS

1 BACKGROUND

This review has been prepared to assist both the FSM and U.S. governments in fulfilling

their respective obligations under the Compact of Free Association with the United

States. In the case of the FSM, the amended Compact states, under Title One, Section

214, that:

“The Government of the Federated States of Micronesia shall report annually to the

President of the United States on the use of United States sector grant assistance and

other assistance and progress in meeting mutually agreed program and economic

goals. The Joint Economic Management Committee shall review and comment on the

report and make appropriate recommendations based thereon.”

The president of the U.S. is required to submit to Congress a report on similar develop-

ments in the FSM. Title One, Section 104.h, of the amended Compact contains the fol-

lowing requirement:

(1) REPORT BY THE PRESIDENT. Not later than the end of the first full calendar

year following enactment of this resolution, and not later than December 31 of each

year thereafter, the President shall report to Congress regarding the Federated States

of Micronesia and the Republic of the Marshall Islands, including but not limited to—

(A) general social, political, and economic conditions, including estimates of

economic growth, per capita income, and migration rates;

(B) the use and effectiveness of United States financial, program, and tech-

nical assistance;

(C) the status of economic policy reforms, including but not limited to pro-

gress toward establishing self-sufficient tax rates;

(D) the status of the efforts to increase investment including: the rate of infra-

structure investment of U.S. financial assistance under the U.S.-FSM Compact

and the U.S.-RMI Compact; non-U.S. contributions to the trust funds, and the

level of private investment; and

(E) recommendations on ways to increase the effectiveness of United States

assistance and to meet overall economic performance objectives, including, if ap-

propriate, recommendations to Congress to adjust the inflation rate or to adjust

the contributions to the trust funds based on non-U.S. contributions.

The review is presented in five main chapters: (i) a review of economic performance in

the FSM; (ii) a discussion of policy developments and issues; (iii) a chapter on the Com-

pact Trust Fund, performance and simulations; (iv) a chapter on state economic perfor-

mance and policies; and (v) a chapter on prospects over the long term with economic pro-

jections. While this review relates to FY2015, analysis of developments in that year alone

xvii

would provide a limited and one-sided view. Accordingly, a longer-term perspective has

been taken, and the review includes material from the commencement of the amended

Compact, in cases where such information will help provide a more informed assessment.

The content of the review of economic developments follows a standard macroeconomic

approach and offers a discussion of growth and employment; monetary developments and

prices; the balance of payments and external debt; and fiscal developments.

The policy, prospects and issues chapter of the review covers a selected group of topical

issues and is not intended to review the whole range of public or private sector policies.

The first section concerns public financial management (PFM) and examines trends in

public sector payroll, Public Expenditure and Financial Accountability (PEFA), and per-

formance management. The second section concerns fiscal issues: attempts to reform the

tax regime, the FSM corporate tax domicile, external debt sustainability, and Social Secu-

rity sustainability. In the third section a selected review of the FSM state-owned enter-

prise (SOE) sector is undertaken. The fourth section focuses on adjustment to the

amended Compact, decrement management, and use of the Compact infrastructure sector

grant. A fifth section looks at special topics: sovereign wealth management, and the Third

FSM Summit, and a final section discusses private sector issues including the World

Bank “Doing Business” survey, and recent moves to improve the regime for Foreign Di-

rect Investment (FDI). A summary of the FSM Policy Score Card is provided as well.

The Compact Trust Fund (CTF) chapter has been abbreviated from last year’s review and

replaced by a summary of a longer paper entitled “Trust Funds in the Three Freely Asso-

ciated States: Mechanics and Stochastic Projections” to which the reader is referred1. The

chapter in this review provides an assessment of the performance of the fund and a sum-

mary of the simulations to assess the probability of attaining the objectives of the CTF

subject to market risk contained in the longer paper.

The state chapter, initiated in the FY2013 review, focuses on economic developments in

the four FSM states: GDP, employment, state government payroll, and fiscal perfor-

mance. In the case of Yap, a short section is devoted to policy issues, while for the other

states, the review will be extended in future editions. Inclusion of the state material in a

special chapter allows the general reader to focus on economic performance at the FSM

level, and those interested in specific states can purview the state chapter.

The last chapter of the review features economic prospects for the economy through the

end of the amended Compact and beyond. It has two main objectives. Firstly, to generate

a set of realistic and plausible projections of the FSM economy over the remainder of the

amended Compact, given the current policy environment and experience of the first 12

years of the period. The second objective is to closely define the level of fiscal resources

that may be available, and the size of the adjustment that may be required in the post

1 forthcoming at http://www.econmap.org

xviii

amended Compact years as the FSM moves from the current annual grants to drawdowns

from the Compact Trust Fund.

2 FY2015 HIGHLIGHTS

FY2015 Economic Performance: Despite the continuing issues with the use of the infra-

structure grant, FY2015 turned out to be good year for the FSM economy and GDP grew

by 3.7 percent. While construction contributed a negative 0.4 percent, fisheries grew

strongly with all the domestic fleet operational and was responsible for 1.5 percent of the

overll growth. The remainder of the growth in the economy was spread across a variety

of industries: wholesale and retailing, finance and business services. Public administra-

tion also grew at the national government reflecting booming revenues.

During the first six years of the amended Compact, economic performance was weak in

the FSM due to difficult adjustments to the new Compact. However, the following four

years saw improvement, in large part resulting from the strong demand for infrastructure.

The poor results FY2012 through FY2014, reflecting management issues with the use of

the Compact infrastructure grant, emphasize the need to comply with the conditions and

improve the environment for private sector led growth, to sustain the improvements

achieved in FY2015 and return the economy to a higher growth trajectory.

Employment: Despite the growth in the economy employment dropped by 0.3 percent in

FY2015. The public sector continued to shed jobs in the tight fiscal circumstances while

private employment grew by 0.2 percent. Over the last four years since FY2011 the im-

pact of falling GDP and declining infrastructure investment has resulted in a 6.8 percent

drop in employment.

Inflation: With the substantial declines in world oil prices inflation had turned negative

during FY2015 and the average level of prices fell by 0.2 percent with fourth quarter

prices being 0.7 percent below the same quarter of the year earlier.

The Fiscal Outturn: the overall fiscal balance recorded a surplus of $33.1 million, or

10.5 percent of GDP. However, this result differed significantly between the FSM na-

tional and state governments. The national government ran a surplus of $35.4 million,

while all states recorded small deficits, amounting to $2.3 million. The FSM state govern-

ments, where service delivery occurs, have been constrained by the declining real value

of Compact grants, while the national government has benefited from booming revenues

from fishing fees and, to a lesser extent, the captive insurance market.

External Debt: External Debt at 26 percent of GDP and 18 percent net of offsetting as-

sets (sinking fund) has remained at very low levels. Debt service at 9 percent of national

government domestic revenues remains well within the capacity of the national govern-

ment, and does not present any threat of risk of debt stress, despite being classified as

such by the IMF. The IMF Debt Sustainability Analysis (DSA) assumes that large fiscal

shortfalls post FY2023 would be sustained through external borrowing. However, the

xix

FSM does not have access to the assumed persistent borrowing from donors. While a

large fiscal adjustment may well exist, external debt stress is not one of the FSM’s poten-

tial problems. However, a recent review by the FSM public auditor revealed many weak-

nesses in the FSM’s external debt management. As a result, a debt management Bill has

been drafted and is currently under consideration by the FSM Congress.

Tax Reform: In the mid-2000s the FSM embarked on a lengthy process of tax reforms,

which after many years of donor support and hard work have not born fruition. This re-

duces the FSM’s ability to adjust to future fiscal shocks and to create an efficient tax en-

vironment that supports private sector development.

FSM Domicile for Japanese Companies: In 2005 the FSM passed corporate tax legisla-

tion that enable the creation of an overseas domicile for Japanese Companies. The law

provides for a corporate tax rate of 21 percent, and through differential tax rates, the FSM

host environment provides an attractive domicile for Japanese captive insurance compa-

nies and other corporations. A particular threat to the sustainability of the FSM domicile

is the lack of progress of the FSM to join the Global Forum and satisfy Phase 1 of the

peer review assessment. The Global forum is a group of 134 members that are working

under guidance of the OECD to create a transparent environment among nations to share

information in the tax area. In June 2016, there was a front-page article on the Nikkei

Shimbum reporting that based on a 2015 assessment Panama, Micronesia and Indonesia

would be blacklisted by the Global Forum. The implications of being placed in the same

group as Panama would be damaging to the FSM’s reputation, and any inclusion on this

list could potentially freeze, or kill the FSM domicile and Captive Insurance Industry.

Compliance with the Phase 1 requires becoming a member of the Global Forum ($26,000

per annum plus expenses), and implementation of a new law on Corporations, which has

in any case been under development. Both of these requirements should be treated as ur-

gent.

SOE performance: The FSM has managed to operate the SOE sector without the need

for large subsidies. However, weak pricing policies in the utility area have led to ineffi-

cient operations and lack of replacement of capital. While the supply of electricity in

Chuuk is now 24 hours, Pohnpei suffers from load sharing, and Yap charges the govern-

ment twice the normal price to maintain a positive cash flow. The World Bank is support-

ing ICT reform, and providing necessary conditions are met, the FSM will be the benefi-

ciary of $47.5 million to lay a fiber connection to Chuuk and Yap. The reforms require

the establishment of an independent regulator, and creation of an SOE to own and operate

the FSM’s fiber assets. The FSM PetroCorp has provided a rare example of a well-run

SOE, but care needs to be taken before embarking on risky projects outside its area of

competence.

Sovereign Wealth Management: The generation of large surpluses by the national gov-

ernment has raised the issue of sovereign wealth management. Increases in the Vessel

Day Scheme (VDS) under the Parties to the Nauru Agreement (PNA) have resulted in

xx

significant increases in national government revenues and the generation of fiscal sur-

pluses. Average VDS daily rates between $10,000 and $11,000 a day have resulted in the

national government running a large structural surplus of $50 million (adding Congres-

sional electoral district project expenditures, and a recent blow out in contractual service

expense). This level of resources could provide for substantial additional contributions, in

the order of $30 million per annum, to accumulate in the Compact Trust Fund or an alter-

native Fund, and reduce the pending massive fiscal shortfall projected for the state gov-

ernments of the FSM as early as FY2024 and thereafter.

In 2012 the then President of the FSM initiated an exercise to plan for transition to the

post amended Compact era after FY2023, known as the 2023 Action Plan. The Plan

while focusing on the post 2023 era also addressed the use of the emerging national gov-

ernment structural fiscal surplus, and proposed allocating $10 million to the CTF. How-

ever, with a new administration since March 2015, the 2023 planning effort and issue of

sovereign wealth management is no longer actively on the policy agenda. Rather in an at-

tempt to address the growing disparities between national and state government revenues,

the allocation of surplus resources has dissolved into an ad hoc process of funding prior-

ity state infrastructure projects, state sub accounts in the FSM trust fund and ballooning

legislative projects. Clearly, there is a need for a rational approach to the emergence of

significant sovereign resources. The former 2023 Plan established a sound framework for

resource allocation, and the FSM would be well advised to revisit the approach, if not the

content, to ensure the best use of the funds to address CTF shortfalls.

Third Economic Summit: In 2004 the FSM convened the 3rd Economic Summit and

adopted a strategy for sustained economic growth based on adjustment and reform. Dur-

ing the Summit, the FSM rejected a “dismal” scenario that relied on a status quo policy

environment and resulted in a projection of substantial and sustained outmigration. In the

initial years of the amended Compact through FY2009 economic performance was in-

deed dismal as the economy adjusted to the new provisions—a long, painful period that

had not been envisioned. In the next three years the economy was on a higher trajectory,

eventually outperforming the dismal scenario. However, in FY2013 and FY2014, with

the reduction in FAA projects and project management issues with the use of the infra-

structure grant, and in the absence of any perceivable economic policy improvements, the

economy has once again dipped below the dismal scenario. The FSM needs to get back

on track, remove the impediments to infrastructure grant use, and adopt a reform agenda,

if not the 2023 Action Plan, then another Plan to establish a sound macroeconomic envi-

ronment. With a sustainable basis for development, the FSM will be in a stronger position

to identify new sources of economic growth and outperform the dismal scenario.

Private Sector Development: The World Bank’s “Doing Business” survey paints a dis-

couraging view of the environment for private sector development. Out of 189 countries

the FSM currently scores 148, about 80% down the list indicating that there is much

room for improvement. The existing Foreign Direct Investment (FDI) regime in the FSM,

established as part of a set of reforms sponsored by the ADB in the late 90s, provides for

xxi

a two-part system that provides jurisdiction for investments that are of a national charac-

ter to the national government and all others to the state governments. However, the sys-

tem is cumbersome and does not provide a simple licensing process. In 2016 further re-

forms were introduced into the FSM Congress to modify the 1997 FDI Act bringing all

foreign investment under the jurisdiction of the national government. The reforms effec-

tively claim that all foreign investment is by its very nature of a national character. While

the current reforms will streamline the FDI process, and should be supported, it is yet to

be seen if they will successfully pass through Congressional committee and become law,

in the face of potentially strong state level opposition.

The FSM Compact Trust Fund experienced market losses during FY2015 of -2.6 per-

cent; however, scheduled contributions from the U.S. enabled the fund to grow in size by

$16.4 million to an end of FY2015 balance of $397.3 million. During the period of in-

vestment since the outset of FY2007, the annualized rate of return has been 5.27 percent.

The fund would need to grow at 14.4 percent annually to achieve a level sufficient to pro-

vide a smooth transition to CTF distributions from FY2024 onward at the real value of

FY2023 sector grants and in the absence of market volatility. However, even achieving

such a level—as unlikely as that is—does not mean the risk of subsequent periodic fiscal

shocks are eliminated. Such risks primarily result from the fundamental reliance upon

market returns which carries with it volatility. In addition, certain design characteristics

of the mutually agreed CTF distribution mechanism require the attention of the CTF

Committee in collaboration with the U.S. and FSM governments. Characteristics of the

CTF Agreement that may require attention include:

problematic design characteristics of the buffer account mechanism;

a distribution mechanism that conflicts with the prevailing practice of confirming

annual allocation decisions each August; and

distribution rules that could better protect the real value of the corpus over the

long-run while also reducing the volatility of distribution levels and reducing the

frequency of shortfalls in annual fiscal support to the FSM.

Changes to the Agreement itself, of course, require approval by the U.S. Congress.

Economic Outlook during the remainder of the Amended Compact and Beyond: Pro-

jections of the FSM economy during the remainder of the amended Compact suggest an

improved performance compared with the first 12 years with a projected average growth

of 1.1 percent annually. Expansion in the fishing sector and compliance with the use of

the infrastructure grant should see the recent improvement in economy performance in

FY2015 continue over the next few years. Implementation of the final phase of the state

level Long-Term Fiscal Frameworks (LTFF), will depress output in FY2020 and growth

in the final years of the amended Compact is projected to be meagre. Fiscal balance is

projected to be maintained at the state level and the national government should continue

to run large structural surpluses.

xxii

Post FY2023, the projected $30 million sustainable drawdown from the CTF, a massive

reduction from the current $80 million annual grant allocations, will require significant

support from the national government. The national government will be able to meet the

operational needs of the state governments, through transfer of the majority of the pro-

jected structural fiscal surplus, and sustainable drawdown from the FSM Trust Fund.

However, the assumptions do not include national government support for infrastructure,

and while public service delivery can be maintained, construction output will fall. The

simulations suggest the FSM should be able to maintain fiscal stability without the need

for external assistance. However, the revenue projections assume that fishing fee receipts,

captive insurance tax collections, and market returns on investments perform at historical

rates. Any one of these assumptions is subject to varying degrees of risk and suggest the

outcome is fragile.

1

II. ECONOMIC DEVELOPMENTS

A Growth and Employment

1 DEVELOPMENTS IN THE FSM ECONOMY

i Overall trends in economic activity

1. At the start of the amended Compact, the economy went into recession, as Com-

pact receipts fell to the new, lower-negotiated levels, i.e. a reduction from $84 million

(the Compact I level without bump-up) to $76 million. A series of other factors also had

strong negative impacts on the economy: (i) the loss of the Compact I energy grant; (ii)

absorptive capacity constraints in the use of the new Compact sector grants; and (iii) the

failure to use the infrastructure grant. Projections in the FSM Strategic Development Plan

(SDP) had anticipated a reduction in GDP of 6 percent in FY2004, but the actual outcome

revealed a decline of 3.1 percent. The initial transition to the amended Compact thus

turned out not to have been as severe as anticipated.

2. While the economy fell sharply by 3.1 percent in FY2004 with the reduction in

Compact funding (Figure 1), some of the lost ground was recouped in the next year.

However, growth turned negative in the following three years, FY2006-FY2008, with

GDP falling by 4.1 percent during the period. In FY2007 Chuuk and Kosrae were each

required to implement a sizeable reduction in force (RIF), among other measures, to re-

store fiscal balance, as the use of the capacity-building sector grant for nonconforming

purposes was phased out, and the economy contracted by 1.9 percent. There were some

positive developments in fisheries, but by FY2008 the negative shock of the world reces-

sion had a strong impact on the state economies. Higher fuel and food prices eroded real

incomes, and GDP fell by a further 2.2 percent.

Figure 1 GDP, constant prices 2004 (percent annual change)

FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

GDP growth -3.1% 2.1% -0.1% -1.9% -2.2% 1.2% 3.3% 1.0% -1.7% -3.0% -2.4% 3.7%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%GDP growth annual percent change

2 FSM Economic Review—FY2015

3. While the international economic conditions remained adverse in FY2009, strong

growth in construction from FAA-funded airport renovation resulted in a return to posi-

tive growth of 1.2 percent. FY2010 turned out to be a good year for the FSM economy.

This reflected continuing expansion in construction, as use of the infrastructure grant

picked up momentum, and the FAA projects injected additional funds. After several years

of fiscal consolidation, FY2010 saw a return to growth in public administration, and the

economy expanded by 3.3 percent overall. These trends continued to exert themselves in

FY2011, although good performance in fisheries replaced public administration as a

source of growth, and the economy grew by 1.0 percent.

4. FY2012 ushered in a period of declining economic activity, reversing the gains of

the previous three years. Construction activity plateaued, as a large increase in the use of

the infrastructure grant was offset by a fall in FAA expenditures. GDP fell by 1.7 percent

reflecting large drops in retailing and education. Both FY2013 and FY2014 were terrible

years for the FSM economy. In FY2013 the economy fell by 3.0 percent, with both con-

struction and fisheries declining, while in FY2014 low construction output was the main

culprit in the 2.4 percent drop in GDP. Construction output tumbled by 26 and 40 percent

in the two years, with the completion of the FAA projects and issues with project man-

agement and inability to fulfill the disbursement requirements of the infrastructure grant.

Infrastructure grant disbursements plunged from $29 million in FY2012 to $5 million in

FY2014.

5. Despite the continuing issues with the use of the infrastructure grant, FY2015

turned out to be good year for the FSM economy and GDP grew by 3.7 percent. While

construction contributed a negative 0.4 percent, fisheries grew strongly with the full fleet

operational after dry-docking and was responsible for 1.5 percent of the overall growth.

The remainder of the growth in the economy was spread across a variety of industries:

wholesale and retailing, finance and business services. Public administration also grew at

the national government reflecting booming revenues.

6. Figure 2 indicates the influence of the major drivers on the economy during the

last seven years. Clearly, construction has been the major influence both on the upswing

and downswing. The domestic fishing industry has also had a significant and volatile im-

pact, as boats have entered the fleet and been withdrawn for dry docking. Other industries

also have had important impacts (although not shown in Figure 2), with education and

wholesale and retail exerting a downward influence during much of the period. Taking

the period of the 12 years of the amended Compact as a whole, the size of the economy

was 3.6 percent smaller in FY2015 than it was before the start in FY2003. This is a very

disappointing result. The above analysis and the impact of weak project management in

the utilization of the infrastructure grant clearly indicate the desirability of rectifying the

shortfalls and getting the economy back on a more stable track.

Economic Developments 3

ii GDP by institutional sector

7. Figure 3 provides further information on recent economic developments by insti-

tutional sector. After an initial decline in FY2004, the government sector expanded sur-

prisingly in FY2005 and FY2006. The increased funding in education and health spurred

growth in these activities, before adjustment was made for the lack of funding in others.

This expansion was mirrored in additional hiring in Chuuk and Pohnpei, with Yap taking

Figure 3 FSM constant price GDP by sector, FY2004 prices (US$ millions)

$220

$225

$230

$235

$240

$245

$250

$255

$260

$40

$45

$50

$55

$60

$65

$70

$75

$80

Tota

l Rea

l GDP (FY04 U

S$ millions)

Rea

l GDP b

y Sec

tor

(FY04 U

S$ millions)

Government

Private Sector

GDP

Figure 2 Contribution to economic growth by major industry (percent)

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Fisheries

Total GDP growth

Construction

Other


on additional staff in FY2005 for cyclone rehabilitation. Thereafter, the government sec-

tor contracted, between FY2007 and FY2008, resulting from phasing out the use of the

capacity-building sector grant to fund nonconforming activities in Chuuk and Kosrae.

Both states implemented RIFs and made big cuts in public expenditures. With the con-

traction in Chuuk and Kosrae complete, government sector services have stabilized and

shown a declining trend since FY2010.

8. Figure 3 illustrates the negative growth in the private sector in each year of the

first six years of the amended Compact through FY2009. Overall, the private sector con-

tracted by 17.6 percent, or an annual average of 3.2 percent, reflecting the drop in de-

mand in the economy. This lower demand resulted from reduced levels of the Compact

sector grants, failure to implement the infrastructure grant, and, from FY2008 to FY2009,

the impact on real incomes of the world recession and higher food and fuel prices. In

FY2010 and FY2011, with the passing of the recession, along with lower levels of infla-

tion, greater use of the infrastructure grant, and large volumes of FAA Airport Improve-

ment Program (AIP) projects, the private sector rebounded and grew by 15 percent over

the two years. In FY2012 the private sector contracted as output in construction, and

other parts of the economy declined. In FY2013 and FY2014 private activity declined

further, with reductions in construction being the dominant force. Much of the large

growth in FY2015 was contributed by State Owned Enterprises, which are not covered in

Figure 3.

iii GDP by industry

9. Review of the economy by industrial sector provides further information on re-

cent developments. Estimates for agriculture (largely for home consumption) indicate a

long-run upward trend of 1.2 percent per annum, which, after allowing for the recent de-

cline in population growth of 0.2 percent, will come as a surprising development. The ag-

riculture estimates are based on the two most recent household income and expenditure

surveys and are interpolated on the basis of population growth and adjusted for weather

conditions. The implications are that in the absence of gainful economic opportunities or

emigration, households have returned to subsistence production to support themselves.

While this is a significant result, consistent with a decline in the modern sector of the

economy, one should be cautious of overreliance on the statistical surveys upon which

the estimates are based.

10. With the withdrawal of the public sector from the fisheries industry, fisheries

have displayed a rising trend of 0.9 percent per annum1. While growth has been signifi-

cant and is consistent with the economy’s comparative advantage, it has yet to provide a

sufficient source of growth to lift the economy onto a higher trajectory. Caroline Fisher-

ies Corporation (CFC) expanded its fleet of 3 purse seiners to 5 during the latter part of

FY2015 and output will rise significantly in FY2016 reflecting the enlargement of the

1 GDP fisheries estimation is now based on volume indicators of catch and has been revised from the

estimates provided in the FY2014 Review.


fleet. In the case of manufacturing, activity fell sharply during the initial years of the

amended Compact, with the closure of the Yap garment factories. Since that time, pro-

duction has focused on the home market, and manufacturing output has remained largely

stagnant.

11. Electricity generation trended downward during the initial years of the amended

Compact, resulting from increases in price per kilowatt. The increases were due not only

to rapidly rising energy prices during this period but also to the loss of the Compact I en-

ergy sector grant. Since FY2008 electricity production has stabilized, but, given the fre-

quent power outages due to highly inefficient generation, it is difficult to assess the un-

derlying trend. Construction activity was largely static in the early years of the amended

Compact, but it grew rapidly between FY2007 and FY2011 because of the FAA-financed

airport renovation and enhanced capacity use of the infrastructure grant. As already noted

the rapid rise in construction peaked in FY2012, and output declined precipitously in

FY2013 and FY2014, by 26 and 40 percent, respectively, as the FAA projects came to an

end and as utilization of the infrastructure grant was held up by project management

weaknesses. By FY2015 construction output had bottomed out and was at a level 4 per-

cent below that prevailing at the start of the amended Compact.

12. The wholesale and retail sector has declined by an average annual rate of 1.6 per-

cent, reflecting the weak conditions of demand in the FSM, and lack of competition. The

variety of goods on store shelves is highly restricted compared with neighboring islands,

such as Majuro, where market entry is less restricted, although prices in Majuro are con-

siderably higher. Value added in the hotels and restaurants sector has fallen by an average

annual rate of 1.8 percent during the amended Compact. This is a disappointing result,

given that tourism has been identified as a sector with the potential for major develop-

ment.

13. In the public sector, provision of general government services fell significantly,

by an annual average rate of 5.9 percent between FY2003 to FY2008, reflecting the adop-

tion of the sector grant approach to grant disbursement. The FSM was required to execute

RIFs in Kosrae and Chuuk to phase out the use of the capacity-building grant for noncon-

forming purposes and to reduce payroll levels to fit within the fiscal envelope. Apart

from the minor sector grants in capacity building, private sector development and the en-

vironment, the resources for general government have been severely constrained. While

the early period of the amended Compact saw a reduction in public administration, ad-

ministrative services have grown by 1.2 percent during the remainder of the amended

Compact over the FY2009-FY2015 period. In the case of education, there was rapid

growth in the first three years of the amended Compact, a levelling off and a subsequent

decline since FY2009, as accreditation and teacher certification issues have reduced ser-

vice delivery levels. Delivery of education services in FY2015 was at the same level as at

the start of the amended Compact. Health services, on the other hand, have expanded at a

consistent rate each year averaging 3.3 percent per annum.


14. Figure 4 summarizes the contributions of the various industries in the FSM to the

overall decline in GDP of 3.6 percent during the amended Compact (FY2003 to

FY2015). Agriculture has grown, reflecting increasing household nonmarket production,

while fisheries output was largely unchanged between most of FY2003 and FY2013, but

output grew stronger in the last two years. Manufacturing output declined, reflecting the

closure of the Yap-based garment factories. After the completion of the FAA projects and

collapse in the use of the infrastructure grant, construction activity is now back to where

it was in FY2003. The decline in the wholesale and retail trade reflects the general ad-

verse conditions prevailing during the period. The contraction in public administration

was responsible for the major part of the overall decline in GDP, with a lack of any sig-

nificant growth elsewhere. While education services have remained largely unchanged

through the amended Compact, growth in health services financed through the Compact

sector grant has been a positive force.

2 THE STRUCTURE OF THE ECONOMY

15. The economy has been dominated by a large public sector, with a dependent pri-

vate sector producing nontraded goods and services to the government and its employees

(Figure 5). The share of government has fallen significantly, by 14 percent, since the be-

ginning of Compact I. This decline reflects three major forces: (i) a reduction in the size

of government due to the lower levels of assistance at the end of Compact I; (ii) the re-

structuring of the public sector through the creation of public sector enterprises (SOEs);

and (iii) adjustments required to conform to the new structure and lower levels of grants

in the amended Compact. An increase in the share of SOEs of 3.2 percent in the initial

period reflects the creation of utility services in power and telecommunications as well as

Figure 4 Contribution to GDP growth by industry, FY2003-FY2015 (percent)

Agriculture, 1.8%

Fisheries, 1.3%

Retailing, -2.0%

Transport, 1.9%

Public Admin., -3.0%

Health , 1.6%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0% Economy declines by -3.6% during amended Compact


the creation of fishing enterprises. By the mid-1990s, the growth in SOEs had largely run

its course, and inefficient fisheries are now mostly defunct or consolidated under private

sector management. However, with the successful creation and operation of the FSM Pe-

troleum Corporation (Petrocorp) in 2008 the share of the SOE sector has expanded by a

further 4.1 percent since the late 1990s. Overall, combining the government and SOEs,

the contribution of the public sector at large has fallen by 6.2 percent since the start of the

Compact.

16. With a decline in the public sector, it might be imagined that there would be a

compensating offset and increase in the share of the private sector, but this did not hap-

pen. The 25 percent share of the private sector in 1987, at the start of Compact I, has now

been reduced by 3 percent. However, the offset to the public sector decline has been an

increase in the share of households, which has grown by 4.4 percent. This sector includes

market production of commodities, nonmarket production (subsistence), and home own-

ership. In essence, the failure of the private sector to become the engine of growth has

forced households to fall back on their own resources and devote more effort to subsist-

ence production.

17. In addition to the households and the private and public sectors, indirect taxes

form a significant proportion of the economy, increasing by 1.4 percent over the Compact

period. This development reflects two trends. First, reform of the national customs tax

structure under the Asian Development Bank (ADB) Public Sector Reform Program

(PSRP) broadened the tax base, by subjecting all sectors in the economy to the same tax

rates. It changed the valuation of duties from a free on board (f.o.b.) to a cost, insurance

and freight (c.i.f.) basis as well. Second, indirect tax rates at the state and national levels

rose through the amended Compact to offset the declining grants.

Figure 5 The institutional structure of the FSM economy (percent)

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

PrivateSector

FinancialEnterprises

Government State OwnedEnterprises

Households IndirectTaxes

FY87-89 FY97-99 FY13-15


3 INDUSTRY DEVELOPMENTS

18. Agriculture: Data on the primary economic sectors of the FSM are weak: there

has been no indicators of agricultural production, although the on-going agricultural cen-

sus will hopefully improve the situation. Subsistence agricultural activities make a sub-

stantial contribution to GDP, while production for either the domestic or export market is

surprisingly small. The perception persists among local growers that returns from agricul-

ture are low and slow to materialize compared to other activities, such as nontraded ser-

vices and government employment. Compact assistance has exerted upward pressure on

wages, turning the terms of trade against agriculture and making agricultural production

unattractive. Copra production, as in many other Pacific Island nations, has all but disap-

peared because of inefficiencies and low prices, but profitable export opportunities exist

in niche agricultural products. The former Coconut Development Authority was trans-

ferred to the FSM Petrocorp with the intention of producing niche organic coconut oil

based products. There has been a trend in some Pacific Islands in this direction although

the basic economics are not favorable despite the large volume of available coconuts (es-

sential lying unused on the ground) in the outer islands. The Pohnpei pepper industry is a

good example of a high quality product that was not able to achieve commercial success

given the high costs of production of a labor intensive activity.

19. Fisheries: With the vast marine resource under FSM jurisdiction, it might be an-

ticipated that fisheries would be a well-developed sector, making a significant contribu-

tion to GDP. However, the sector has failed to achieve the anticipated growth. In the

early 1990s, in an attempt to develop the economy, the FSM embarked on a strategy of

substantial public sector investment in fisheries facilities and enterprises. Joint ventures

with foreign partners in purse seine fishing operations were initiated. While there was

awareness that the public sector should not be involved in the productive sectors of the

economy, it has taken a long time for this policy to be implemented. The two remaining

businesses, Caroline Fisheries Corp. (now with 5 purse seiners) and Diving Seagull (with

2 purse seiners), formerly SOEs but now under private management or ownership, make

a substantial contribution to GDP, but this varies significantly from one year to the next

depending on catch and prices. As indicated in the earlier discussion CFC has recently

expanded its fleet with two new vessels operating in late FY2015 and will have a signifi-

cant impact on GDP with the new vessels operating a larger capacity.

20. The main benefit of the fisheries resource has been the annual rents earned from

fishing access fees; these make a substantial contribution to national government reve-

nues. After a prosperous period in the mid-1990s, when annual fishing royalties averaged

$21 million, receipts fell by about 50 percent during the initial years of the 2000s. During

recent years, this trend has reversed, and in FY2015 fishing fees exceeded $65 million,

reflecting the new arrangements under the Parties to the Nauru Agreement (PNA) and

implementation of the Vessel Day Scheme (VDS). The cost of a day’s fishing rose from a

PNA minimum rate of $5,000 introduced in 2012 to $6,000 in 2014 and rose further to

$8,000 in 2015 although actually rates traded are currently in the $10,000 to $11,000


range. The fishing increase in revenues has generated a significant structural fiscal sur-

plus at the national government level and raises important distributional issues between

the national government and FSM states. These are taken up in later sections of the re-

view.

21. The operation of the “FSM” agreement whereby domestic fishing vessels pay a

lower daily rate has encouraged a large number of overseas operators to establish local

operations. In essence these ventures set up an office in the domestic economy and pay

lower fees on the basis and justification of local industry development. However, skip-

jack tuna is a migratory species and fishing occurs where the fish are located. Increased

local value added is thus not a realistic proposition unless it results in on-shore pro-

cessing. Two foreign operators teamed up with the National Fisheries Corporation (NFC)

and set up a local office, but in effect operate no differently to any other foreign fishing

entity. Koos fishing company which has operated 6 seiners in the RMI, relocated two

vessels to the FSM to gain more favorable access to lower daily rates. However, the loss

in fishing fee income is substantial with a third of vessel days in the PNA region is now

estimated coming under the conditions of the FSM agreement. A careful analysis of the

benefits of the FSM arrangement and enlarging the “domestic” fleet needs to be under-

taken so that island leaders and their populations are fully aware of the costs associated

with allowing foreign corporations to take advantage of the provision.

22. Tourism: Information on visitor arrivals from immigration sources is considered

unreliable and has deteriorated in recent years. However, the data suggests tourist arrivals

have remained virtually stagnant since the start of the amended Compact, and the national

accounts indicate a trend reduction of 2.7 percent per annum of the hotel and restaurant

sector over the same period. Despite the weaknesses in the data, it is clear that the perfor-

mance has been lackluster and well below the potential for an industry designated as a—

if not the—major growth sector of the FSM economy.

23. Many factors currently hinder the development of a vibrant tourism industry. The

climate for foreign direct investment (FDI) was streamlined during the PSRP. Additional

improvements were carried out during the Private Sector Development Program (PSDP),

which was also initiated with ADB loan financing and intended to rectify many of the

weaknesses. The operation of a Foreign Investment Board in Pohnpei and recently in Yap

hinder a predictable and transparent FDI environment. According to the World Bank

“Doing Business Survey,” the FSM ranks 148th out of a total of 189 nations surveyed in

2015, clearly indicating that further reform must be completed before an attractive cli-

mate for private sector investment is established. Difficulties in obtaining secure, long-

term land leases are an impediment. Hotels currently operate at low capacity levels, but

most, if not all, of the facilities offer a standard of accommodation that is unattractive to

international travelers. Growth in demand has been hampered by reliance on a single car-

rier operating high-priced flights to and from a remote geographical location. While these

factors have all discouraged tourist development, the FSM has much potential, particu-

larly as a niche market in the ecotourism and dive areas. The recent extension of the


Pohnpei runway, which will enable direct flights from Japan, could help increase visitor

arrivals. However, the current, generally low quality of tourism facilities and infrastruc-

ture is unlikely to attract any but the most-hardened of travelers.

4 INCOMES, POPULATION AND MIGRATION

24. At the beginning of the Compact, population growth, as recorded between the

1986 and 1989 censuses, was rapid, at 3 percent per annum (Table 1). Between 1989 and

the next count in 1994, the rate fell to 1.9 percent, reflecting lower fertility rates and

modest rates of emigration. However, between the 1994 and 2000 censuses, the popula-

tion growth rate fell significantly to 0.2 percent, and the 2010 census indicated the popu-

lation was falling annually by 0.4 percent. Population dropped in both Chuuk and Kosrae,

while Pohnpei and Yap saw small-but-positive increases. While fertility rates fell, the

majority of the decline reflected outward migration to neighboring U.S. territories, Ha-

waii, and the U.S. mainland, under the migration provisions of the Compact. Clearly, the

negative economic growth rates in the FSM at the end of Compact I and RIFs in Chuuk

and Kosrae resulted in large-scale migration to seek employment opportunities and better

rates of remuneration in the U.S. In the long run, migration plays an equilibrating role: as

incomes fall, outward migration compensates, improving average income levels for those

remaining. Outward migration will have a distorting impact on the local economy, how-

ever, if it is achieved through a loss of the economically active and skilled individuals.

This loss of human capital will reduce the long-term productive potential of the economy.

25. Figure 7 indicates the rates of change in real incomes, employment and migration

in the four FSM states during the amended Compact. GDP per capita has fallen in Chuuk

by an annual average of 0.3 percent, remained largely unchanged in Kosrae, and im-

proved slightly in Pohnpei and Yap. Employment opportunities have fallen in all states,

with the exception of Pohnpei. The rate of out-migration1, as measured by net movements

of air passengers leaving the FSM between 2004 and 2011, has been remarkably similar

in all FSM states, averaging 1.8 percent. The figure suggests that while there is little di-

rect relation between changes in GDP per capita, there might be a significant correlation

with employment, although the lack of association in Pohnpei opposes that view. Figure

1 U.S. Department of Transportation. Data quality deteriorated in 2011, implying an untenable increase in

net inward migration and has not been used in the current analysis.

Table 1 Population by state and annual average growth rates

Sources: National census reports, May 2002; preliminary census results, 2011.

1980 1989 1994 2000 2010 1980-89 1989-94 1994-00 2000-10

Chuuk 37,488 47,871 53,319 53,595 48,654 2.7% 2.2% 0.1% -1.0%

Kosrae 5,491 6,835 7,317 7,686 6,616 2.4% 1.4% 0.8% -1.5%

Pohnpei 22,080 30,669 33,692 34,486 36,196 3.7% 1.9% 0.4% 0.5%

Yap 8,100 10,365 11,178 11,241 11,377 2.7% 1.5% 0.1% 0.1%

FSM 73,159 95,740 105,506 107,008 102,843 3.0% 1.9% 0.2% -0.4%

Population Annual average growth


6 provides an interesting comparison of annual net migration and the annual change in

employment. The association and direction of change is similar in the two series, alt-

hough clearly the level of migration is much larger than the change in employment.

While migration would thus appear to be associated with employment opportunities,

there also appears to be a constant rate of migration, regardless of employment condi-

tions. It is worth noting that a similar study in the Republic of the Marshall Islands (RMI)

found no such relationship. Clearly, the lack of economic opportunities in the FSM and

the attraction of higher wages in the U.S. provide strong incentives to migrate. Since the

start of the amended Compact through FY2011, it is estimated some 14,845 people have

Figure 7 GDP per capita, migration, and population growth (annual averages)

-3.0%

-2.5%

-2.0%

-1.5%

-1.0%

-0.5%

0.0%

0.5%

1.0%

GDP per capita growthFY95-FY15

Employment growthFY03-FY15

Net Migration FY04-FY11

Figure 6 Net migration and employment change, FY1996-FY2011

-3,000

-2,500

-2,000

-1,500

-1,000

-500

0

500

1,000

-3,000

-2,500

-2,000

-1,500

-1,000

-500

0

500

1,000

Net Migration

Net Employment


migrated, which is approximately 15 percent of the FY2011 population—a large percent-

age by any standard.

26. Figure 8 indicates the changes in constant price GDP and real GNDI per capita in

2004 prices. The constant price GDP estimates are derived from chaining the former

GDP series with the current national accounts series. Real GNDI includes the primary

and secondary incomes received and paid to the rest of the world from the balance of

payments. The major differences between the two estimates are the inclusion of: (i) fish-

ing fees, (ii) earnings on foreign investments, (iii) transfers from overseas households,

and (iv) the receipt of grants from the U.S. and other donors. The data for the GNDI esti-

mates begin in FY1995 and indicate a far higher level of disposable incomes, when the

additional flows are taken into account. In FY2015, GNDI per capita in current prices

was over $4,850—which is 58 percent higher than current price GDP per capita figure of

$3,079.

27. Figure 8 provides a clear message about the developments in average real in-

comes (discussion is based on the GDP series). The advent of the Compact saw a large

improvement in income levels in the run-up to the Compact; this improvement was sus-

tained until the adjustment in the late 1990s, when Compact grant levels fell. While this

triggered a significant shock, there was a gradual improvement during the remainder of

Compact I, and by FY2001 per-capita incomes had surpassed the last highest recorded

level (FY1993). The implementation of the amended Compact caused a reduction in in-

comes, as the economy adjusted to the new regime. Incomes recuperated in the following

two years but then fell, with the need of a second round of adjustments and the interna-

tional recession taking hold. During the FY2008-FY2011 period, incomes regained the

Figure 8 GDP and GNDI per capita, 1981-2015, constant prices 2004 (US$)

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

GNDI per capita

GDP per capita


lost ground and attained the highest level ever recorded. However, since FY2011 per cap-

ita GDP has fallen, reflecting the weak economic performance, but in FY2015 improved

slightly was at the same level as at the start of the amended Compact in FY2004.

28. Since the start of the amended Compact, real GDP per capita has stagnated, in

comparison with an annual average decline of 0.3 percent in real GDP. The lower rate of

decline in GDP per capita has in part been achieved by out-migration, which has sus-

tained the average living standards of those remaining behind. The GNDI series, although

reflecting the same trends in GDP, tells a slightly different story. Real disposable per cap-

ita incomes rose strongly after the second step-down in funding under Compact I, but

with the advent of the amended Compact, incomes fell as the economy deteriorated.

However, since FY2008 real disposable per capita incomes have oscillated, but have

risen in the last two years since FY2013, reflecting increases in fishing fees and corporate

tax receipts from the FSM domicile for Japanese Corporations, offsetting the decline in

the real GDP per capita.

29. Analysis at the state level tells an interesting story (Figure 9), both in terms of

growth and income differences between the states. The level of current GDP per capita in

Yap is 150 percent higher than in Chuuk, while that in Pohnpei and Kosrae is 122 percent

and 65 percent higher, respectively. Attributions of the differences are complex and re-

flect many factors. Under the Compact revenue-sharing formula between the states, the

smaller receive a higher proportion. On this basis, Kosrae should top the list, but, in fact,

it achieves third place. The remoter location and particularly small size impose special

constraints. While Pohnpei benefits significantly from being the host of the capital, Yap

Figure 9 GDP per capita in Chuuk, Kosrae, Pohnpei and Yap, 1981-2015, constant

prices 2004 (US$)

$1,000

$1,500

$2,000

$2,500

$3,000

$3,500

$4,000

$4,500

Chuuk

Yap

Pohnpei

Kosrae


has attained the highest per-capita levels. Growth and development polices have obvi-

ously played an important part. While the disparities were less pronounced at the start of

the Compact, higher growth rates have enabled states to improve living standards. In

Chuuk, per-capita incomes have declined by 0.9 percent over the amended Compact pe-

riod. In Kosrae, there was a large improvement in FY2011 and FY2012, reflecting the

FAA project, but incomes have now fallen and are at same the level as at the start of the

amended Compact. In Pohnpei, the trend indicates a clear and substantial improvement in

living standards, although the recent decline in construction activity has again had its im-

pact. In Yap after being one of the best performing states, living standards have declined

by an average 1.1 percent, and in fact has recorded the worst performance of all the FSM

states.

5 EMPLOYMENT

30. Table 2 indicates that from FY1995 to FY2015, formal sector employment con-

tracted by an annual average rate of 0.8 percent (a 15 percent decline over the period) and

was unable to provide enough opportunities for new job seekers. During the period, some

2,147 jobs were lost in Chuuk (35 percent of those employed in FY1995); Kosrae suf-

fered a loss of 206 (14 percent of those employed in FY1995); and Yap lost 325 (13 per-

cent of those employed in FY1995). Pohnpei generated an additional 152 new jobs, rep-

resenting some 2 percent of those employed in FY1995. Public sector employment con-

tracted overall and in all states except Pohnpei, reflecting the downsizing of the public

sector at the end of Compact I and the completion of the RIFs in Chuuk and Kosrae in

FY2007. Private sector employment grew in Kosrae and Pohnpei but contracted in both

Chuuk and Yap. The general results are very disappointing, and the lack of job creation

clearly reinforces the already strong incentive to emigrate and seek employment opportu-

nities in the United States. The results for the amended Compact period are not dissimilar

and are shown in Table 2.

31. Figure 10 represents long-term trends in private and public sector employment

since FY1995. Employment in the public sector contracted severely at the end of Com-

Table 2 Employment growth rates by sector and state (annual averages)

Source: FSM Social Security Administration data

Total Gov Private Total Gov Private

Chuuk -2.2% -3.5% -0.4% -2.4% -4.2% -0.1%

Kosrae -0.8% -1.5% 0.2% -1.7% -1.5% -2.8%

Pohnpei 0.1% 0.0% 0.3% 0.6% 0.0% 1.3%

Yap -0.7% -0.3% -1.1% -2.0% 0.4% -4.4%

FSM -0.8% -1.4% -0.1% -0.9% -1.4% -0.5%

Amended Compact

FY2004-FY2015FY1995-FY2015


pact I, reflecting a major fiscal adjustment. The ADB-financed PSRP enabled implemen-

tation of an early retirement program (ERP) that facilitated the needed compression to re-

store fiscal balance. Employment in the public sector fell from 9,766 in FY1995 to 8,357

in FY2000, a 14 percent reduction. However, in the following period, FY2000-FY2015,

public sector employment continued its downward trend, but with periodic spikes corre-

sponding to the fiscal position in different states. A lack of discipline in Chuuk in

FY2002 and FY2006 is reflected in sharp increases in total FSM public sector employ-

ment levels. However, with the need to compress expenditures—a result of the phase-out

of the use of the capacity-building grant to fund government operations in both Chuuk

and Kosrae—public employment had fallen by in FY2015 by a further 939 (11 percent)

below what it was at the height of public sector reforms in FY2000.

32. Private sector employment contracted between FY1995 and FY1997, reflecting

the reduction in the public sector, but rose strongly between FY1997 and FY2000. Dur-

ing these years, the FSM economy improved, after the completion of the adjustment at

the end of Compact I and the resolution of the earlier financial crisis in Chuuk. However,

from FY2000 to FY2008, private sector employment declined significantly, by 872 jobs

or 12 percent, as Compact I came to an end, and adjustments were made during the initial

three years of the amended Compact. During the FY2008-FY2011 period, private sector

employment grew strongly, fueled by the need for additional jobs in construction, and an

additional 893 jobs were created. However, as the expansion in construction peaked and

subsequently contracted, private sector employment fell between FY2011-FY2015, and

the newly created jobs were lost.

Figure 10 Employment by sector, FY1995-FY2015

6,000

6,500

7,000

7,500

8,000

8,500

9,000

9,500

10,000

Public Sector

Private Sector


6 WAGES

33. The labor market in the FSM is relatively free from regulatory distortions and in-

stitutional rigidities. Pohnpei is the only state to impose a minimum hourly wage ($1.35)

for the private sector. While the minimum wage may not affect the demand for skilled

workers, it may be an active constraint in labor-intensive activities, although private sec-

tor operators do not suggest that this is the case. All the FSM governments have set mini-

mum hourly wages for government employment ($2.00 for Pohnpei, $1.25 for Chuuk,

$1.49 for Kosrae, $0.80 for Yap, and $2.36 for the national government), but these levels

coincide with the lowest step on the public servant pay scale and are thus redundant.

There are currently no unions in the FSM, and there is no indexation of wage rates.

34. However, while the labor market is relatively free from imposed regulatory re-

strictions, it is distorted by: high public-sector wage rates; the ease of migration; and the

availability of higher wages in Guam and other U.S. labor markets. Table 3 illustrates the

level of real wages by state and compares the private and government sectors. Average

wages between FY2013 and FY2015 for the FSM as a whole were 216 percent higher in

government than those of the private sector. While the skill mix of the two activities af-

fects the differential, the public sector clearly asserts an upward pressure on wages and

influences the allocation of labor among the sectors.

35. Unfortunately, policy makers are constrained in their ability to influence distor-

tions in the labor market. The effect of unrestricted external migration is part of the basic

rights of FSM citizens under Title III of the Compact. However, during the Second Eco-

nomic Summit, the FSM adopted a policy to reduce the differences between the private

and public sectors. Data in Table 3 indicate that this objective has been achieved in Yap

and Kosrae, and to a lesser extent, in Pohnpei, but in Chuuk there has been an increase in

the disparity. Figure 11 indicates recent developments in nominal and real wages in the

private and public sectors. Nominal wages have grown on average by 1.6 percent in the

private and public sectors, respectively. However, in real terms wages, after adjustment

Table 3 Real wages and differentials by sector and state

Source: FSM Social Security Administration data Notes: * Includes national government

Average

FY95-FY97

Average

FY13-FY15

Average

FY95-FY97

Average

FY13-FY15

Average

FY95-FY97

Average

FY13-FY15

Chuuk 6,399 6,028 3,269 2,683 196% 225%

Kosrae 8,161 6,010 3,238 2,873 252% 209%

Pohnpei* 11,667 8,432 4,712 3,650 248% 231%

Yap 10,188 7,376 3,798 3,634 268% 203%

FSM 8,724 7,120 4,044 3,318 216% 215%

Real Public Sector

Wages (2004 US$)

Real Private Sector

Wages (2004 US$)Differentials


for inflation, have declined by 2.1 percent in the two sectors, indicating a decline in living

standards.

B Monetary Developments and Prices

1 PRICES

36. Figure 12 provides information on the rate of annual change in the FSM CPI, in-

cluding food and energy prices. In the early two thousands inflation was very benign, and

during the initial years of the amended Compact, was moderate and averaged 3.5 percent

through FY2007. However, in FY2008 and FY2009, with the onset of the world reces-

sion, inflation peaked, reaching 6.6 percent and 7.7 percent, respectively. Inflation has

moderated during the remainder of the amended Compact, although it rose again in

FY2012. During FY2015 inflation turned negative reflecting the impact of rapidly falling

fuel prices. The main forces influencing the rate of inflation have been: (i) increases in

imported food prices in FY2008 and again, to a lesser extent, in FY2012; (ii) soaring util-

ity prices at the start of the amended Compact, because of the loss of the Compact I en-

ergy grant; and (iii) surges in world petroleum and utility prices in FY2011, and large re-

ductions in FY2015.

37. Imported food prices rose sharply in FY2008, reflecting the disequilibrium in

world markets. Given the significance of food in the FSM CPI (37 percent), the 18 per-

cent jump in food prices in FY2009 had a large impact on the overall CPI. The Compact I

energy grant was used in Chuuk and Kosrae to subsidize utility prices, and its loss com-

pelled both states to raise electricity tariffs. In Pohnpei and Yap, the state governments

had adopted a cost-recovery price basis of production and had, in the mid-1990s, ceased

Figure 11 Nominal and real wages, private and public sectors, FY2004-FY2015

$3,000

$4,000

$5,000

$6,000

$7,000

$8,000

$9,000

$10,000

$11,000

$12,000Public sector average nominal wage increase = 1.6

Private sector average nominal wage increase = 1.6 %

Public sector average real wage increase = -2.1 %

Public sector average real wage increase = -2.1 %


to use the energy grant to subsidize prices. However, the impact of the loss of the energy

grant was compounded throughout the period by rising world petroleum prices, which not

only pushed up prices of gasoline at the pump but also required further increases in utility

tariffs in all states. At the end of 2008, world energy prices began to moderate, and the

energy section of the CPI recorded a negative change in the first quarter of 2009. In

FY2010 energy and utility prices again started to rise, reaching 12.1 percent in FY2011,

but they have since moderated and fell by 4.1 percent during FY2015.

2 MONEY AND BANKING

38. With the adoption of U.S. currency in the FSM, macroeconomic policy and ad-

justment has been limited to the use of fiscal policy. Many other small island economies

of the Pacific use foreign currency, and this practice has served the FSM well. The range

of macroeconomic policy options is limited; thus, there is no potential to use inflationary

monetary policy to adjust to changes and reductions in Compact funding. Of course, this

has left the FSM with no way to adjust to reduced levels of resource transfers other than

the more politically painful processes of cutting government expenditures, reducing pub-

lic sector employment and wages, and increasing domestic revenues. The use of a foreign

currency has removed exchange rate realignment and devaluation as ways to encourage

the export and traded goods sectors of the economy. At this stage of the FSM’s economic

development, with many underlying structural impediments, exchange rate adjustment

without accompanying supporting policies would be unlikely to encourage a favorable

supply response in traded goods production.

39. The result of a lack of an independent monetary policy is that domestic interest

rates are closely aligned with those of the United States. Deposit interest rates observed

Figure 12 Change in consumer price index, food and energy sections (year-on-year

percent change)

-10.0

-5.0

0.0

5.0

10.0

15.0

20.0

25.0

FSM CPI

Fuel and Power Food


in the market are broadly similar to those throughout the U.S., while lending rates are

generally higher, reflecting the additional risk and costs of doing business in the FSM. In-

itially, the higher rates charged on loans resulted in regulation, and limits were placed on

both consumer and commercial loan interest rates. As part of the PSRP, removal of regu-

lation was recommended and was a loan condition. The interest rate limits were effec-

tively dropped (leaving only a nonbinding usury limit of 24 percent) in 1998, and there

was no adverse change in the local interest rate structure, as the financial system was al-

lowed to adjust to market forces. CD rates have fallen from 1 percent prevailing in 2004

to 0.6 percent, where they now stand, reflecting the low level of interest rates in the

United States. Lending rates on consumer loans have always been high and have aver-

aged 15 percent during the amended Compact. Commercial lending rates appear more

subject to market forces and are generally lower than consumer rates. Commercial rates

stood at 6.8 percent in FY2015.

40. The FSM banking system benefits from the Federal Deposit Insurance Corpora-

tion (FDIC), as provided in the Compact. The FDIC has played a critical role in supervis-

ing the banking system and ensuring a sound and stable financial system. Under the

amended Compact, FDIC support remains effective and will help maintain financial sta-

bility in the economy and avoid the adverse consequences of a banking system failure,

which has occurred in many other Pacific Island economies. The banking system is also

regulated by the FSM Banking Board, which is developing the capacity for banking su-

pervision. The role of the board includes licensing of domestic and foreign banks, on-site

and off-site supervision of all banks, consumer protection, and consultation with the

FDIC. Since December 2002, when the Bank of Hawaii withdrew from the FSM market,

there has been one U.S. bank operating in the FSM. There is also one locally owned

bank, Bank of the Federated States of Micronesia. The remaining U.S. bank, Bank of

Guam, is a branch of its parent, and thus also comes under U.S. federal supervisory re-

quirements. The present system is thus well-supervised and provides a secure basis for

financial intermediation, and has avoided “de-risking” issues associated with a loss of

correspondent banking relationships that have been experienced in the RMI.

41. Statistics on the FSM banking sector were first created in 1990, but analysis be-

gins at the start of the amended Compact in FY2004 (see Figure 13). With regard to de-

posits, the data indicate a static period during the first five years. Since FY2008, the de-

posit base has grown more rapidly, averaging 11 percent during the FY2008-FY2015 pe-

riod. The lack of financial deepening during the early period is consistent with the lack-

luster performance of the economy, and the expansion since then represents the improve-

ments in economic conditions. The large difference between the level of deposits and

loans is invested offshore. Reflecting the trends in deposits and domestic credit, the level

of foreign assets stagnated between FY2004 and FY2008, averaging $92 million, but rose

strongly through the remainder of the amended Compact, attaining $199 million in

FY2015.


42. Regarding lending, at the start of the amended Compact, the Bank of Hawaii had

just completed withdrawing from the FSM market, leaving a very low level of outstand-

ing credit of $19.3 million (excluding lending offshore). At the time, the Bank of the

FSM was restructuring its portfolio but has since taken a more proactive stance, opening

operations in Saipan. The level of outstanding credit in the FSM has grown by $23.0 mil-

lion since FY2004 and stood at $42.3 million at the end of FY2015. While the opening of

new markets was a good idea at the time, the subsequent weakened state of the Common-

wealth of the Northern Mariana Islands (CNMI) economy gave rise to concern about the

quality of the business, although conditions in Saipan have now improved.

43. The difference between loans and deposits indicates the large level of liquidity in

the FSM banking system and reinforces a widely observed phenomenon in the Pacific Is-

lands region: as a factor of production, capital is not in short supply. Reflecting the trends

described above, the loans-to-deposit ratio had fallen to a very low level of 18 percent at

the start of the amended Compact, after the withdrawal of the Bank of Hawaii. The ratio

improved through FY2008 to 41 percent, with the new lending in the CNMI, but has

since slipped back to 27 percent in FY2015. This reflects the high level of perceived risk

in the FSM and “lack of bankable projects.” Overall, the inability of businesses to prepare

meaningful business plans, lack of collateral, the inability to use land as security, and in-

adequate provisions to secure transactions have inhibited development of the financial

sector. With limited opportunities, commercial banks have preferred to invest their assets

off-shore in less risky and more secure markets.

44. Because of a lack of bankable projects, the commercial banks have generally pre-

ferred to extend credit to consumers with secure public sector jobs and an identified re-

payment stream. Consumer lending has grown by an annual average of 12 percent during

the amended Compact and, apart from a weak point in the recessionary years of FY2008

Figure 13 Commercial bank loans and deposits, end of period (US$ millions)

0

50

100

150

200

250

300

Deposits

Loans including Saipan lending


and FY2009, has been buoyant (Figure 14). Commercial credit, less lending by the Bank

of the FSM in Saipan, grew rapidly through FY2011, by an annual average rate of 14 per-

cent. In FY2008 the newly created FSM Petroleum Corporation (FSMPC) was extended

a large credit facility by the Bank of Guam to initiate operations, but most of that was

paid down early in FY2009. During FY2012 and FY2013 lending to the commercial sec-

tor dropped, but has failed to recapture the loss ground during the last three years.

C Balance of Payments, External Debt, GNI, GNDI and Interna-tional Investment Position

1 BALANCE OF PAYMENTS

i The current account

45. In this section, the balance of payments (BoP) is discussed and presented in Table

4 and Table 5. This is followed by a review of GNI and GNDI (rather than along with

GDP, earlier in the review), as they reflect changes in the primary and secondary income

accounts of the BoP. The international investment position (IIP) is presented in the next

section, followed by a discussion of the nominal and real exchange rates. The section

closes with an analysis of external debt.

46. The trade account of the balance of payments is composed of imports and exports

and runs a significant deficit, reflecting the excess of imports over exports. Exports cur-

rently include fish, re-exports of fuel, and a small quantity of agricultural produce. While

small volumes of inshore reef fish are exported to neighboring islands, fish exports are

mostly tuna caught by local purse seine and longline vessels operated by enterprises with

joint private-public ownership but under private management. Most of the fish caught in

Figure 14 Commercial bank credit by sector, less lending in Saipan (US$ millions)

0.0

5.0

10.0

15.0

20.0

25.0

30.0

35.0

Commerial credit, excluding Saipan lending

Consumer loans


FSM waters are, however, caught by foreign vessels under license, and the associated

fishing access fees are treated as a primary income in the balance of payments. Imports

dominate the trade account, and growth reflects the level of activity in the economy. In

FY2015 imports rose reflecting the importation two purse seiners despite the 15 percent

reduction in fuel prices reflecting reductions in the world fuel prices. Other imports rose

by 3 percent over their FY2014 levels. Imports have grown by an annual trend rate of 3.2

percent since FY2003. This is a similar rate of growth to nominal GDP (2.1 percent),

GNI (3.4 percent) or GNDI (2.4 percent).

47. The service account is dominated by two main items: receipts from travel (tour-

ism) and payments for transport of freight and passengers. The demand for tourism/travel

has grown during the amended Compact, but while the BoP estimates indicate increasing

revenue from tourism, the GDP figures show a declining trend. Service imports are domi-

nated by the cost of freight and reflect the level of imports of goods into the FSM. Travel

Table 4 Balance of payments, current account, FY2008-FY2015 (US$ millions)

FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015

Current account balance -44.2 -53.3 -45.9 -58.5 -43.7 -31.8 3.8 13.3

Goods and services balance -160.3 -178.3 -170.0 -178.3 -168.4 -166.2 -149.6 -154.1

Goods balance -120.7 -127.0 -128.4 -134.0 -125.4 -128.8 -117.5 -127.9

Exports of goods 28.4 26.5 31.6 40.5 57.8 50.2 38.2 39.9

Fish 18.7 14.9 19.0 27.7 39.7 28.3 21.2 22.5

Other 9.7 11.6 12.7 12.8 18.1 21.9 17.0 17.4

Imports of goods 149.1 153.4 160.0 174.4 183.2 178.9 155.7 167.7

Services balance -39.6 -51.3 -41.6 -44.3 -43.0 -37.4 -32.1 -26.3

Exports of services 33.0 34.7 38.1 35.0 38.3 43.5 45.2 43.6

Travel 21.9 22.1 24.4 21.8 22.3 26.8 28.7 25.3

Other 11.1 12.6 13.7 13.3 16.0 16.7 16.5 18.2

Imports of services 72.6 86.0 79.7 79.4 81.3 81.0 77.4 69.8

Transport 39.0 41.3 41.3 43.9 47.0 44.7 42.1 42.4

of which: Passenger services 15.4 15.7 15.6 15.4 17.2 16.8 16.7 17.4

of which: Freight and postal services 23.6 25.5 25.6 28.4 29.7 27.8 25.4 24.9

Construction services 10.4 18.4 10.2 7.1 7.3 8.1 8.2 4.2

Other 23.2 26.3 28.2 28.4 26.9 28.2 27.1 23.3

Primary income balance 7.2 16.5 10.8 9.8 15.7 25.9 24.2 55.8

Receipts 24.1 26.6 23.5 23.7 31.4 39.9 52.9 70.5

Fishing licence fees 17.0 20.0 17.7 18.7 26.3 34.9 47.4 65.1

Other (mainly dividends and interest) 7.1 6.6 5.8 5.0 5.1 5.0 5.4 5.4

Payments 16.9 10.1 12.7 13.9 15.7 14.0 28.6 14.7

Secondary income balance 108.9 108.4 113.2 109.9 109.1 108.6 129.1 111.6

Receipts 119.6 122.8 128.6 125.5 125.0 124.3 144.7 128.1

Budget grants 82.3 84.4 85.9 83.7 81.7 79.7 78.4 78.9

Compact current grants 61.6 66.0 66.1 66.9 65.2 63.8 61.0 64.6

Other budget grants 20.7 18.4 19.8 16.8 16.4 16.0 17.3 14.4

Off-budget grants 9.1 6.8 6.6 6.2 5.7 4.8 3.3 8.9

College of Micronesia 10.8 13.3 16.3 13.4 13.7 12.8 11.5 11.3

Corporate tax from non-resident companies 0.0 0.1 0.8 2.1 2.6 4.4 27.6 4.1

Other (mainly households) 17.4 18.2 18.9 20.1 21.4 22.6 23.8 24.8

Payments (mainly households) 10.7 14.4 15.3 15.6 16.0 15.7 15.5 16.5


(including medical referrals) is significant as well. Construction services provided by

nonresident producers are also important and peaked in the FY2008-FY2010 period, re-

flecting the buildup in FAA grants for airport improvements and Compact infrastructure

projects. However, they have weakened in the last three years, as the projects neared

completion and with the reductions in Compact infrastructure grants. “Other” service im-

ports are large in total but comprise a host of smaller items.

48. The primary income account comprises fishing access fees, earnings of dividends

and interest on overseas investments, payments of dividends, and payment of interest on

debt. Fishing fee earnings have shown a positive uptrend since FY2001 and in FY2015

maxed out at $65 million. The FSM governments including Yap State have maintained a

sizeable level of foreign investments, which have provided a significant source of interest

and dividend earnings in the past. The level of FSM investments was largely stable

through the initial part of the amended Compact, but has risen significantly in the last two

years as additional revenues from fishing fees has accumulated in the FSM Trust Fund.

However, returns on investments has fallen reflecting lower market returns. Commercial

bank earnings on foreign assets and earnings on Social Security funds are also important.

On the payment side, dividend payments of foreign investment are the major item, while

the low level and concessional nature of the FSM’s external debt has held debt service

obligations in check.

49. The most notable component of the balance of payments is the secondary income

account, which includes Compact transfers and other aid flows. Compact flows comprise

the sector grants, while other budget grants include federal and special programs. Off-

budget grants reflect additional receipts from the U.S. and other donors, while receipts by

the College of Micronesia include Pell grants. In total, current grants represent about a

third of current account receipts. A new item in the BoP is corporate taxes received

through the FSM domicile for Japanese captive insurance and investment-oriented major

corporation (IMC) scheme. The lower tax rates, 21 percent, in the FSM are attractive to

Japanese companies and have resulted in a growing level of receipts in recent years. In

FY2014 a very large payment was received, reflecting tax payment by an individual com-

pany declaring a large capital gain. In FY2015, payments reverted to more normal levels,

which can be expected to continue, although occasional large payments can be expected

from time to time. The FSM domicile is managed by a private corporation, which re-

ceives a fixed percentage of the tax take. Inward private remittances are relatively small

in the FSM compared with other Pacific Islands, which have large migrant communities

living in neighboring metropolitan nations. However, the BoP has estimated this item to

be rising strongly, during the amended Compact era, as a result of the large out-migration

in previous years and the subsequent associated flows back home. Outward payments of

remittances from households reflect transfers from foreign workers living in the FSM and

are also substantial.


ii The capital and finance accounts

50. Table 5 provides details of the capital and financial accounts of the balance of

payments. The major items in the capital account include Compact capital transfers (in-

frastructure sector grant) and other capital transfers (FAA airport improvement grants).

Drawdowns under the infrastructure grant grew significantly through FY2012, once the

FSM was able to meet the conditions of the grants. However, as noted in numerous other

places in this review, grant disbursements dropped by half in FY2013 and fell to low lev-

els in FY2014 and FY2015, reflecting inability to fulfill grant conditions and project

management weaknesses. Other capital transfers have grown strongly during the initial

years of the amended Compact, mirroring the large FAA contributions, but declined sig-

nificantly in the last two years, as the projects came to a close. While there is a major air-

port renovation planned in Chuuk, the pipeline of FAA projects is otherwise complete.

51. The main items in the financial account are foreign direct investment (FDI), port-

folio investment, and other investments. While FDI has been small, reflecting low levels

of FDI in the FSM, portfolio investment has been a significant component of the BoP.

Portfolio investment comprises the foreign assets of the various governments and public

sector entities and liabilities of the commercial banks. Public sector investments represent

the pooled reserves managed by the national government and Yap state Trust Fund. In

FY2015 the large savings from fishing fees incomes was allocated to the FSM Trust Fund

coupled together with the exceptional FY2014 FSM domicile tax receipt. Other invest-

ments include changes in the levels of foreign assets of the commercial banks and exter-

nal debt drawdowns and repayments. In FY2015 the buildup in the FSM Trust Fund was

offset by withdrawals from local banks resulting in a lower than usual bank foreign in-

vestment accumulation. External debt drawdowns and repayments have generally been

small but were large in the FY2008-FY2009 period, reflecting the drawdown of the FSM

Telecom fiber optic loan.

Table 5 Balance of payments, capital and financial account, FY2008-FY2015 (US$ millions)

FY2008 FY2009 FY2010 FY2011 FY2012 FY2013 FY2014 FY2015

Capital account balance 27.5 54.9 64.2 62.0 68.3 42.2 21.2 22.9

Compact capital grants 4.9 7.5 16.3 19.2 28.5 16.5 4.9 7.3

Other 22.7 47.4 47.9 42.7 39.8 25.7 16.3 15.6

Capital outflows (contributions to CTF) ~ ~ ~ ~ ~ ~ ~ ~

Net lending/Borrowing (Curr + Cap) -16.6 1.5 18.3 3.5 24.6 10.4 25.0 36.2

Financial account balance 12.1 -1.2 -19.9 -8.2 -34.6 -16.0 -27.4 -47.7

Direct investment -5.3 0.6 0.7 0.8 0.9 0.6 0.3 0.2

Portfolio investment (increase in assets: -) -1.0 5.1 -8.5 0.2 -1.0 -3.6 -7.1 -41.0

Assets -3.2 5.7 -8.8 1.4 -0.4 -4.7 -7.0 -42.8

Liabilities 2.1 -0.6 0.3 -1.2 -0.6 1.1 -0.0 1.8

Other investment (increase in assets: -) 18.4 -6.9 -12.2 -9.1 -34.5 -13.0 -20.6 -6.9

Assets (mainly bank deposits) 11.9 -17.7 -12.5 -12.5 -35.2 -13.0 -21.6 -4.9

Liabilities (public sector loans) 6.6 10.8 0.3 3.4 0.7 -0.0 0.9 -1.9

Reserve assets ~ ~ ~ ~ ~ ~ ~ ~

Errors and omissions -4.6 0.4 -1.6 -4.7 -10.0 -5.6 -2.5 -11.5


52. Since FY2006 the errors and omissions in the balance of payments has generally

been within 3 percent of total import and exports of goods and services, which represents

a satisfactory outcome. The analysis and structure of the BoP clearly indicate the depend-

ent nature of the FSM economy. Attainment of the Compact goal of economic self-suffi-

ciency and replacement of official transfers with other foreign-exchange earning sources

will be a long-term process and presents, perhaps, the major and most difficult challenge

facing the FSM economy.

2 GNI AND GNDI

53. In most economies, analysis focuses on GDP, since this indicator most accurately

reflects the economic circumstances of the country under investigation. However, in the

FSM the large inflows of primary and particularly secondary incomes from the rest of the

world have a significant impact on aggregate demand and indicate that analysis should

also feature changes in GNI and GNDI. In the FSM, GNI and GNDI were 18 percent and

53 percent higher than GDP (nominal values) in FY2015. In terms of analyzing the re-

sults, it is useful to single out developments in constant price changes in primary and sec-

ondary incomes, which are provided in Figure 15. Both the primary and secondary in-

comes of the BoP have been deflated by a composite index of the CPI and GDP deflator.

54. While several factors influence primary income, the most dominant has been

changes in fishing fee royalties. Fishing fees have risen through the amended Compact,

rising rapidly between FY2012 and FY2015. While dividend and interest receipts have

fallen, reflecting weakening market conditions, the overall trend in primary income re-

ceipts has been upward. On the payment side, dividend and interest outflows have shown

a rising trend. In FY2014 the large secondary income receipt from the FSM domicile has

Figure 15 Primary and secondary incomes, constant prices 2004 (US$ millions)

0

20

40

60

80

100

120

Secondary Incomes

Primary Incomes


been offset by dividend outflow from the managing company. Overall, the primary in-

come balance (Figure 15) has displayed a rising trend, with deviations reflecting the de-

velopments noted above.

55. In the case of secondary incomes, Compact and other U.S. grant receipts have ex-

erted a large impact on GNDI. Secondary incomes are dominated by Compact and other

grant flows. These include the operational Compact sector grants, other budget and off-

budget grants from a variety of donors, and significant grants to the College of Microne-

sia (Pell grants). Most of these grants, especially the Compact grants, are static in nomi-

nal values. The other major categories of the secondary income account, receipts and

payments of household remittances, show a rising trend but tend to offset each other. The

overall impact of these forces is that the secondary income series, while remaining sta-

tionary in nominal values, displayed a marked downward trend in constant prices through

FY2013. In FY2014, however, the series shows a sharp uptick reflecting the extraordi-

nary receipts from the FSM domicile (see Figure 15), but in FY2015 reverts to trend.

56. Once the primary income account in constant prices is added to GDP, the result-

ing series for GNI is above GDP, with the additional fishing fee receipts offsetting the de-

cline in GDP in FY2013 through FY2015 (Figure 16). In the early part of the amended

Compact, GNDI shows a declining trend as both GDP and secondary incomes fall, alt-

hough FEMA receipts for cyclone rehabilitation exerted a significant upward movement

in FY2005. In the FY2008 through FY2011 period, the rising level of GDP comes into

play, offsetting the decline in secondary incomes, and GNDI remains stagnant. However,

in FY2012 through FY2015, the decline in GDP is offset by rising fishing fee income

(primary incomes) and receipts from the FSM domicile for Japanese corporations (sec-

ondary incomes), which maintained the level of GNDI in FY2013 and pushed it up in

FY2014 and FY2015.

Figure 16 GDP, GNI and GNDI, constant prices 2004 (US$ millions)

200

220

240

260

280

300

320

340

360

380

GNDI

GNI

GDP


3 INTERNATIONAL INVESTMENT POSITION

57. The FSM international investment position (IIP) is presented in Table 6. The data

provide stock positions at the end of each year corresponding to the financial account of

the balance of payments (note the Compact Trust Fund is treated as a nonresident interna-

tional unit). While there is no available record of foreign direct investment, the table pro-

vides an important indication of the FSM’s portfolio investments. The state and national

governments of the FSM pool their investments, which are maintained by the national

government. In FY2010, Yap state decided to withdraw $30 million of its resources from

the FSM pooled investments and set aside the funds in a separate trust for future genera-

tions of Yapese. The remaining FSM investments stood at $113 million at the end of

FY2015, including a further $22 million of Yap’s investments; resources for ADB loan

repayment (the PSRP, PSDP and BSS loans); and the FSM national government trust

fund. The FSM Social Security Administration, FSM Development Bank, and FSM Tele-

com also hold significant portfolio investments.

58. “Other” investments include commercial bank foreign deposits and represent that

portion of bank deposits that are not loaned out in the FSM. These stood at $199 million

at the end of FY2015. Finally, the external debt of the governments of the FSM and pub-

lic corporations represents the major external liability of the nation. Debt to public corpo-

rations has grown with the extension of the Rural Utility Service (RUS) loan in FY2009

Table 6 FSM international investment position, FY2008-FY2015 (US$ millions)

(US$ millions) FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

TOTAL STOCKS, NET 146.2 156.6 182.6 185.1 225.3 263.8 302.7 338.7

Direct investment, net n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a.

Portfolio investment, net 138.1 140.8 153.7 146.3 151.3 174.3 192.1 215.1

Assets 145.2 147.3 160.6 152.0 156.4 180.6 198.4 223.1

Investment portfolio, Government 91.7 90.4 72.4 67.5 65.7 75.2 84.4 112.6

Yap investment trust fund ~ ~ 31.7 30.5 35.7 40.0 43.0 42.5

Social Security 31.6 36.4 36.9 35.2 37.2 43.7 45.3 43.0

Development Bank 10.6 9.3 9.5 9.6 11.3 14.4 15.6 14.7

Telecommunications Corporation 7.6 7.3 5.5 4.6 1.3 1.4 1.6 1.5

Other 3.7 3.9 4.6 4.7 5.2 5.9 8.4 8.9

Liabilities 7.2 6.6 6.9 5.7 5.1 6.2 6.2 8.0

Equity: Capital and retained earnings of

foreign-owned banks 7.2 6.6 6.9 5.7 5.1 6.2 6.2 8.0

Debt: Medium-term notes ~ ~ ~ ~ ~ ~ ~ ~

Other investment, net 6.0 13.7 26.7 36.6 71.9 85.7 106.8 120.0

Assets 81.6 99.4 111.8 124.3 159.5 172.4 194.0 198.9

Deposits 81.6 99.4 111.8 124.3 159.5 172.4 194.0 198.9

Other assets, accounts receivable ~ ~ ~ ~ ~ ~ ~ ~

Liabilities: Loans 75.6 85.6 85.1 87.6 87.5 86.7 87.2 78.9

Government 50.8 51.0 50.6 54.6 56.3 57.3 57.0 50.7

Public corporations 24.8 34.6 34.5 33.0 31.2 29.4 30.2 28.3

Reserve assets 2.1 2.1 2.1 2.1 2.1 2.1 2.1 2.1

SDR 2.1 2.1 2.1 2.1 2.1 2.1 2.1 2.1

Memorandum item

FSM Compact Trust Fund 117.5 138.1 177.2 198.5 257.3 323.1 380.9 397.3


to FSM Telecom for the fiber optic cable. The reduction in government debt in FY2015

reflects changes in holding gains1.

4 NOMINAL AND REAL EFFECTIVE EXCHANGE RATES

59. The nominal effective exchange rate (NEER) is a trade weighted index of the ex-

change rates with which the FSM engages in trade in goods and services. The currency

composition of the FSM’s trading relations has been estimated through analysis of the

origin of imports and estimation of exports of both goods and services. Given the FSM’s

historical relationship with the U.S., the U.S. dollar dominates and accounts for 70 per-

cent of international trade. Considering that the FSM uses the U.S. dollar as its currency

of exchange, the NEER is essentially a trade weighted index of the U.S. dollar against the

FSM’s trading partners. Figure 17 indicates that the NEER depreciated during much of

the amended Compact, mirroring the weakening of the U.S. dollar. However, since the

end of 2012, the NEER has appreciated significantly as the dollar has gained strength.

60. The real effective exchange rate (REER) is a measure similar to the NEER, but

currency movements are adjusted for changes in the respective country CPIs. It is thus a

proxy for the gains or losses of international competitiveness. At the start of the amended

Compact through FY2007, the REER went largely unchanged. However, after that point,

with the significant increase in inflation in the FSM due to rising fuel and food prices, the

REER spiked, resulting in a loss of competitiveness. Through mid-2011 the REER depre-

1 The national government audit recorded external debt valued at market prices for the first time in

FY2015.

Figure 17 Nominal and real effective exchange rates, FY2004-FY2015 (FY2004 =

100)

80

85

90

95

100

105

110

115

120

Nominal Effective Exchange Rate

Real Effective Exchange Rate


cation reflects the low rate of inflation, but since that time the REER has appreciated, re-

flecting two main forces: the appreciation of the U.S. dollar and the rate of inflation in the

FSM compared with the RMI’s trading partners. In some measures of the REER cur-

rency, movements are adjusted by relative movements in wages. As discussed above

nominal wages have grown modestly, and real wages have fallen. It is thus likely that the

REER based on CPIs overstates the loss of competitiveness. However, the large rise in

fuel prices from a subsidized level at the start of the amended Compact affected all agents

and would have pushed up the cost of doing business in the FSM. The pattern emerging

would be that there was a significant loss of competitiveness during the period of the fi-

nancial crisis by 10 percent, and since mid-FY2011 the REER has appreciated again by 8

percent.

5 EXTERNAL DEBT

61. The FSM has adopted a prudent external-debt-management strategy during the

amended Compact era, and external borrowing has been modest. The current portfolio of

government external debt is represented by debt to the ADB. Loans were contracted dur-

ing the late 1990s for fisheries and water sanitation (outstanding debt for both loans is

$11 million). In FY1997 the FSM underwent a period of fiscal adjustment, resulting from

reductions in Compact transfers. A Public Sector Reform Program (PSRP) was initiated

with ADB support to finance an early retirement program (outstanding debt is $15 mil-

lion). There were no further commitments until loan effectivity of the Private Sector De-

velopment Program (PSDP) in FY2003 and the Basic Social Services (BSS) loan in

FY2004. Drawdowns under both programs were not extensive, as several of the FSM

states failed to qualify for the loans or meet the conditions for second-tranche drawdown

(outstanding debt under both loans is $10 million). In FY2008, the FSM made the first

drawdown under the Omnibus Infrastructure loan to finance specific infrastructure pro-

jects in the FSM states (outstanding debt is $15 million). In FY2014 Yap state drew down

its first tranche of a utilities loan to finance a variety of energy projects (outstanding debt

is $0.4 million). For government guaranteed debt, the main item is finance provided from

the RUS to FSM Telecom. This stood at $23 million in FY2008, but in FY2009 it rose

significantly, with the drawdown of $12.1 million to finance the installation of a fiber op-

tic cable connection to the U.S. backbone (outstanding debt is $26 million). FSM Tele-

com drew down $4 million in FY2014 to finance the installation of a 3G network from

the equipment supplier (outstanding debt is $2.6 million).

62. The FSM external debt level has shifted from a position that during Compact I

was quite adverse to one that is now very favorable (see Figure 18). With a debt-to-GDP

ratio of just 26 percent in FY2015, the FSM’s debt level is low by Pacific Island stand-

ards. However, the FSM holds a sinking fund established in the late 1990s to pay down

the public sector reform program loan, which was subsequently extended to include re-

payment of the basic social services sector and private sector development loans. Netting

out the value of the sinking fund, external debt falls to 18 percent of GDP. (While most


external debt has been on-lent to the state governments, the liability rests with the na-

tional government). Debt service of as percent of national government domestic revenues

(excluding grants) was 9 percent in FY2015.

D Fiscal Developments

1 FISCAL POLICY FRAMEWORK

63. The agreement and adoption of the amended Compact by the FSM and U.S. gov-

ernments became effective in FY2004 and initiated a wholly new fiscal framework for

the FSM. The structure entailed a series of sector grants earmarked for education, health,

environment, private sector development, capacity building and infrastructure. The inno-

vation in the amended Compact was a trust fund designed to provide a yield sufficient to

replace the annual grants after 20 years. Table 7 shows the aggregate structure of the an-

nual Compact grants and the contribution to the CTF. Each year, over a 20-year period,

the U.S. will contribute to the FSM $92 million, partially adjusted for inflation. The infla-

tion adjustment factor remains as in the original Compact. The annual sector grants start

at a level of $76 million in FY2004 but are to be annually reduced by $0.8 million from

FY2007 onward. The difference between the total contribution and the annual sector

grant levels will be deposited in a trust fund to accumulate over the 20-year Compact pe-

riod.

64. In comparison with the original Compact, the new regime avoids the need for

large fiscal adjustments every five years. However, in order to establish the viability of

the trust fund, the U.S. instigated the annual decrement. While avoiding large shocks to

the system, the decrement requires an annual compression of expenditures from FY2007

onward. This compression, coupled with the lack of full inflation adjustment, means an

Figure 18 FSM external debt ratios

FY15 , 26%

FY15 , 9%

FY15 , 18%

0%

5%

10%

15%

20%

25%

30%

35%

External Debt % GDP

Debt Service % of National Goveernment Revenues

External Debt net of Offsetting Assets % GDP


annual reduction in real resources of about 2 percent. In the initial years of the amended

Compact, attention was focused on more immediate adjustment problems, but the issue

has subsequently became critically important and is described in greater detail below.

65. The annual budget allocations are awarded through the Joint Economic Manage-

ment Committee (JEMCO). The U.S. has a controlling influence with three members and

the FSM has two. Each year the FSM presents its annual sector grant submissions to the

U.S. in advance of the JEMCO meeting, which is convened in late August to make the

annual budget allocations before the new fiscal year starts October 1. While most

JEMCO resolutions are agreed upon by consensus, some are subject to “3-2” votes.

66. The sectoral structure of the amended Compact presented a special problem. In

the FY2004 budgets, the altered fiscal framework resulted in funding shortages for the

operations of government not covered under the sector grants. In order to address the

shortfall, JEMCO permitted the FSM to utilize the capacity-building sector grant for this

purpose—provided that the FSM agreed that it would, over a five-year period, phase out

the use of the grant for “nonconforming” purposes. Under duress, the FSM had no alter-

native but to concede. While the operation of the FY2004 budgets was not affected, the

transition requirements became binding in FY2007 and required a painful adjustment of

expenditure cuts as well as increased revenue effort.

Table 7 U.S. annual Compact grants and contributions to the Trust Fund (US$ millions)

Annual GrantsTrust Fund

Contribution

Total

Contribution

FY04 76.0 16.0 92.0

FY05 76.0 16.0 92.0

FY06 76.0 16.0 92.0

FY07 75.2 16.8 92.0

FY08 74.4 17.6 92.0

FY09 73.6 18.4 92.0

FY10 72.8 19.2 92.0

FY11 72.0 20.0 92.0

FY12 71.2 20.8 92.0

FY13 70.4 21.6 92.0

FY14 69.6 22.4 92.0

FY15 68.8 23.2 92.0

FY16 68.0 24.0 92.0

FY17 67.2 24.8 92.0

FY18 66.4 25.6 92.0

FY19 65.6 26.4 92.0

FY20 64.8 27.2 92.0

FY21 64.0 28.0 92.0

FY22 63.2 28.8 92.0

FY23 62.4 29.6 92.0


67. At the FY2005 JEMCO meeting in August 2004, it was resolved that the FSM

must allocate at least 30 percent of Compact sector grants to the infrastructure grant, ef-

fective from FY2006. The FY2005 infrastructure requests were considered substantially

below desired levels, and JEMCO felt that a floor should be established to ensure that

public investment was maintained at levels sufficient to support the development of the

economy as aggregate Compact resources declined. Access to federal programs has con-

tinued during the amended Compact, with the exception of certain education programs,

which were “cashed out” and have been replaced through the Supplemental Education

Grant (SEG). Finally, implementation of the amended Compact entails a whole new ac-

countability regime that is specified in the Fiscal Procedures Agreement (FPA). Taken as

a whole, the fiscal arrangements of the amended Compact have had a wide-ranging im-

pact on the conduct of fiscal policy and management in the FSM.

68. Fiscal policy is formulated individually by the national and state governments,

with separate expenditure and revenue policies in the absence of significant coordination.

With respect to revenue policy, the national government has the power under the consti-

tution to collect import and income taxes, and all remaining taxes are reserved for the

states. Through its taxing powers, the national government collects about three-fourths of

all domestic taxes. In FY2015, national taxes (excluding corporate taxes received from

the FSM domicile) amounted to $25.8 million, while the four states collected an addi-

tional $9.0 million. The states, with widely varying levels of tax effort, collect the re-

maining one-fourth of domestic taxes, primarily through general sales taxes and excise

taxes on alcohol, tobacco and other goods.

69. In 2006, the FSM Congress enacted legislation (modified in 2009) to establish an

FSM domicile for Japanese corporations. In essence, the law provides lower tax rates

than those in Japan and provides an incentive for firms to register in the FSM. In

FY2009, the FSM collected its first receipts under the system and raised $4.4 million in

FY2013, $27.6 million in FY2014 and $4.1 million in FY2015. Collections under the

domicile are shared 60:40 with the company responsible for administering the scheme,

Micronesia Registration Advisors (MRA). In FY2014 an extraordinary receipt greater

than $20 million was received on behalf of one company that declared a large capital

gain. In FY2015 revenues reverted to more normal levels, although periodically similar

large windfalls can be anticipated.

70. By constitutional mandate, at least 50 percent of the nationally imposed taxes

(and 80 percent of the fuel import tax) must be shared with the state in which the taxes

were collected. In the case of the FSM domicile, the revenues are not collected in the

FSM, and the tax is not subject to revenue share. Overall tax effort remains low relative

to other Pacific Islands, and in FY2015 tax revenues equated to 12 percent of GDP. There

have been minor changes to the tax regime over time including: changes to the import tax

that shifted the base from f.o.b. to c.i.f.; rate increases on beer and tobacco (effective

FY2005); and the new FSM domicile scheme in FY2009. These increases were offset in


FY2007 by deductions from the gross receipts tax for payroll costs. It is likely that collec-

tion performance has improved modestly; however, tax administration and, in particular,

compliance and audit functions still need strengthening.

71. Nontax revenues continue to be dominated by fishing access fees, which in

FY2015 represented 67 percent of all domestic revenues (including revenues from the

FSM domicile). The national government manages the tuna resources and keeps all reve-

nues from the licensing fees. Revenue from penalties and fines is shared with specific

states and, in some cases, local governments. The fishing access fee as a source of reve-

nue grew rapidly, from less than $4 million in FY1987 to a peak of $21 million in

FY1995. After an extended period of decline, fishing access fees have grown strongly in

recent years, and a record $65.2 million was collected in FY2015. However, the recent

rapid rises reflecting increasing Vessel Day Scheme (VDS) rates are set to stabilize going

forward although may be expected to rise overtime with inflation and state of the fishing

industry.

72. The national government has acted as an agent in distributing to each government,

according to mutually agreed-upon formulas, the grant funding received from the U.S.

under the Compact. Up until FY2014 the national government received 10 percent of

grants, and the remainder was distributed to the states, based on a formula that splits

roughly 30 percent of funding evenly among the four states and the remaining 70 percent

according to population. As part of the FY2014 JEMCO budget allocations, the national

government relinquished part of its share. The existing support provided through the sec-

tor grant for the College of Micronesia will fall by $700,000 a year until $1 million re-

mains. The funds relinquished will be allocated to the states.

73. On the expenditure side of fiscal policy, the five governments all operate within

balanced budget requirements based on either constitutional or statutory provisions.

However, the definition of a “balanced budget” is not restricted to the operations of a sin-

gle budget year. Funds unexpended in one year are reported as revenues in the following

year. The use of this so-called “carryover” component in revenue projections tends to

cloud fiscal management and can mask the onset of significant structural imbalances. The

vulnerability to fiscal imbalance is compounded by delays in financial reporting and ex-

penditure controls; consequently, legislative bodies must make appropriations without an

accurate appraisal of each government’s true fiscal position.

74. The national and state governments conduct budgetary operations through a series

of separate funds, the most important of which is the general fund. Expenditures from the

general fund are largely unrestricted in nature, but there is limited flexibility or authority

to use resources from the other funds. Under Compact I, a major part of the external as-

sistance provided revenue to the general fund. Under the amended Compact, all such re-

ceipts are recorded as special funds and are restricted in nature.


2 FSM FISCAL PERFORMANCE

75. The first five years of the amended Compact witnessed a difficult period of fiscal

adjustment, as the nation was forced to adapt to the new arrangements (Figure 19). At the

start of the amended Compact in FY2004, the FSM recorded a deficit of $39 million (15

percent of GDP). This deficit reflected the need to transfer $30 million to the CTF. It also

showed Compact funding at levels below those prevailing at the end of Compact 1. In the

subsequent years of FY2005 and FY2006, deficits of $14 million—or 5 percent of GDP

in each year—were recorded. The amended Compact restricted the use of resources to

specified sectors and prohibited their use to fund the general government. To ease the ad-

justment, the U.S. permitted the use of the capacity-building grant to fund general activi-

ties, provided these were transitioned out over a five-year period. There was a gradual

improvement in the fiscal position in FY2007 and FY2008, as the nation adjusted to the

new requirements and implemented RIFs in Chuuk and Kosrae.

76. By FY2009 the adjustment to the new sector grant approach was complete, and

the FSM recorded a surplus of $5.2 million or 1.9 percent of GDP for the first time in the

amended Compact period. In FY2009 the FSM received significant FAA grants for air-

port improvement, which pushed up both revenues and expenditures significantly. In

FY2010 there was further FAA infrastructure investment, and a slightly smaller surplus

of $1.4 million was achieved, representing 0.5 percent of GDP. In FY2011 the expansion

in airport renewal was maintained, and the nation began to make significant use of the

Compact infrastructure grant. However, the nation recorded a small deficit of $1.8 mil-

lion or 0.6 percent of GDP.

77. In FY2012 the FAA projects began to decline but were offset by a further increase

in use of the infrastructure grant. The FSM also experienced the benefits of the Parties to

Figure 19 FSM consolidated revenues and expenditures (US$ millions)

$120

$140

$160

$180

$200

$220

Fiscal surplus in FY15 = $33 million or 11% of GDP

Revenues

Expenditures


the Nauru Agreement (PNA) through the Vessel Day Scheme (VDS), and the national

government was the beneficiary of a large fiscal surplus of $8 million. With all FSM

states running small fiscal deficits with the exception of Kosrae, an overall FSM-wide

surplus of $2.9 million was achieved or 0.9 percent of GDP.

78. In FY2013 both expenditures on FAA projects and use of the Compact infrastruc-

ture grant fell dramatically. While the FAA projects were nearing completion, the use of

the infrastructure grant was constrained by in an inability to fulfill the grant conditions,

project management issues, lack of clarity in FSM priorities, and conflicts between the

national government PMU and state governments. Meanwhile, fishing fee revenues con-

tinue to rise. As state governments continued to run small deficits, the national govern-

ment ran a surplus of $12 million and the FSM recorded an overall surplus of $9 million

or 2.9 percent of GDP.

79. Much the same story held in FY2014. Both FAA and Compact infrastructure pro-

jects declined further and expenditures on non-financial assets fell from $70 million in

FY2012 to $23 million in FY2014. Fishing fee revenues rose again to new highs and rec-

orded a level of $48 million. The national government ran a surplus of $43 million or 14

percent of GDP, although receipt of a once off $20 million windfall under the FSM domi-

cile program for Japanese companies, artificially boosted revenues. Meanwhile the states

governments continued to operate tight budgets and recorded a larger deficit of $7.6 mil-

lion or -2.4 percent of the FSM GDP.

80. A similar result occurred in FY2015, although the makeup was different. Expend-

itures on infrastructure fell to $21 million, but fishing fees rose to $65 million offsetting

the decline to normal revenue levels from the FSM domicile. The national government

surplus fell to $35 million or 11 percent of GDP, as revenues fell and expenditures rose.

At the state level fiscal performance improved, although all states except Pohnpei ran

deficits, and the combined fiscal outturn was reduced to $2.3 million or 1 percent of

GDP.

81. Figure 20 indicates the emerging trend and discrepancy between the national and

state governments’ fiscal position. During the first five years of the amended Compact,

the fiscal outturn of the national and state governments improved. From FY2011 onward

the position of the state governments has remained weak, as the real value of the sector

grants has declined, but the national government has benefited from rising fishing reve-

nues and receipts from the FSM domicile market. This outcome is set to continue through

the remained of the amended Compact, with a sustained fiscal surplus at the national gov-

ernment as fishing fee royalties stabilize at about their current levels, although reliance on

the fledgling corporate domicile for off shore companies maybe fragile. At the same time

the states will continue to experience mounting fiscal pressure. This begs the question of

the best use of the large national government surplus between state government needs to

maintain basic social services and to shore up the CTF to reduce adjustments post

FY2023. These issues are addressed in the policy Chapter.


3 STRUCTURAL CHANGES IN KEY FISCAL VARIABLES

82. Figure 21 displays long-run trends in revenues. It indicates that there was a signif-

icant boost in tax effort in the late 1990s, reflecting reforms in the import tax regime, but

during the next decade, tax effort remained flat in proportion to GDP. Grants, both cur-

rent and capital, indicate a long-run decline, but the impact of the failure to use the Com-

pact sector infrastructure grant needs to be taken into account. At the start of the amended

Compact, there was a large drop in grant usage. However, this was remedied as the FSM

adjusted to the new regime in FY2009-FY2011 and made use of the large FAA capital

and Compact sector infrastructure grants. In FY2011 capital grant use began falling.

Once project management issues are resolved and the FSM becomes compliant with grant

conditions, usage is expected to rise, echoing levels in relation to GDP that existed in the

Figure 20 Fiscal balance, state and national governments (US$ millions)

-$20.0

-$10.0

$0.0

$10.0

$20.0

$30.0

$40.0

$50.0

National Govnernment

State Govnernments

Figure 21 FSM tax effort and grants, percent GDP

0%

20%

40%

60%

80%

100%

120%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

16.0%

18.0%

20.0%

Tax Revenue % GDP

Grants % GDP


late ‘90s, suggesting that little structural change has occurred in the 18 years since

FY1997.

83. Figure 22 displays the structural transformation of the share of the FSM govern-

ments in GDP. Clearly, there has been a large reduction in current government expendi-

tures relative to GDP since the start of the original Compact in FY1987. Consistent with

the design of the original Compact and large step-downs, current expenditures declined

through the period. At the end of the original Compact, there was a spike in expenditures

as the FSM benefited from the “bump-funds” provided in FY2002 and FY2003 and the

need to allocate these funds to the new Compact Trust Fund. However, since that time

expenditures as a percent of GDP continued to decline through FY2012, reflecting a se-

ries of factors: phasing out the use of Compact sector grants to fund general government

and associated RIFs in Chuuk and Kosrae; the need for consolidation in the education

sector; and the recent reductions in allocation of Compact grants to the national govern-

ment. In the last three years FY2013 through FY2015, there has been 5 percent increase

in the current expense/GDP ratio of which 3 percent reflects increases in national govern-

ment expenditures and 2 percent at the state level; these are discussed in greater detail be-

low. Use of capital funds displays a more volatile picture: an initial reduction from the

high levels at the start of Compact 1; a large reduction at the start of the amended Com-

pact; greater use in the FY2009-FY2011 period; and collapse in the last three years.

4 STRUCTURE OF THE FSM TAX SYSTEM

84. The tax regime in the FSM is based on a tax system inherited from—and largely

unaltered since—Trust Territory days. There are three major taxes: wages tax, the busi-

ness gross receipts tax, and import duties, each of which collects a very similar level of

revenue. Taxes (excluding the corporate taxes collected from the FSM domicile) has

Figure 22 FSM current and capital expenditures, percent GDP

0.0%

10.0%

20.0%

30.0%

40.0%

50.0%

60.0%

70.0%

80.0%

Capital Expenditures % GDP

Current Expenditures % GDP


grown by an annual average of 2.2 percent over the amended Compact, less than the rate

of nominal GDP of 2.9 percent. This represents an overall buoyancy ratio1 of 0.66, re-

vealing the inefficiencies of the current regime, and indicates the need for tax reform.

85. Wage earners pay 6 percent of incomes, up to a threshold of $11,000, and above

that, 10 percent. Those earning less than $5,000 have a tax-free threshold of $1,000. In

FY2015 the wages tax collected $8.2 million and has grown by a trend annual average of

1.9 percent during the amended Compact. Estimates of the wage tax buoyancy indicated

a ratio of 1.8 compared to the tax base of compensation of employees. This estimate ap-

pears on the high side and given the limited number of observations should treated with

caution.

86. The gross receipts tax (GRT) is levied at 3 percent of business turnover and is in-

tended as a proxy income tax, although the incidence is comparable to that of a sales tax.

In FY2015 the tax raised $8.6 million and has grown by a trend annual average of 3.1

percent during the amended Compact. The tax suffers from the well-known cascading ef-

fect, such that each sale from one business to another multiplies the tax yield and distorts

resource allocation. As part of the Public Sector Reform Program (PSRP) in the late

1990s, exports were exempted from the tax. In 2007 the government implemented tax

measures to provide relief to the private sector by allowing firms to offset payroll costs in

the calculation of the gross revenue tax. The impact of the reductions on tax effort was

minor. Estimates of the GRT buoyancy in relation to nominal GDP (monetary component

only) indicate a ratio of 1.02 (without adjustment for the payroll offsets), suggesting a

satisfactory performance.

87. Customs duties are the remaining category. They have displayed an erratic trend

through the amended Compact, averaging 1.0 percent per annum over the period, and col-

lected $9.0 million in FY2015. The general rate of import taxes is 4 percent, while food is

subject to a lower rate of 3 percent. Gasoline and diesel fuel are subject to 5 cents per gal-

lon, while alcohol and tobacco are subject to the usual higher rates. In early 2005, to en-

hance revenue effort, legislation was passed to implement additional tax measures to in-

crease revenues on beer and tobacco. Estimates of the buoyancy ratio for customs duties

(estimated in relation to total imports c.i.f.) indicate a ratio of just over 0.32, reflecting

the inefficiencies of the duties as a form of revenue collection, which are subject to a va-

riety of leakages and concessions.

88. The estimate of the overall tax buoyancy ratio for the FSM reflects the underlying

weak compliance and an inefficient administration long overdue for overhaul. The wage

tax seems to have performed well in revenue terms, and the GRT has provided a satisfac-

tory yield although suffering from well-known deficiencies. Customs tax performance

has been poor, but this is not unusual for this form of tax. The distortionary impact of the

1 Estimates of tax buoyancy ratios are derived from log-linear estimation of the growth in tax collections

divided by the growth in the tax base over the amended Compact era. These ratios are based on a limited

number of observations and should be considered indicative only.


GRT and weak performance of the boarder taxes indicate the need for replacement with a

modern tax system such as the VAT; this is discussed in the policy chapter.

5 FISCAL PERFORMANCE AT THE NATIONAL GOVERNMENT

i Revenues

89. As a result of the reduced level of grants negotiated for the amended Compact, the

FSM states pressed for a greater share of Compact revenues to compensate. At a leader-

ship meeting in FY2003, the share of the national government was reduced from 13.3

percent to 8.65 percent, effective FY2004. To restore the loss, the Congress of the FSM

authorized the restoration of the 20 percent revenue share given to the states in FY1999,

thus reducing the state’s share from 70 to 50 percent. At the beginning of FY2005, the

national government further legislated to set the minimum share of Compact resources at

10 percent, effective FY2007. The Compact revenue share formula remained unchanged

until the FY2014 sector grants allocations. Reflecting the decision of the national govern-

ment to not prepare a decrement management plan—as required by JEMCO (see Chapter

2)—the national government relinquished its share of Compact resources in favor of the

states, with the exception of the annual grant to the College of Micronesia. The share is

set to decline by $700,000 per year until the prevailing level is reduced to $1 million (to

be achieved by the FY2017 budget). The reduction in national usage will be allocated to

the states, in precise proportion to the existing state shares and assist in offsetting the sec-

ond tranche of the decrement management plan (due to be implemented in the FY2017

state budgets). Finally, with the sizeable increase in revenues from fishing fees and cor-

porate taxes received from the FSM domicile, the national government legislated at the

start of 2015 to once again increase the state government’s revenue share to 70 percent

with the additional 20 percent allocated to the FSM Trust Fund in state sub-accounts ef-

fective FY2016 to support state government operations after FY2023.

90. In FY2008 the national government implemented reforms to the tax code legislat-

ing a 21 percent tax on corporate enterprises with a capitalization of greater than $1 mil-

lion. In practice the tax was not effective in the domestic market, as no local companies

breached the minimum requirement. However, the changes in law were attractive to the

Japanese captive insurance market seeking domicile and lower tax rates in foreign juris-

dictions. The scheme is attractive to not only Japanese captive insurance companies but

also investment-oriented major corporations (IMCs). The scheme is operated by the Mi-

cronesian Registration Advisors on behalf of the FSM government, and revenues are

shared on 60:40 basis. Figure 23 indicates the gradual introduction of the FSM domicile

market, with the national government’s share reaching $4.4 million in FY2013. With an

extraordinary receipt of $20 million in FY2014 from the IMC segment, $27.6 million of

revenues were collected. In FY2015 collections reverted to trend with receipts of $4.1

million

91. Figure 23 also indicates recent performance of major domestic taxes. The GRT

stagnated during the early part of the amended Compact, reflecting the weak economic


performance of the FSM. In FY2008 GRT collections picked up speed with the growth in

the economy, but they fell back during the last three years, as construction activity col-

lapsed. Wage tax collections faltered at the start of the amended Compact, with the RIFs

in Chuuk and Kosrae, but has since displayed an upward path, apparently unrelated to the

state of the economy. Customs collections rose in FY2005, reflecting discretionary

changes in tobacco taxes, and with the increases in construction activity, but since

FY2010 collections have dropped off, indicating weak collection and deteriorating econ-

omy.

92. Grant receipts consist of both current and capital. Current grants include Compact

sector grants and federal programs. National government use of sector grants has been

declining in recent years, from a level of $9.1 million in FY2004 to $1.3 million in

FY2015. As noted above, these are set to decline further in FY2017, as they are reduced

to the $1 million allocation for the College of Micronesia. Federal programs are used for

the national government as well as a large portion for the states. In order to ease cash

flow at the state level, the national government has fronted federal program expenditures

at the state level, although the national government is returning these programs to the

states. Capital grants comprise both the use of the infrastructure grant and the FAA air-

port renovations. Trends are displayed in Figure 24. Both types rose at a modest rate dur-

ing the early part of the amended Compact but then took off in FY2009. Both FAA pro-

jects and infrastructure spending occur at the state level but are booked to the national

government. This reflects the treatment adopted by the auditors, although functionally it

would aid interpretation if the expenditures were classified by state. As noted the FAA

projects grew to high levels but then declined in FY2013 through FY2015, due to the

completion of the projects. The Chuuk runway renovation will boost expenditures, but

long-term FAA project levels are set to remain modest. The poor utilization and inability

Figure 23 National government tax collections by type (US$ millions)

5.000

10.000

15.000

20.000

25.000

30.000

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

Customs GRT

Wages Tax

Corporate Tax, net (captive insurance)


to comply with the infrastructure grant conditions have been discussed, but hopefully

these issues will be resolved, and grant disbursements will resume an upward trend.

93. Figure 24 also includes the remaining other major category of national govern-

ment, fishing fees. As stated above, fishing fees have grown at high rates since FY2011,

reflecting the implementation of the VDS and the increase in daily rates. The PNA is not

requiring further increases in the minimum VDS rates and these are projected to stabilize

slowly from this point further with modest allowances for inflation.

ii Expenditures

94. Figure 25 indicates the size and growth in the national government payroll during

the amended Compact. Employee numbers have increased, by a modest 2.1 percent over

the period. In contrast, the wage bill increased rapidly between FY2004 and FY2010, in

part due to a cost-of-living adjustment (COLA) awarded in FY2008. During the amended

Compact, average wage costs have risen by 29 percent, and the wage bill has grown by

27 percent. Although both the size of the wage bill and number of employees declined af-

ter FY2010, in the last two years an upward path may be emerging reflecting booming

revenues.

95. In FY2009 the auditors provided details on expenditures by economic categories,

which enables a vastly improved GFS classification. Use of goods and services was $22.6

million in FY2009 and jumped from $25.9 million in FY2014 to $31.3 million in

FY2015. Again the recent strong increase may reflect the substantial fiscal space afforded

to the national government. Other categories of expense—interest, subsidies transfer to

other layers of government, and miscellaneous—totaled $6.1 million in FY2015 and are

relatively minor and stable. Outlays on nonfinancial assets or fixed capital mirror the

Figure 24 National government major revenue items (US$ millions)

$0.0

$10.0

$20.0

$30.0

$40.0

$50.0

$60.0

$70.0

Compact Infrastructure

FAA Projects

Fishing Fees


level of Compact sector, FAA grants, and legislative projects, In FY2004 through

FY2012 outlays on legislative projects average $3.3 million, but in the last three years

have risen to $6.8 million, $8 million and $7.6 million, respectively. Historically, the na-

tional government has maintained tight control of recurrent expenditures, with the ex-

ception of the FY2007-FY2010 period, when payroll grew by 23 percent. However, in

the last three years as the fiscal situation has afforded considerable scope for increased

spending, all major categories of expenditures; payroll, use of goods and services, and

public projects have grown rapidly.

iii Overall balance

96. The overall fiscal outcome of the national government is shown in Figure 26.

During the early period through FY2008, the national government ran a series of modest

deficits averaging 1.0 percent of GDP. From FY2009 through FY2012 both revenue and

expenditures rose rapidly on infrastructure spending, and the national government sus-

tained a series of small surpluses averaging 1.4 percent of GDP. During this period the

government built up financial assets and reduced liabilities. In FY2013 both revenues and

expenditures dropped back, reflecting the decline in infrastructure projects, but a signifi-

cant surplus was attained, representing 3.5 percent of GDP, as fishing fee royalties rose

rapidly. The $11 million surplus was accumulated in financial assets ($6 million) and re-

payment of accounts payable ($5 million).

97. In FY2014 revenues continued to rise as additional fishing fees and corporate tax

earnings from the FSM domicile market rose to record highs, despite the drop in capital

grants. Overall the national government achieved a fiscal surplus of $42.9 million or 13.5

percent of GDP. On the financing side domestic assets, namely local bank accounts, rose

by $34.4 million, and accounts payable were reduced by a further $8.4 million. In

Figure 25 National government payroll and employees

500

550

600

650

700

750

800

850

900

950

1,000

$0.0

$2.0

$4.0

$6.0

$8.0

$10.0

$12.0

$14.0

Number

s of

Public

Ser

van

ts

Wag

e Bill US $millions

Wage Bill

Public Servants


FY2015 will a return to normal revenues from the FSM domicile sector, a reduced sur-

plus of $35.4 million was attained representing 11.2 percent of GDP. However, the fi-

nancing positions was different. There was a buildup of financial assets of $44 million,

represented by an increase in domestic assets of $14 million and offshore investments of

$30 million, the latter reflecting contributions to the FSM Trust Fund. The improvements

in accounts payable in FY2014 was reversed out in FY2015 with an increase in $9 mil-

lion, an unfavorable result given the large surplus.

Figure 26 National government consolidated revenues & expenditures (US$ millions)

$40

$50

$60

$70

$80

$90

$100

$110

$120

$130Revenues

Expenditures

44

III. POLICY ISSUES

A Public Financial Management

1 PUBLIC SECTOR PAYROLL

98. In the second half of the 1990s, as Compact grants declined sharply, the FSM and

state governments underwent a series of reforms, with the assistance of the ADB, known

as the Public Sector Reform Program (PSRP). While the PSRP is now part of history, it

provides a useful benchmark against which to review recent performance. The PSRP in-

corporated a goal of reforming and reducing the size of the public sector and, in particu-

lar, cutting the size and operating costs of the civil service.

99. Table 8 presents a comparison of the situation in FY1996, with the PSRP targets

and current position twenty years on. In terms of numbers of civil servants, the PSRP tar-

geted a reduction of 27 percent. By FY1999, a 16 percent decrease had been achieved.

This reduction has been maintained and a further 4 percent reduction achieved, a consid-

erable accomplishment. However, the story in payroll costs is significantly different.

With an initial target savings of 35 percent of payroll costs, the five governments of the

FSM had attained 20 percent by the PSRP closeout in FY1999. However, 17 years later,

in FY2016, the benefits of the PSRP have been completely eroded, and payroll costs re-

main at the same levels. At the individual government level, the two states with the most

adverse fiscal position, Chuuk and Kosrae, have reduced the size of their workforces sig-

nificantly and to a lesser extent their wage bill costs. Pohnpei has also reduced both the

Table 8 Payroll reduction performance: PSRP targets, actual performance as at loan closeout in FY1999 and FY2016

Workforce

Reduction

Target

Workforce

Reduction

FY99

Workforce

Reduction

FY16

Wage Bill

Reduction

Target

Wage Bill

Reduction

FY99

Wage Bill

Reduction

FY16

Annual

Payroll

Savings

(US$)

Chuuk -29%-15%

(2,676 ==> 2,268)

-36%

(2,676 ==> 1,723)-44% -29% -16% 3.0 million

Kosrae -14%-19%

(783 ==> 634

-25%

(783 ==> 589-26% -19% -7% 0.4 million

Pohnpei -28%-20%

(1,554 ==> 1,251)

-9%

(1,554 ==> 1,415)-37% -23% -7% 1.2 million

Yap -30%-21%

(1,109 ==> 874)

-9%

(1,109 ==> 1,009)-29% -19% 20% -1.4 million

National -21%8%

(631 ==> 679)

8%

(631 ==> 679)-21% 7% 35% -3.1 million

FSM -27%-16%

(6,753 ==> 5,706)

-20%

(6,753 ==> 5,415)-35% -20% 0% 0.1 million

Policy Issues 45

size of its civil service and cost, but Yap, while reducing numbers, has seen a large in-

crease in the wage bill. The average wage cost in Yap state was considerably lower than

all of the other FSM governments during Compact I, and the increases bring Yap closer

but still below those in Chuuk and Kosrae. For the national government, the workforce

has recently grown and average wage costs have risen significantly. Average wage costs

in the national government are over twice those in Yap, 89 percent, 93 percent above

those in Chuuk and Kosrae, respectively and 56 percent higher than in Pohnpei.

100. Given the attention the issue of escalating wage costs has received in prior

reviews, it is important to note the basis upon which it is calculated. The payroll data

measures total wage costs or the wage bill, the numbers employed, and the average wage

cost per employee. The former is the total wage cost recorded through the FSM payroll

systems. The number of employees is an average of the total number of employees on the

biweekly payroll over each fiscal year. The average wage cost measures the total wage

bill divided by the number of employees. This is different from measures of wage rates,

which would be based on factors such as hourly wage rates and annual salaries. Average

wage cost per employee can rise for many reasons, despite the fact that wage rates have

remained unchanged.1

101. Figure 27 indicates trends in the FSM wage bill and workforce size. While there

was a considerable reduction in the total FSM government workforce during Compact I,

wage costs per employee were held in line, and the wage bill also fell. At the start of the

amended Compact, the number of employees rose, reflecting a lack of discipline in

Chuuk. However, since FY2006 numbers have fallen, representing the RIFs in both

Chuuk and Kosrae. Wage costs per employee rose strongly during the first seven years of

the amended Compact, by an annual average of 2.3 percent, and although the wage bill

fell as the RIFs were implemented, it had risen to pre-reform levels by FY2010. The up-

ward trend in wage costs per employee has flattened out. In FY2016 these costs were 3.8

percent higher than in FY2010, and the wage bill had declined by 1.9 percent.

102. During the early period of the amended Compact, a variety of factors were at play

that influenced wage costs per employee. These factors included: restructuring the work-

force with RIFs in Chuuk and Kosrae; returning to the normal number of working hours

in each pay period; upgrading teacher skills; and awarding a COLA in the national and

1 In the following discussion and in the state chapter, it will be noted that average wage costs per employee

have risen significantly during the amended Compact, although wage rates have risen to a lesser degree.

Second, the data on employment in the statistical appendix have been modified in the present analysis

to allocate all federal program employment administered by the national government to the states in

which the employment takes place. Federal program employees at the state level have been administered

at different times by both the state and national governments; to provide a clearer picture of the trends,

it is desirable to treat these employees on a consistent basis. Third, employees under Yap Cap and Head

Start in Pohnpei were transferred to the SEG during the amended Compact. These employees have been

allocated to the two state government payrolls before the implementation of the SEG to ensure con-

sistency in the present analysis, despite their allocation to the “government agency” category in the sta-

tistical tables.


Pohnpei governments. These factors led to an increase in wage costs per employee, alt-

hough most governments enacted a wage freeze. Since FY2010, with adjustments to the

amended Compact complete, average wage costs per employee and the wage bill have

stabilized, and, hopefully, future increases will remain modest.

103. During the discussion of payroll costs, it is frequently suggested that much of the

recent increase is related to federal program employees, who are not subject to the same

fiscal pressures as general fund or Compact sector funded employees. Figure 28 provides

further information concerning average wage costs by major fund types: federal pro-

grams, general fund, and Compact sector grants. Through FY2010 all fund types exhibit

the same trends, although federal program wage cost has displayed a more erratic path.

However, beginning in FY2010 a different pattern emerged. While general fund and

Compact sector sourced wages leveled off, federal program wage rates continued the

same upward momentum through FY2014 as experienced in the first seven years. Over

the amended Compact period, federal program employees saw an annual average increase

of 4.5 percent, compared with 2.2 percent and 1.7 percent for general fund and Compact

sector employees, respectively. These observations support the conclusion that federal

program employees have not been subject to the same constraints as other government

employees. However, of the total increase in wage bill cost of $18.4 million during the

amended Compact, only $3.0 million or 16.0 percent is due to federal employees. The

bulk of the additional cost thus remains with general fund and Compact sector funded

employees.

104. The FSM does not have an explicit wage rate policy, and, in the past, policy has

implicitly been determined by resource availability. Going forward, the nation would

Figure 27 FSM government employees and wage Bill, FY1995-FY2016

4,000

4,500

5,000

5,500

6,000

6,500

7,000

7,500

8,000

$30

$35

$40

$45

$50

$55

$60

Number

s of

Public

Ser

van

ts

Wag

e Bill US$ millions

Wage Bill

Publilc Servants

Policy Issues 47

benefit from an explicit policy, particularly as the annual decrement and lack of full in-

dexation erode the real value of the annual grants. However, holding nominal wage rates

constant would not be a desirable policy if the FSM wants to retain better qualified staff

and limit emigration. A policy of limited wage increases, offset by rationalization of the

workforce and efficiency gains, may be more appropriate in an otherwise ever-tightening

fiscal envelope. Such a policy has been implicitly integrated into the long-term fiscal

framework that is discussed in the following sections.

2 PUBLIC EXPENDITURE AND FINANCIAL ACCOUNTABILITY

105. In late 2010 the FSM invited PFTAC to assist the nation in the preparation of a

PEFA self-assessment for the national government. The PEFA is a framework for the as-

sessment of public financial management (PFM) that was developed by the World Bank

and a group of international donors in 2005 and has subsequently been updated (Public

Expenditure and Financial Accountability (PEFA), PEFA Secretariat, Washington D.C.,

2011 revised). It has been implemented in many countries around the world and provides

an objective yardstick by which countries can assess and improve their PFM perfor-

mance. The framework has six broad categories. Each of the six major areas is divided

into 28 high level indicators, which in turn are further subdivided. The scoring system is

based on international standards and provides a precise measurement system. The major

PEFA categories are as follows:

i. Credibility of the budget—the budget is realistic and implemented as intended;

ii. Comprehensiveness and transparency—the budget and fiscal risk oversight are

comprehensive, and fiscal and budget information is accessible to the public;

Figure 28 FSM public sector average wage costs by fund type, FY2004-FY2016

$5,000

$6,000

$7,000

$8,000

$9,000

$10,000

$11,000

$12,000

$13,000

$14,000

General Fund

Federal Programs

Compact Sector Grants


iii. Policy-based budgeting—the budget is prepared with due regard to government

policy;

iv. Predictability and control in budget execution—the budget is implemented in an

orderly and predictable manner, and there are arrangements for the exercise of

control and stewardship in the use of public funds;

v. Accounting, recording and reporting—adequate records and information are

produced, maintained and disseminated to meet decision-making control, man-

agement and reporting purposes; and

vi. External scrutiny and audit—arrangements are made for the scrutiny of public

finances and follow-up by the executive agents.

106. In 2011 the FSM underwent a formal, external PEFA assessment. A team of as-

sessors comprised of PFTAC, the World Bank, and members of the national government,

assisted by a PEFA expert, completed the assessment. Drawing from the formal assess-

ment the next stage was for the national government to compile a “roadmap”. The

roadmap was to identify areas in PFM that are in need of improvement and reform, and

focus efforts on the more critical components. Based on the roadmap a program of Tech-

nical Assistance was to be developed. However, since the PEFA assessment no further

progress has been achieved with implementation.

107. Recent EU proposals for budgetary support requires a PFM monitoring mecha-

nism as part of the grant conditions and the use of PEFA to evaluate performance. As a

result, it is understood the FSM will reengage in the PFM initiative and a further assess-

ment is to be made with PFTAC support late in 2016. However, while the adoption of

PEFA at the national government is to be encouraged and may fulfill the conditions for

release of funds, the federal nature of the FSM also requires a program of introduction at

the state government level, if it is to become an effective tool in PFM management.

3 FINANCIAL MANAGEMENT INFORMATION SYSTEMS AND PERFOR-

MANCE MANAGEMENT

108. The FSM adopted a strategic approach to implementing the amended Compact

sector grants expressed in the FSM Strategic Development Plan. The approach required

the allocation of resources in accordance with performance criteria to measure both the

delivery of services (outputs) and the results (outcomes) attained. However, the nation

was not well-prepared to implement the framework. While existing budgeting procedures

adopted a performance approach and specification of outputs, these were largely hypo-

thetical, as no monitoring or evaluation mechanism had been put in place. Although the

U.S has emphasized results and monitoring of outcomes, little emphasis has been placed

on deliverables, begging the question of how to respond to observed outcomes.

109. At the start of the amended Compact, the FSM had inherited a disparate set of fi-

nancial accounting systems in the five governments. It was clear that the old systems

would not be able to support the kind of financial and performance information required

Policy Issues 49

in the fiscal procedures of the amended Compact. Following a request for proposal

(RFP), and the implementation of a new financial management information system

(FMIS), all five governments were using the same system by FY2008. However, the im-

plementation of the system focused on the financial reporting requirements of the

amended Compact, rather than the fiscal management of the five governments, or perfor-

mance in service delivery. While the focus on financial and accounting requirements was

necessary, the systems now fail to provide the type of management information required

for fiscal and economic management, or measurement of outputs and outcomes.

110. Development of a software module (Integrated Planning and Budgeting (IPB) sys-

tem) to rectify these problems and to replace the existing stand-alone Budget Preparation

System (BPS) was under development for some time, but failed implementation in the

FSM governments with the exception of a test site in Pohnpei state. The existing FMIS in

use is reaching the end of its effective life with a lack of software support and upgrades

from the parent company and requires replacement. The implementation of a new system

will provide an opportunity to develop a chart of accounts that will enable improved Pub-

lic Financial Management (PFM), conform to GFS standards (IMF Government Finance

Statistics for fiscal management), and enable monitoring of deliverables or outputs (for

performance management).

B Fiscal Issues

1 TAX REFORM

111. Previous FSM Economic Reviews have discussed the tax reform proposal at

length. During the March 2015 session of the FSM Congress, the Unified Revenue Au-

thority (URA) Act was repealed and effectively terminated the decade-long attempt to re-

form the FSM tax system. With two FSM states failing to sign the reforms, the act of

Congress brought the process to a close. Tax reform has long been a central pillar of the

FSM reform agenda to replace an outdated and inefficient system, born out of the Trust

Territory days over 50 years ago. It was intended to provide a nondistortionary system

that would have created an enabling environment for private sector development. It was

also intended to provide a source of funds at the outset of the amended Compact and,

more recently, to address either the needs of the second or third tranche of the adjustment

required under the Decrement Management Process. A large amount of domestic and do-

nor effort has been applied to the tax reform initiative, and the final result—or, more ac-

curately nonresult—is a large disappointment.

2 CORPORATE TAX POLICY AND THE FSM DOMICILE

112. In FY2005 the FSM initiated the process of creating an attractive domicile for

Japanese captive insurance companies and other corporations. A corporate tax law, “In-

come Tax Regime for FSM Corporations,” was enacted that specified that companies in-

corporated in the FSM with a minimum equity of $1 million would be subject to a tax

rate of 25 percent. In FY2006 the FSM further enacted an insurance law that set the

ground work for establishing an environment attractive to the captive insurance market.


Since that time numerous amendments have been passed and the corporate tax rate re-

duced to 21 percent to ensure the FSM domicile remains compatible with Japanese law

and regulations. In essence, through differential tax rates, the FSM host environment pro-

vides an attractive domicile for Japanese captive insurance companies and other corpora-

tions. The establishment and subsequent steady growth of the industry has been sup-

ported by the Micronesia Registration Advisors (MRA), a private company that benefits

from a 40 percent share in the tax collected.

113. Before the FSM established the insurance law of 2006, Japanese-owned captive

insurance companies were primarily formed in the following captive domiciles: Ber-

muda, Hawaii and Singapore, even though there are dozens of U.S. states and several

other jurisdictions around the world that have laws and regulations that enable captive in-

surance companies. The competitive characteristics among these potential domiciles in-

clude industry infrastructure, regulatory environment, and access to reinsurance and in-

vestment markets.

114. Although Japan is the third-largest global economy in the world, there are only

approximately 110 Japanese-owned captive insurance companies. As of December 31,

2014, total worldwide captives totaled 6,8761 of which approximately 70 percent have

North American owners, 20 percent have European owners and the remaining 10 percent

have owners in other locations. The first Japanese captives were established in 1975 and

the numbers have grown rather steadily since then. Given the size and GDP of Japan

compared to the US and Europe, the primary reason that there are not relatively as many

captives as would be expected is largely because the tight-knit group of major Japanese

insurance companies have discouraged them in a variety of ways. In addition, certain

policy coverages which are popular with captives in US and Europe are partially covered

by government or not seen as necessary (e.g., workman’s comp and product liability).

115. There are currently about 60 jurisdictions around the world, including 30 US

States, that have established captive insurance regimes. Japanese captives have utilized

15 of those captive domiciles, including Bermuda, Hawaii, Singapore and since 2009 the

FSM. Because the FSM offers several advantages for Japanese over other domiciles (e.g.,

tax, FX, proximity, culture, and cost), the FSM is now serving the second largest number

of Japanese captives and is expected to pass up Bermuda in the next couple of years. In

fact, in the last seven years since the FSM promulgated captive regulations, it has at-

tracted more than 80 percent of all Japanese captives that have either recently established,

redomesticated or relocated domiciles. The FSM now has 18 licensed captives.

116. Captive insurance companies typically provide commercial insurance to its parent

company and the parent’s subsidiaries and affiliates. Depending on insurance rules at the

location of the parent, or for international companies the location of the risk, a captive

may be able to provide insurance directly to the parent company. In most instances (as is

1 AM Best 2015 Captive Review, Business Insurance Annual Captive Update, April 1, 2015

Policy Issues 51

the case in Japan), the captive insurance company provides reinsurance through an exist-

ing primary insurance company, also called a fronting company. The parent company of

the captive will negotiate with the fronting company to secure the amount of premium

that will be sent to the captive insurance company. The captive will then share claims

with the fronting company in direct proportion to the sharing of premiums. A captive is

used as a risk management and risk financing tool to reduce the overall cost of insurance

for the parent company. The captive can control the amount of risk it retains by purchas-

ing its own reinsurance, called a retrocession agreement. This will limit the amount of

risk that the captive insurance company will carry and, thus, the maximum claims they

might have to pay. Captive insurance companies are most often used to provide property

insurance, liability insurance and marine insurance.

117. In 2016 the FSM marked its tenth year as a captive insurance domicile. Since

2006 the FSM government has worked closely with Micronesia Registration Advisors

(MRA) to steadily grow the captive insurance industry in the FSM. Regulatory oversight

of the captive insurance industry in the FSM lies with the insurance commissioner, who

reports to the Insurance Board. The majority of the captive industry infrastructure is made

up of international service providers located in Guam, Hawaii, Japan and Singapore.

These service providers include captive managers, audit firms and actuaries.

118. The net receipts received by the national government (after deduction of the MRA

fee) rose from an initial value of $34,000 in FY2008 to $4.4 million in FY2013 and

peaked at $27.6 million in FY2014 and in FY2015 return to the more normal level of re-

ceipts of $4.1 million. The extraordinary value received in FY2014 was due to a $20 mil-

lion declaration of capital gains by an individual company and did not signify a trend in-

crease. However, the nature of the industry is such that periodic large receipts can be an-

ticipated from time to time.

119. The potential for future development of the captive industry is considered as

bright by industry representatives. As one of the leading captive domiciles for Japanese-

owned captives, the FSM is usually now evaluated as an option during a captive feasibil-

ity study. However, while the FSM has the opportunity to become a major domicile for

Japanese-owned captive insurance companies, the nature of the business is such that cap-

tives can very easily locate to alternative domiciles should the environment become unat-

tractive. The national government of the FSM thus needs to continue to work closely with

its advisors and ensure that the legal, regulatory and overall business environment for the

captive insurance market continues to adjust to remain competitive for the industry to

prosper in the future.

120. A particular threat to the sustainability of the FSM domicile is the lack of progress

of the FSM to join the Global Forum and satisfy Phase 1 of the peer review assessment.

The Global forum is group of 134 members that are working under guidance of the

OECD to create a transparent environment among nations to share information in the tax

area. A Phase 1 review of the FSM was conducted in 2012 and the results were published


in April 2014. In June of 2016 the OECD agreed on criteria for assessing non-compliance

and the FSM was determined non-compliant. In order to achieve compliance, the FSM

would be required to: (i) make changes to existing law, most importantly enact the new

Corporations Law to replace the outdated Trust Territory regulations, (ii) join the Global

Forum, (iii) sign the Convention. The OECD Convention on Mutual Administrative Mat-

ters in Tax Matters is a comprehensive instrument available for all forms of tax co-opera-

tion to tackle tax evasion and avoidance. The multilateral nature of the Convention elimi-

nates the need for bilateral tax treaty agreements. A nation must be a member of the

Global Forum before signing the Convention. Any two of the requirements listed above

would be deemed as being compliant and prevent the FSM being placed on the “black-

list”. Precise timing of the blacklist seems uncertain although the OECD has indicated it

wishes all countries to be compliant by July 2017.

121. In June 2016 there was a front page article on the Nikkei Shimbum reporting that

based on a 2015 assessment Panama, Micronesia and Indonesia would be blacklisted.

While there were inconsistencies in the article, the implications of being placed in the

same group as Panama would be damaging to the FSM’s reputation and international

standing. MRA has indicated that it has had many inquiries from the FSM’s clients and

any inclusion on this list could potentially freeze, or kill the FSM domicile and Captive

Insurance Industry. To comply with the requirements would not seem onerous. The cost

of membership of Global Forum is about $26,000 per annum plus expenses, and to sign

the convention requires a request to the members of the Global Forum, acceptance by the

members, and invitation from the Forum. Implementation of the new law on Corpora-

tions, which has in any case been underdevelopment plus any amendments required for

Phase 1 compliance, should be treated as urgent. Overall the costs of compliance would

seem small in relation to the potential loss of the FSM domicile. Once Phase 1 is com-

plied with, the FSM would move onto the Phase 2 Peer Review during the second half of

2018.

122. A last point of note is that given both the inherent risk in the business and the vol-

atility of the annual receipts, revenues should not form part of core government opera-

tions. Rather, the revenues received should be earmarked for the FSM Trust Fund, given

the anticipated shortfall in the Compact Trust Fund after FY2023. In that regard, the na-

tional government deposited the FY2014 $20 million windfall in the FSM Trust Fund,

which that was a prudent and welcome first step. Another thorny issue remains: the ques-

tion of sharing receipts with the state governments. So far the receipts have not been sub-

ject to revenue sharing, although the legality of this position is open to question. At the

current time the main location of the MRA is in Pohnpei, although the company has es-

tablished an office in Chuuk. This has the potential to become a divisive issue, with the

states competing to provide the most attractive domicile, while possibly discouraging

new captives from entering the domicile if the FSM domicile appears to Japanese corpo-

rations and their technical advisors to be rife with internal legal disputes. For the benefit

of the FSM as a whole, a suitable accommodation between the national and state govern-

ments that preserves and advances the competitiveness of the domicile needs to be found.

Policy Issues 53

Deposit of the proceeds in state sub-accounts of the FSM Trust Fund, in proportion to the

traditional sharing formula, would be one solution for the foreseeable future.

3 EXTERNAL DEBT MANAGEMENT AND POLICY

123. While the analysis conducted in the Chapter 1 of the FSM external profile pre-

sented a favorable, recent Debt Sustainability Analysis (DSA) conducted by the

IMF/World Bank1 has classified the FSM as being at “high risk of debt distress.” The re-

sult follows from the standard DSA model, which assumes that any fiscal shortfall results

in debt financing. The projections are based on insufficient yields from the Compact

Trust Fund after FY2023 to support prevailing levels of public service delivery. As a re-

sult, large fiscal deficits require external financing. This analysis is misspecified. While

the FSM may be subject to large fiscal shocks post FY2023, the nation has no recourse to

international capital markets or persistent borrowing from donors and therefore would not

be able to finance fiscal shortfalls by incurring unsustainable levels of external debt. Fis-

cal adjustment would be unavoidable, and the ensuing fiscal compression would present a

serious challenge, but not through the channel of debt distress.

124. The IMF/World Bank DSA thus appears to be misspecified and is an example of

application of a generic debt sustainability model under circumstances that are not appli-

cable to the FSM case. As a result of such analysis countries may be declared as “grant

only” indicating that they are only eligible for grants and not loans from the donor com-

munity. While such designation may be favorable for such projects as the World Bank

ICT reforms, which currently entail $47.5 million of grant funds, others such as a pro-

posed loan to the Pohnpei Ports Authority from the ADB may not. It is unclear at the pre-

sent time whether the FSM has been declared grant only by the ADB and that designation

is still pending. While there are benefits to being “grant only” with increased grant fund-

ing, there are costs in ineligibility for loan funding of large infrastructure projects.

125. While a well specified assessment of the FSM’s external debt would find that the

FSM is not at “risk of debt stress,” a recent audit conducted by the FSM public auditor

with support of the ADB2 found the absence of a public debt policy and debt manage-

ment and as far from satisfactory. The goal of the audit was:

“To enhance transparency and accountability in FSM’s management of public

debt and assist the policy makers institute necessary and legal and institutional re-

forms in order to strengthen public debt management, enhance the sustainability

of public debt and reduce its vulnerability to international financial shocks.”

1 Staff report for the 2015 Article IV consultation—Debt Sustainability Analysis (DSA), International

Monetary Fund, April 2015. 2 National Public Auditor, “Audit of the Public Debt and Institutional Framework,” Report No. 2014-07,

Palikir, Pohnpei, FSM, 2012.


The debt audit concluded that the “FSM’s legal and institutional framework lacked per-

manent and necessary provisions to implement adequately the system of debt manage-

ment.”

The audit established a series of weaknesses that included:

Out of the FSM’s external debt of $90 million, a significant amount-$21 million-

had been spent on failed or only partially successful projects.

No assessment was regularly made on the sufficiency of the Sinking Fund, estab-

lished to repay government debt.

The legal system lacked provisions to enable implementation of a sound debt

management system.

Institutional capacity to implement an effective debt management system was lim-

ited.

There was an absence of risk analysis of national government guaranteed debt.

Public information on public debt and borrowing activities was lacking.

126. Relating to the findings a series of recommendations was made. These included:

Improvement of management functions in project appraisal and implementation;

Improvements in the management of the Sinking Fund;

Improvements in the legal framework for debt management, including the devel-

opment of a debt management strategy;

Improvements in the institutional framework for debt management, including the

creation of a debt management advisory committee;

Limits on states and state-owned enterprise debt; and

Enhancement of transparency and accountability in debt management, including

reporting and publication.

127. In other words, the ADB-supported audit recommended the development of a

thorough overhaul of the legal and institutional framework governing the incurrence of

external debt and its management. While this review has argued that external debt sus-

tainability in the financial sense is not an issue of immediate concern, the recommenda-

tions of the ADB-supported audit are fully endorsed. The absence of a debt management

strategy and project appraisal capacity has led the FSM to incur debt that would probably

not have been incurred otherwise, despite the ADB having recommended much of the

debt in the first instance. The inadequacy of the FSM external debt sinking fund likely

would not have arisen if proper rules and reporting on the management of the fund had

been in place. A Debt Management Advisory Committee was recommended by the audit

and was subsequently created. In response the ADB funded follow-up technical assis-

tance to further develop the legal and institutional reforms required.

Policy Issues 55

128. A Bill was drafted in 2015 entitled the FSM Public Debt Management Act, whose

main purpose was to promote sound public financial management to ensure debt sustaina-

bility, transparency and accountability. The Bill provides authority to the FSM Congress

over sovereign debt, which includes direct loans to the national government, guaranteed

debt, and on-lent loans primarily to state governments. Borrowing is to be restricted to

revenue-generating capital projects for priority infrastructure and development initiatives.

Debt to fund budget deficits is prohibited unless exceptional circumstances defined in the

Act are met. A sinking fund is to be set for the repayment of debt. The Secretary of Fi-

nance of the national government would be responsible for the implementation of the bill,

and required to:

Develop and implement a debt management policy,

Review every borrowing proposal and determine the fiscal and economic implica-

tions,

Establish standards of good governance in the execution of public debt and inte-

grate with the respective government departments and agencies,

Establish internal controls,

Provide an annual report on public debt, and

Undertake a Debt Sustainability Analysis.

129. The bill provides for the formal establishment of the Debt Management Advisory

Group, and would be comprised of civil servants, but representation from financial insti-

tutions is absent. The responsibilities of the group are to provide technical discussion of

each proposed borrowing, quality assurance, and review the DSA drawing on experts if

required. In general, the bill seems to remedy the deficiencies of the Public Auditor’s re-

port and establish a sound basis for external debt management. Implementation of the

new bill will require significant capacity building in the Ministry of Finance and should

be supported by technical assistance in the early phases to ensure sound procedures and

regulations are established.

4 SOCIAL SECURITY SUSTAINABILITY

130. Based on the actuarial evaluation completed in January of 2012 relating to

FY2011 and again in FY20141, Table 9 indicates the status of the valuation of the Social

Security fund. The accrued liability, in respect of active workers, retirees and other bene-

ficiaries and inactive workers, was $308 million as of 2014. The value of the assets of the

fund were valued at $49 million indicating an unfunded liability of $258 million. The

funded ratio of assets to liabilities represented 16 percent. This is below Palau which has

a funded ratio of 41 percent and that of the RMI is 26 percent. However, while the RMI

Social Security Fund is in danger of collapse, the FSM system, despite the very low

1 Pacific Actuarial Services, FSM Actuarial Valuation, January 2012; Nichols Actuarial Consulting, Ac-

tuarial Valuation, January 1 2014.


funded ratio, has a closer match between projected benefits and contributions and is thus

more sustainable.

131. Effective from January 1, 2013, the law was amended to improve the viability of

the fund and adjust the benefits for changes since the last legislative action taken by the

FSM Congress. Taxable earnings were raised by $1,000 to $7,000 per quarter and are

scheduled to rise by $1,000 per quarter every five years until a maximum of $10,000 is

reached. The current retirement age of 60 was raised to 65 in October 2015, although

those over 60 years of age may take 50 percent of benefits upon reaching age 60. Further

the FSM Congress has contributed $1 million per annum to shore up the status of the

fund.

132. A projection of the likely growth of the contributions, benefits and fund status is

shown in Figure 29. The estimates for benefits adopts the projections provided in the

Table 9 Social Security valuation during 2011 and 2014 (US$ millions)

2011 2014

Active Workers Earning Benefits 138.8 128.3

Retirees, Spouses, Children, and Disabled Workers Receiving Benefits 110.4 129.2

Fully or Service Insured Inactive Workers Entitled to a Future Benefit 38.6 50.1

Total Accrued Actuarial Liability 287.8 307.6

Market Value of Assets -42.4 -49.1

Unfunded Actuarial Accrued Liability 245.4 258.5

Funded Percent 15% 16%

Figure 29 Social Security fund balance, contributions and benefits, FY2013-FY2025

$0

$5

$10

$15

$20

$25

$30

$35

$0

$10

$20

$30

$40

$50

$60

$70

$80

$'s M

illions

$'s m

illions

Fund Assets

Benefits

Contributions

Policy Issues 57

2014 actuarial report, while the value of contributions uses the projections of compensa-

tion of employees generated in this review. The annual change in wages is estimated at

2.9 percent, which is considerably lower than the actuarial assumption of 3.3 percent,

which would appear optimistic. A market rate of return of 6.5 percent was adopted, com-

pared with 7.5 percent used in the actuarial report. This is closely aligned with the return

on the Compact Trust Fund simulations in Chapter 3. As Figure 29 indicates, projected

contributions and benefits are relatively well balanced in the early years, but after

FY2019 they start to diverge, when benefits grow more rapidly than contributions. The

difference is made up from earnings on investments and contributions by the FSM gov-

ernment, but from FY2023 the Fund corpus starts to fall. This indicates that at some point

in the future further adjustments to the system will be required if it is to maintain sustain-

ability. The projections are, of course, subject to market risk, which may result in a less

favorable outcome.

C State-Owned Enterprises (SOEs)

133. Analysis of the SOE sector in the FSM has not until the FY2014 Economic Re-

view been part of the annual review. In part this absence stemmed from the relatively low

fiscal burden and risk to financial stability of the sector compared with other policy is-

sues. During Compact I there was a blossoming of the public investment in the fisheries

sector, reflecting the aspirations of the newly independent nation to transform its econ-

omy. Although these investments, some of which were supported by the ADB, were an

unmitigated failure, all have now become defunct or are now under private ownership or

management. The utility sector, power and telecom, also grew at the start of the amended

Compact, reflecting the transformation from government departments to SOEs. After

fisheries was restructured, the SOE sector stabilized in size and contribution.

134. The FSM Strategic Development Plan of 2005 identified 22 major SOEs operat-

ing in the financial sector, utilities, fisheries, and miscellaneous activities, and has

changed little to this day. In FY2015 the sector employed an average 794 people (5 per-

cent of the labor force) and contributed $33 million to GDP (10 percent.) Overall the sec-

tor required annual operating subsidies of $1.8 million to support operations, 0.6 percent

of GDP. Salaries are 2.67 times the private sector average. However, despite the apparent

low fiscal cost, nearly all SOEs post recurring losses. Losses are sustained through ero-

sion of the capital base. In effect, a positive cash flow is maintained through a lack of

provision for capital replacement. Failure to adopt policies of full-cost recovery force in-

efficient operation on utility managers, and the FSM states experience frequent power

outages and disruptions.

135. In the early 2000s the ADB supported a TA1 to assist the FSM in the review and

reform of the SOE sector. While a valuable benchmark study was conducted, no direct

reforms took place. Instead, the TA proposed an institutional structure for reform and

1 Project No. 3201-FSM, Privatization of Public Enterprises and Corporate Governance Reform, 2001,

Pohnpei


identified suitable candidates for transformation. The findings and recommendations

were, however, to form part of the 2003 ADB Private Sector Development Program re-

form requirements, which included: (1) preparation of master plans for SOE reform for

submission to each government; and (2) transformation of at least one enterprise. How-

ever, the ADB program was not a success, and no significant re-structuring was under-

taken. No further SOE reform initiatives have been considered, and there is no SOE pol-

icy or legislation.

1 FSM TELECOM AND ICT REFORM

i FSM Telecom

136. The telecom sector in the FSM consists of one main provider, FSM Telecommu-

nications Corporation, which was established in 1983 as a state-owned enterprise of the

national government. There are no other private sector competitors or service providers.

FSM Telecom provides GSM mobile, fixed line, internet, and digital TV services. Major

capital investment was undertaken in 1990 through a loan of $32 million from the U.S.

Department of Agriculture Rural Utility Service (RUS). The loan provided the funds to

invest in basic telephone infrastructure through the provision of copper wire to communi-

ties in the main centers of the four FSM states. During the 1990s and 2000s FSM Tele-

com performed well financially and accumulated a growing pool of cash reserves.

137. In FY2009 the U.S. government was laying the infrastructure for a fiber optic

connection from Guam to the military base on Kwajalein atoll. This provided the oppor-

tunity for the FSM to connect to the internet backbone of Pohnpei at relatively low cost.

FSM Telecom extended the RUS loan by a further $12 million and drew down on its cash

reserves to finance the cost of the new fiber connection. However, despite the new inter-

net services being provided, total revenues were not growing. Mobile cell phone revenues

had peaked by FY2010, and the growth in internet services was offset by a reduction in

overseas calls due to new services such as Skype and texting. With increased debt servic-

ing cost, an enterprise that had operated a positive net operating income and net income

balance had now moved into deficit territory.

138. Figure 30 displays these results. In the early part of the amended Compact, the en-

terprise was maintaining positive net operating and income balances, although the trend

in this pre-internet era was downward, and both measures were turning negative in

FY2007. In FY2010 the new fiber optic connection was installed, and FSM Telecom was

required to finance larger debt servicing commitments on the loan extension. By FY2011

net operating income and total net income had bottomed out and were recording negative

flows of $1 million and $2 million, respectively. Cash flow, on the other hand, remained

positive, although it was considerably below the strong position of the early period. In es-

sence, after taking into account debt amortization and adding back deprecation, the cor-

poration has held its head above water, albeit barely. However, the capital base has been

quickly eroding, and total assets have fallen $16 million, from $65 million to $49 million,

since FY2010.

Policy Issues 59

139. The story is an interesting one. Even though it is a monopoly provider, FSM Tele-

com has been unable to generate a profit in recent years. Despite its competitive prices,

by regional standards, for mobile and internet services, two factors—changes in technol-

ogy and the small size of the FSM market—have hampered revenue growth. FSM Tele-

com introduced a 3G service in FY2014 and is looking to move into 4G LTE. Market po-

tential for this type of service is not proven in the FSM, although it is a fast growing mar-

ket internationally. Whether this will provide the revenue boost that is needed is uncer-

tain. While pricing may be competitive, the cloistered nature of FSM Telecom’s pro-

tected position would not have encouraged a lean and efficient organization. Cost saving

and productivity enhancing measures should be examined, especially in the payroll area,

which represents a high component of total cost.

ii ICT Reform

140. During 2013 the World Bank initiated a series of ICT reforms as part of its Pacific

regional initiatives. In the FSM, the World Bank noted that internet penetration outside of

Pohnpei was very limited, with Chuuk, Kosrae and Yap served by high cost satellite con-

nections. In order to encourage greater access to the internet for all communities in the

FSM, the World Bank drafted a project1 to provide fiber connections to Chuuk and Yap,

and internet access to Kosrae on similar terms as those in the other FSM states. A project

was prepared with $47.5 million in IDA grant financing that included $22.5 million for

the Yap connection, $18.5 million for the Chuuk cable spur from Pohnpei, $3.5 million

for Kosrae, and $3 million for technical assistance and project management support.

1 World Bank, Project Appraisal Document (PAD), 76896-PW, Washington D.C., 2015

Figure 30 FSM Telecom net operating income and cash flow, FY2004-FY2015

-4.0

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

Net operating income

Net income

Cash flow


141. The Yap component of the project is to be part of a regional consortium providing

a fiber connection to both Yap and Palau. The regional aspect of the project enables ac-

cess to the FSM from both country and regional IDA funds, in an amount greater than

would otherwise be available. A total project funding for the Palau-Yap hook up of $47.5

million has been provided, with $25 million of co-financing available from the ADB for

Palau. Final project costs may be reduced considerably, depending on the nature of the

cable connection.

142. As part of the ICT reforms, the project entails market liberalization and opening

of the FSM telecom market to competition to encourage greater efficiency and affordable

services to the public. As a result the FSM issued a National Information and Communi-

cation Technology Policy in September 2012, which called for sector reforms to increase

greater private sector participation and investment in the provision of ICT services. In

April 2014 the FSM Telecommunications Act was enacted, giving effect to the ICT pol-

icy. The new law ended FSM Telecom’s right as sole provider and allowed for licenses to

be issued to new network operators and other service providers. The law envisages that

FSM Telecom would be one of a number of service providers and that the market would

be regulated by an independent entity to ensure a level playing field and fair access to

shared infrastructure. The World Bank indicates that the FSM law provides a modern

framework for ICT consistent with international “best practices.”

143. An important element of the reforms is the creation of an FSM cable company to

be an Open Access Entity (OAE) for the sale of band width to the FSM market on a fair

and equitable basis to all service providers in the FSM. The new OAE would take owner-

ship of the new fiber connections together with the existing HANTRU cable to Guam. In

compensation for the loss of the asset, FSM Telecom would be relieved of the existing

RUS debt associated with the cable purchase. However, the consultants contracted to sup-

port the process recommended that FSM Telecom become the OAE provider, rather than

an independently created SOE. The consultants indicated that this would provide a more

efficient institutional structure, with several competitive operators purchasing bandwidth

from FSM Telecom. However, the World Bank rejected this concept as they determined

it undermines the principle of a competitive market place. While it is not a condition of

release of the World Bank grants, if the FSM fails to create the OAE, Telecom is commit-

ted under the new law to provide bandwidth free of charge to all other telecom service

providers.

144. Connectivity of Yap and Palau to the internet will be provided through the South-

east Asia-United States cable consortium (SEA-US) that is laying the fiber between Indo-

nesia, the Philippines, Guam, Hawaii and the U.S. mainland. The current timing has pro-

vided a golden opportunity for Palau and Yap to build spurs to the SEA-US fiber at low

cost, in a timely fashion, and with assured cable maintenance afforded through an inter-

national consortium. However, for release and drawdown of the funds from the World

Bank, the FSM must operationalize the office of the Independent Regulator before the

consortium commences construction in January 2017; so the clock is ticking.

Policy Issues 61

145. The recent ICT reforms initiated by the World Bank with $47.5 million in grant

funding have set in motion a series of changes with a momentum that will be hard to de-

rail. Further, the World Bank is considering an additional cable project connecting Nauru,

Kiribati, and Kosrae to Pohnpei. It is clear from the foregoing analysis on FSM Telecom,

that while it provides services at competitive prices compared to neighboring Pacific Is-

land economies, there is significant scope for efficiency gains. Restructuring services to

reduce operational costs will be required if the entity is to emerge as an efficient and

competitive market operator. Without reform and true openness to competition, the trends

indicated in Figure 30 are likely to prevail, with FSM Telecom cash flow crossing into

negative territory and the entity facing a pathway from illiquidity toward insolvency.

2 FSM PETROLEUM CORPORATION

146. Not long after the start of the amended Compact, it became clear that Mobil Oil

Micronesia (MOMI) intended to reduce its presence in the Micronesian region. Although

operations in the Republic of the Marshall Islands (RMI) would remain under Mobil con-

trol, the company would divest its interests in the FSM and Palau. Operatons in Palau

would be transitioned to the private sector, while in the FSM they would be conducted by

a state-owned enterprise. The FSM Petroleum Corporation was created by public law in

September 2007. FSM PetroCorp became functional in Chuuk, Pohnpei and Yap in 2008

and took over operations from Micronesian Petroleum Corporation in Kosrae in 2009.

147. During its first seven years, FSM PetroCorp has seen the successful emergence of

an efficient operation, replacing the former international oil company. Initially financed

with a $10 million loan from the Bank of Guam and FSM Development Bank guaranteed

by the national government, FSM PetroCorp quickly paid down its loans. The corporation

began to expand its asset base from $14 million in 2008 to $47 million in 2015. Figure 31

indicates the profitability of the initial years of operation. Apart from a spike in opera-

tions in 2009, the corporation has generated net operating profits averaging greater than

$4 million per annum, and a similar level, after allowing for nonoperational expenses,

such as interest payments on debt, that have fallen with debt repayment. The rate of re-

turn on assets has declined over the period, while stabilizing FY2015. Rather than repre-

senting a decline in the numerator, net income, this reflects a rise in the asset base. Accu-

mulation of a static profits and re-investment in the asset base leads to a decline in profit-

ability ratios.

148. Clearly, FSM PetroCorp is a monopoly business and, unlike FSM Telecom, oper-

ates in an environment of inelastic demand for its major product, petroleum goods. The

pricing policy was designed to be competitive with neighboring Micronesian islands and

targets a ¢45 margin on Guam prices. This was not achieved in 2015 due to falling fuel

prices and policy to build up reserves to cushion future increases in price. During a recent

visit prices in Pohnpei were found to be higher than those in Palau, which has a similar

tax structure but different cost structure. PetroCorp targets a 10 percent rate of return on

investment, which has largely been achieved, but, unlike its predecessor MOMI, there is

no hidden cross-subsidization of different product markets.


149. After a successful launch of the new business, the declining profitability indicates

the dilemma facing the corporation. Company policy has been to re-invest savings in

fixed asset rehabilitation and diversification away from fuel and expansion of operations

outside the FSM, rather than payment of dividends. Reflecting these policies, the corpo-

ration diversified its activities, setting up terminal operations in Guam to supply fuel to

the Guam Power Authority. Clearly, this is a sign of the good reputation of PetroCorp. In

2015 PetroCorp took over fuel supply operations in Nauru, extending its reach farther

into the region. The Guam and Nauru operations are conducted under a subsidiary, Vital

Energy, Inc.

150. However, while regional diversification into established lines of business would

present a relatively low risk policy for productively using unemployed capital, diversifi-

cation into nontraditional markets raises questions. In September 2014 the operations of

the FSM Coconut Development Authority (CDA), a national government SOE, were

transferred to PetroCorp. While relying on national government subsidy, the CDA was

constrained by limited funding. However, plans to restructure the coconut oil business,

invest in new coconut processing facilities, and diversity into niche market coconut prod-

ucts, is a high risk venture that has failed to bear fruit in other Pacific Island communi-

ties. While there is no cost of the raw input (coconuts), and bringing economic livelihood

to the outer islands of the FSM is an important social objective, experience has shown

that the basic economics of coconut diversification have been difficult to realize.

151. In addition to coconut operations, PetroCorp operates an independent 2.0 MW

power plant in Pohnpei, to ameliorate the disastrous policies adopted by the state, Petro-

Corp has also expressed interest in pursuing power generation in Chuuk. Power produc-

tion in the FSM has been subject to a lack of full cost recovery pricing imposed by state

Figure 31 FSM PetroCorp: net operating income, $’millions and return on assets, per-

cent, FY2008-FY2015

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

$0

$1

$2

$3

$4

$5

$6

$7

$8

Net operating income

Net income

Rate of Return on Assets

Policy Issues 63

legislatures (or utility commissions) on utilities, and subsequent implications for plant

maintenance. As a result, power outages are suffered virtually on a daily basis in

Pohnpei. There appears to be a belief that a successful, well-run enterprise like PetroCorp

can resolve an ailing domestic power industry. However, the failure of the FSM utility

sector is in large part due to political interference in tariff setting, rather than weak man-

agement.

152. PetroCorp has established itself as a successfully run SOE, arguably the only one

on a sustained basis in the FSM. However, caution should be exercised before expanding

into nontraditional markets, where risks are very large, and political considerations rule

the day. It would be better for an entity—albeit a public enterprise—with successful but

limited sustainable management capacity, to continue consolidating its strengths and con-

sider paying a dividend to its primary shareholder as is typically required of monopoly

enterprises in healthy, well-regulated SOE sectors.

D Compact Issues

1 ADJUSTMENT TO THE AMENDED COMPACT

153. After renegotiating the amended Compact with the United States, the FSM was

left with a set of fiscal adjustments. First, the amended Compact entailed an 8 percent de-

cline in funding, from $83 million to $76 million. Second, the switch from general budg-

etary support to a sector grant approach meant that there was a shortage of domestic reve-

nues to fund non-Compact sector operations, such as administration, law and order, pub-

lic works and transportation. In the interim, the U.S. agreed that the FSM could use the

capacity-building sector grant to fund operational activities listed under the grant, pro-

vided that the FSM agreed to phase out these activities over a five-year period. Third,

those activities that were not listed under the capacity-building grant required immediate

adjustment. Fourth, the U.S. required that 30 percent of Compact resources be devoted to

infrastructure. Fifth, the annual decrement and partial inflation adjustment required long-

term fiscal adjustment to the decline in the real level of Compact assistance, amounting to

approximately 2 percent per annum. And finally, the loss of the Compact I energy grant

meant that in certain states, utility corporations were forced to raise prices to cover costs

that had previously been subsidized. The second and fifth of the above adjustment issues

are discussed below.

154. The need to phase out the use of the capacity-building grant for nonconforming

purposes required painful adjustments: expenditure cuts entailing a substantial loss of

jobs as well as additional revenue efforts. The governments of Chuuk and Kosrae were

required to make severe expenditure cuts. In the most extreme case, Kosrae was required

to curb non-Compact expenditures by 32 percent. This was achieved by eliminating 110

positions, enacting an across-the-board pay cut, reducing nonpayroll costs and increasing

taxes. In Chuuk the compression was 28 percent, and 317 public service positions were

eliminated. In Yap the financing gap was 19 percent, but the state has adjusted by holding

operational expenditures within current revenues and funding nonrecurring and capital


projects through the use of the state’s reserves. Only Pohnpei and the national govern-

ment have been spared the need to phase out the nonconforming uses of Compact funds.

2 DECREMENT MANAGEMENT

155. With near-term adjustment to the amended Compact complete, attention switched

to the impact of the lack of full indexation and annual decrement on fiscal management

during the remaining years of the amended Compact, which equates to an annual average

real decline of 2 percent. This represents a real resource loss of 0.5 percent of the current

value of GDP each year. The amended Compact was specifically designed to avoid the

large impact of each five-year decrement of Compact I funding and thus ease the process

of adjustment. However, the relatively small adjustment of 2 percent per annum cannot

be easily achieved year-to-year on a long-term basis without distorting the delivery of

public services or the cost structure of government. Recognizing the impact of the annual

real decline of Compact resources, JEMCO adopted a resolution (JEMCO 2009-2) in

September 2009 that subsequently became known as the “decrement” management plan:

JEMCO resolves that the FSM National and State Governments shall develop plans

for managing annual decreases in Compact direct assistance and/or general fund

support, and shall use those plans as the basis for Fiscal Year 2012 budget deci-

sions. The plans should include an evaluation of the ability of the health and edu-

cation sectors to fulfill their strategic outcomes in fiscal years 2012-2014.

156. The FSM initially rejected the need for a decrement management plan and chose

not to comply with the JEMCO resolution. During the following annual JEMCO meeting

in 2010, an extended version of the original resolution was adopted, requiring the prepa-

ration of a report in greater detail, to cover the remaining period of the amended Compact

through FY2023. The resolution specified a participatory approach, inclusive of policy

makers at all levels of government and across all sectors.

157. As a result of the 2nd JEMCO resolution, the FSM began the preparation of a

long-term fiscal framework (LTFF), and convened a National Economic Symposium

(NES). The LTFF was prepared by the Office of Statistics, Budget and Economic Man-

agement, Overseas Development Assistance, and Compact Management (SBOC). The

NES was convened in February 2011 and was widely attended with the participation of

the FSM leadership. Four resolutions were endorsed by the NES, including adoption of

the LTFF, which was to be returned to the states for their endorsement.

158. However, the states did not endorse the LTFF. At the FY2012 JEMCO meeting,

the states indicated that the national government LTFF had been drafted without adequate

state-level consultations and did not reflect their priorities or needs. In the absence of a

credible LTFF, a new process was initiated with the prime intention of ensuring that the

final product or LTFF had state-level participation and reflected local priorities.

Policy Issues 65

159. A series of state leadership meetings were accordingly convened. Each state was

informed that the annual decrement and lack of full indexation amounted to a roughly 20

percent real cut in the sector grants over the FY2013-FY2023 period: approximately 2

percent per annum. The initial task falling on each state was to prepare budgets as if the

20 percent reduction would be effective from FY2014. The leadership meetings were re-

quired to prioritize the budgets prepared by each department/agency, ranking the order of

the cuts from highest to lowest priority. However, it was not intended that the 20 percent

cut would take place immediately in FY2014, but rather in a set of three tranches of 6

percent each over a three-year period (see Figure 32). Each state was then requested to

identify the initial three-year cut of 6 percent, which would be a firm commitment and re-

flected in the FY2014 budgets submitted to JEMCO.

160. It was envisioned that the leadership process would be repeated in three-year in-

tervals. Identification of specific budgets and priorities over a 10-year horizon was not re-

alistic, as many factors and circumstances would be subject to change. Reassessment and

prioritization over a three-year, medium-term horizon was considered more appropriate.

It was further indicated that if offsetting revenue measures were identified and passed

into law, such as the FSM-wide tax reform or “burden sharing” with the national govern-

ment, the cuts in future rounds could be relaxed.

161. The intended LTFF provides for some inflation adjustment in the intervening

years. Since the Compact allows for partial inflation adjustment, the nominal value of the

annual sector grants remains relatively static: the annual decrement would be offset by

the inflation adjustment. Thus, after each initial cut of 6 percent in the first year of each

three-year cycle, some allowance—up to 2 percent—can be permitted in each of the fol-

lowing two years. It can be seen that the issue of wage policy discussed above can be ac-

commodated within each of the three-year cycles through modest adjustments.

Figure 32 LTFF three-year adjustment cycles, constant prices (US$ millions)

$75

$80

$85

$90

$95

$100

$105Three year 6% budget cuts Annual 2% dilution of sector grants


162. In June of 2012, Kosrae state was the first to complete the process with leadership

endorsement. Yap state was to follow in July, and Chuuk undertook the process in Au-

gust, with Pohnpei following in January 2013. The LTFFs prepared by the states formed

the basis of the FY2014 budget requests presented to JEMCO. No formal review of the

efficiency of the LTFF process in addressing the decrement issue has been undertaken.

While it could be argued that “dilution” remains evident behind many of the expenditure

cuts, the process did provide a participatory approach to prioritizing expenditures in a

comprehensive way.

163. While the FSM states completed their LTFFs, the national government argued

that a national LTFF was not required, since it faced completely different fiscal circum-

stances. However, a major element of the discussion at the state level LTFF meetings was

the contribution that tax reform and burden sharing could make to assist the states in

maintaining services as Compact resources declined. The requirement of the national

government LTFF was therefore quite different from that of the states. Sharing of buoy-

ant unrestricted national revenues would go a long way in solving the decrement issue at

the state level. The envisioned national government LTFF was thus intended to be a plan

for distribution of revenue and not like those of the FSM states, which were designed to

reduce and consolidate expenditures.

164. Reflecting the national government’s position to not prepare an LTFF, no alloca-

tion for Compact sector grants was made for FY2014, with the exception of the continu-

ing operational grants to the College of Micronesia (COM), which are programmed to de-

cline by $700,000 a year until reaching $1 million in FY2017. The release of Compact

resources by the national government has been held in reserve and will assist the States to

offset the 2nd tranche adjustment in FY2017. However, the FY2017 budget allocations

have included the full national government share, representing an increase of 9 percent of

existing state level funding, with no allowance for future decrement or partial inflation

adjustment. The budgets for FY2018 and FY2019 will thus remain flat in nominal terms

without any increase for inflation as envisaged under the LTFF process, and will again

raise the issue of dilution. The FY2017 budget should have programmed a 3 percent cut

(9 – 6 percent) and allowed for an annual 2 percent inflation (as under the LTFF method-

ology) for the following two years (FY2018 and FY2019).

3 INFRASTRUCTURE DEVELOPMENT AND ECONOMIC GROWTH

165. Delayed disbursement of the Compact infrastructure sector grant has been a

chronic issue facing the FSM since the start of the amended Compact. During the initial

year’s disbursements were made very slowly, and only in FY2010 had grant usage sur-

passed $10 million on an annual basis. In FY2012 grants exceeded the yearly average en-

titlement of $24 million, indicating drawdown of backlogged funds. However, by

FY2015 grant usage had declined to $7 million. Problems emerged between the states

and national government on priorities, and despite JEMCO awarding sufficient funds to

support the national project management unit (PMU), the FSM Congress failed to appro-

priate adequate resources, believing that savings could be achieved through recruitment

Policy Issues 67

of low cost consultants from nontraditional sources. In the absence of adequately quali-

fied project management staff, lack of clarity on priorities between national and state

governments, erratic and often inconsistent project requests in relation to the FSM’s orig-

inal Infrastructure Development Plan combined with PMU resourcing problems, dis-

bursements ground to a virtual halt. JEMCO resolution 2012-MT-7: Infrastructure Devel-

opment Plan, Health Facilities, and FAA Matching Funds required that an updated ver-

sion of the Infrastructure Development Plan (IDP) be prepared and endorsed by the na-

tional and state governments.

consistent with Article V (1)(e) of the Fiscal Procedures Agreement, the GFSM

shall develop and submit to JEMCO a professionally prepared update of its Infra-

structure Development Plan (IDP) to reflect GFSM priorities for new and recon-

structed capital infrastructure to be financed by Compact funds. Insofar as Sector

Grant funds are involved and prior to allocation of Public Sector Infrastructure

assistance by the JEMCO, the IDP shall be subject to the concurrence of the

JEMCO.

166. With support of the ADB, a TA was designed with the objective of crafting an up-

dated IDP, (the initial IDP had been prepared in FY2004 as part of the original amended

Compact requirements), and for the specification of a suitable project management struc-

ture. The IDP is now complete, and projects have been identified in 10 key sectors: elec-

tric power, water/wastewater systems, solid waste management, road and pedestrian fa-

cilities, maritime transportation, air transportation, telecommunications, education, health

and government administrative buildings. The projects have been ranked at the state level

by the respective state level Infrastructure Planning and Implementation Committees

(IPICs). Each project was assessed according to nine criteria with each category being

ranked 1-5. Based on the criteria each state’s projects could be ranked in order of priority.

While the FSM uses its traditional distribution formula to allocate funds between states,

this has not been recognized by the U.S. in the case of infrastructure. Selection of projects

between states is thus done according to perceived overall FSM priorities, although in

practice this has not departed significantly from the FSM’s internal allocation process.

The nine criteria included:

i. investment and economic growth;

ii. private sector capacity and/or employment;

iii. living conditions and/or income generation;

iv. access to/delivery of public health services;

v. access to/delivery of education;

vi. environmental outcomes/conditions;

vii. natural disaster and climate change resilience;

viii. capacity of government infrastructure agencies; and

ix. financial sustainability of infrastructure.


167. Regarding the project management structure, two systems were initially investi-

gated: an enhanced national project management unit (PMU) as already in existence, and

a decentralized model with a national PMU and four state project management offices

(PMOs). Given the history of the centralized PMU in the FSM, lack of adequate staffing,

and conflict between the national and state levels, the decentralized version has been se-

lected. Bringing the states into the process, where the projects take place and where there

are greater incentives is more likely to get the process moving. The project management

framework calls for the PMU to serve a coordinating role, setting engineering standards

for the FSM and building a reference library. In this model, the state offices would focus

on project oversight, with contracting officers, engineers and inspectors. Although the de-

centralized version is costlier, it is not considered excessive, and a total project cost of 9

percent is envisaged.

168. The ADB TA and IDP for the national and each state governments were finalized

by the end of 2015. For FY2016 JEMCO awarded a total of $2 million and in FY2017

$13.7 million of projects was approved, but still way short of the annual funds available

of $23 million. A consultancy firm was selected to staff the PMU, but operationalization

of the PMOs at the state level is yet to bedded down, although funding has been included

in the FY2017 grant allocations. There thus remains a long-way to go before the FSM can

crank up implementation, fulfill grant conditions and to start the projects rolling or utilize

the large backlog of funds.

169. Figure 33 provides an indication of the impact of construction activity and other

leading industries on economic performance. The graph shows the contribution to eco-

nomic growth (measures in constant FY2004 dollars) for fisheries, construction and all

other industries. Domestic fisheries have played a major role in the economy, stimulating

growth as the fleet has expanded as in FY2014 and FY2015, and triggering economic de-

cline as boats have been withdrawn for dry docking as in FY2013. Construction activity

has, however, clearly been a very significant contributor to recent economic activity. The

decline in GDP in FY2013 and FY2014 underscores the importance of resolving the

compliance and management issues that have held up construction projects under the

Compact infrastructure grant.

170. There is currently an estimated $165 million in unspent Compact infrastructure

funds, some 60 percent of the total available that has accrued from previous years.

Clearly, use of current infrastructure grant allocations, including part of the back funds,

would go a long way to improving economic performance. That being said, once project

compliance and management issues have been resolved, the funds should be released in

an orderly fashion to smooth economic activity over the remainder of the amended Com-

pact and beyond. Temptation to front load the funds, as provided for in the IDP, would be

equally disruptive, generating a boom and bust cycle and likely reducing the cumulative

local value-added component of projects due to absorptive capacity constraints.

Policy Issues 69

E Special Topics

1 SOVEREIGN WEALTH MANAGEMENT

171. Figure 34 indicates the level of domestic revenues (taxes, fishing fees, and other

revenues) of the national government compared to the four FSM states collectively.

While the level of state domestic revenues has been largely stagnant through the amended

Compact, that of the National government has risen significantly by over $59 million

since FY2004 and is 233 percent higher than the combined level of the four state govern-

ments in FY2015. With the creation of the cartel of fishing nations through the Parties to

the Nauru Agreement (PNA), the national government has been the beneficiary of signifi-

cant increases in fishing royalties. Fishing fee revenues rose from $19 million in FY2011

to $26 million in FY2012, $35 million in FY2013, $48 million in FY2014, and finally to

$65 million in FY2015. The captive insurance market has also grown significantly since

its inception in FY2008 and in FY2014 yielded $28 million, although there was an excep-

tional receipt of $20 million, and fell back to $4.1 million in FY2015. The increase in

fishing royalties and captive revenues—both falling in the category of “sovereign

rents”—has led to the emergence of a structural surplus at the national level, while the

state governments continue to operate under a tight fiscal envelope.

172. The strong growth in national government revenues has now reached a plateau

although it may be anticipated to grow with inflation over time and perhaps with growth

in the captive revenues. In 2012 the fee under the vessel day scheme (VDS) charged on

the skipjack tuna fishery rose to $5,000 a day. In 2014 the fee rose to $6,000 and in 2015

the PNA agreed to raise the fee again to $8,000 per day. Actual VDS rates sold are in fact

in the range $10,000 to $11,000.

Figure 33 Impact on GDP of major economic drivers, FY2009-FY2015

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

Fisheries

Total GDP growth

Construction

Other


173. From a fish conservation perspective, the current evidence suggests the fishery is

well managed and not at risk from depletion. However, the rise in domestic fleets which

pay lower VDS rate and are largely represented by local registration of foreign purse

seine operators with little or no local ties poses a threat and erosion of total receipts. In-

creased fishing in the Eastern Pacific open high seas outside of any countries EEZ where

no fees are charged also poses risk with a reduction in days sold by the PNA members.

174. Based on the fiscal outturn in FY2015, the national government ran a structural

surplus (adding Congressional electoral district project expenditures) of $43 million or 14

percent of GDP. Ignoring the risks outlined above, a similar level of surplus (adjusted for

inflation) can be reasonably anticipated going forward and, begs the question of the allo-

cation of these sovereign rent-driven gains.

175. In 2012, the then President of the FSM initiated an exercise to plan for transition

to the post amended Compact era after FY2023, known as the 2023 Action Plan. The

Plan while focusing on the post 2023 era also addressed the use of the emerging national

government structural fiscal surplus, and proposed allocating $10 million to the CTF and

amongst other measures to boost the economy, the allocation of $15 million to an Invest-

ment Development Fund (IDF).

176. However, with a new administration since March 2015, the 2023 planning effort

and the issue of sovereign wealth management is, by all appearances, no longer high on

the policy agenda. Rather, in an attempt to address the growing disparities between na-

Figure 34 National and state government domestic revenues, FY04-FY2015

FY04, 30.5

FY13, 56.4

FY14, 91.6

FY15, 89.8

$0

$10

$20

$30

$40

$50

$60

$70

$80

$90

$100

National Govnernment

State Govnernments

Policy Issues 71

tional and state government revenues, the rational allocation of surplus resources has dis-

solved into an ad hoc process. National government appropriations have been proposed

for state level priority infrastructure projects, but the states have had difficult in identify-

ing projects, and available funding appears to be at risk of dissolving into state level leg-

islative projects. The national government has established a set of state level FSM trust

fund sub-accounts, which begs the question of the use of the large FSM trust investments,

which, in the absence of state designation, are presumably subject to the direct control of

the national government now and in the future. While significant resources have been al-

located to the FSM trust fund, there has also been a ballooning of national government

legislative public projects.

177. Clearly, there is a need for a rational approach to the emergence of significant

sovereign resources. The former 2023 Plan established a sound approach to resource allo-

cation, although the proposed establishment of a large IDF allocation despite the failures

of that program during the original Compact period, should be severely reduced. In the

following Chapter, the likely shortfall of the Compact Trust Fund is highlighted, and if

unaddressed the consequences are likely to be dire. Supplementation of the CTF with the

additional resources generated from the fishing fees and captive revenues would go a

long way to addressing the shortfall. Allocation of $30 million a year (inflation adjusted)

would make a very significant addition, although the projected impact would still be be-

low the simple sufficiency estimate indicted in Chapter 3 for FY2023.

2 THIRD FSM ECONOMIC SUMMIT

178. The Third FSM Economic Summit was held in Palikir, Pohnpei, from March 29

to April 2, 2004. The summit was presented with three economic scenarios that the FSM

might experience during the next 20-year period of Compact support: a dismal scenario, a

medium-growth scenario, and a sustained-growth scenario. While noting that the FSM

might face a truly dismal scenario if the country's leadership failed to make needed eco-

nomic adjustments to offset the drag on economic activity resulting from the structure of

Compact assistance, the discussion focused primarily on the moderate-growth and sus-

tained-growth scenarios. The summit adopted a six-part strategy for transition and accel-

erated growth:

establishing macroeconomic stability;

promoting good governance: improving effectiveness and efficiency of govern-

ment;

developing an outward-oriented, private-sector-led economy;

investing in human resource development;

investing in infrastructure; and

creating long-term sustainability.


179. The FSM Strategic Development Plan examines the three growth scenarios in de-

tail and makes projections of the likely economic growth and development patterns. Un-

der the sustained-growth scenario, economic growth is held back initially, as the econ-

omy adjusts to the structure of the amended Compact. However, as the benefits of the

sustained-growth strategy take hold, the economy is projected to accelerate and attain an

annual average growth rate of 2.6 percent over the whole period. On the other hand, un-

der the dismal scenario, economic growth is weak, and the economy is projected to

achieve only 0.1 percent during the period.

180. Figure 35 compares the projected dismal scenario with the actual performance

since FY2003. In the initial years of the amended Compact through FY2009 economic

performance was indeed dismal as the economy adjusted to the new provisions; a long

painful period that had not been envisioned. In the next three years the economy was on a

higher trajectory. However, in FY2013 through FY2015 with the reduction in FAA pro-

jects and compliance and administrative issues with the use of the infrastructure grant, the

economy once again dipped below the dismal scenario. The FSM needs to get back on

track, remove the impediments to infrastructure grant use, and adopt a reform agenda.

With a sustainable basis for development, the FSM will be in a stronger position to iden-

tify new sources of economic growth and outperform the dismal scenario.

F Private Sector Development

1 THE WORLD BANK DOING BUSINESS SURVEY

181. The World Bank's Doing Business Survey provides a general assessment of the

environment for private sector development. Table 10 indicates The FSM’s ranking for

Figure 35 Comparison of the Third Summit dismal scenario with performance, GDP per

capita, 1998 prices (US$)

$2,050

$2,100

$2,150

$2,200

$2,250

$2,300

$2,350

$2,400

$2,450

Dismal scenario

Actual performance

Policy Issues 73

each of the 10 major categories, which deteriorated in 2013, improved in 2014, but

slipped back again in 2015. Overall, the FSM currently scores 148 out of a total of 189

countries, about 80% down the list suggesting that there is much room for improvement.

The FSM fairs worse than either of her Micronesian sisters of Palau and the RMI, which

rank 136th and 140th, respectively, although not by a large score. In the South Pacific, Pa-

pua New Guinea is ranked 145th, Fiji 88th, Vanuatu 94th, Tonga 78nd and Samoa 96th.

Overall, the FSM’s scores are generally weak. Registering property scores 189 the worst

of all countries surveyed by the World Bank, while for protecting investors the FSM

comes 185th. Enforcing contracts is also poor at 181. The FSM registers its best score

with 53 for trading across borders.

2 FOREIGN DIRECT INVESTMENT (FDI)

182. As part of the reforms enacted under the ADB supported Public Sector Reform

Program (PSRP) and designed by the Facility for Investment Advisory Service (FIAS) of

the World Bank, the FSM enacted a series of State and National laws to regulate and en-

courage FDI. A two-part system was developed that provided jurisdiction of FDI that re-

lated to investment of a national character to the national government and all others to the

state governments. At the national level investments were classified in four parts:

Category A red list: banned investments in arms manufacturing, production of

currency, nuclear power, and any others determined in consultation with the

states.

Category B amber list: investment in activities to which specific criteria applied,

such as banking, insurance, and others in consultation with the states.

Category C green list: investments of a national character where no special crite-

ria were required, including telecommunications, fishing in the EEZ, international

and interstate air travel, international shipping, and others in consultation with the

states.

183. Category D: all others not of a national character.

Table 10 FSM: Ease of Doing Business, World Bank ranking

Category 2012 2013 2014 2015

Ease of doing business overall rank 140 150 145 148

Starting a business 102 104 151 162

Dealing with construction permits 19 42 37 141

Getting electricity 40 53 30 103

Registering property 183 185 189 189

Getting credit 126 129 61 70

Protecting investors 174 177 186 185

Paying taxes 92 85 114 116

Trading across borders 106 100 106 53

Enforcing contracts 146 149 162 181

Resolving insolvency 164 166 118 116


184. At the state level a similar, but three-part process was adopted: red, amber and

green for those investment not of a national character. Under the PSRP the national,

Chuuk, Kosrae and Yap states enacted their respective laws and established regulations.

Only Pohnpei did not follow this model, which established an old fashioned Foreign In-

vestment Board. After adopting the model legislation in Yap, the law was repealed and

replaced with a similar restrictive process as adopted in Pohnpei in response to a pro-

posed large Chinese hotel investment complex (see Chapter on State Developments).

Overall and not limited to the FDI regime, the FSM has not proved attractive in encour-

aging FDI.

185. In 2016 reforms were introduced in the FSM Congress to modify the 1997 FDI

Act which brings all foreign investment under the jurisdiction of the national govern-

ment. The reforms effectively claim that all foreign investment is by its very nature of a

national character. The same three-part process: red, amber and green is proposed under

the current reforms, but now only at the national government. At the time of the PSRP the

issue of national and states’ rights was topical, generated a substantial debate, and led to

Pohnpei adopting a different process. While the current reforms will streamline the FDI

process, and should be supported, it is yet to be seen if they will successfully pass

through Congressional committee and become law. The reformed law could be contested

at the supreme court and at the state level restricted through adverse business licensing.

G The Policy Score Card

186. Table 11 provides a selected summary of various components of the FSM’s policy

and institutional structure that have been part of the reform agenda and have been dis-

cussed in this review. A brief summary is included in the table, with a color-coded indi-

cation of the success of the reforms.

187. Fiscal Policy: At the start of the amended Compact the FSM was faced with the

issue of restructuring departmental expenditures to meet the new structure. After a period

of adjustment and execution of RIFs in Chuuk and Kosrae, close to fiscal balance has

been achieved in all states since FY2007, although balance is finely tuned (scored green).

Public sector employment has fallen with the need to re-duce expenditures outside the

sector grant areas. However, wages rose in the early part of the amended Compact, re-

flecting the re-structuring, annual wage drift, and payment of COLA. Since FY2010 pub-

lic sector wages costs have been held in check with modest annual increases (scored yel-

low). The FSM has adopted a favorable external debt strategy, reflected in a low debt to

GDP ratio and poses no significant risk (coded green). Long-term fiscal management has

entailed both the initial and painful downsizing in Chuuk and Kosrae and the need for

decrement management. Each State prepared a long-term fiscal framework to enable an

efficient adjustment to the annual decrements in real Compact funding levels (scored yel-

low). The Social Security system has undergone reform to meet the deteriorating un-

founded liability of the mid-2000s. With adjustments to tax rates, thresholds and retire-

ment provisions the fund is now moving towards sustainability (scored yellow).

Policy Issues 75

188. Macroeconomic Monitoring: At the start of the amended Compact, the FSM had

a limited set of basic macroeconomic statistics available on which to assess economic

performance. Since that time with the assistance of U.S. technical assistance the FSM has

a full set of the major economic statistics: GDP, employment, wage data, CPI, banking

statistics, balance of payments, international investment position, external debt, and gov-

ernment fiscal statistics. Local capacity is improving, and capacity building is supported

by international donors (coded green).

189. Public Financial Management: The FSM initiated a program to adopt the World

Bank and IMF standard: Public Expenditure and Financial Accountability (PEFA), as a

means to improving PFM. However, after an external assessment was made at the na-

tional government level no further progress has been achieved (coded yellow). In the area

of financial accountability and control all audits are now no longer qualified and the na-

tional and state finance offices are generally adequately staffed (code yellow). At the on-

set of the amended Compact the FSM prepared a Strategic Development Plan required to

Table 11 Summary of FSM Policy Reforms

Achievements Score

Fiscal policy

Fiscal balance Fragile, balance achieved since FY2007

Public sector payroll Size of public service reduced through amended Compact; wages grew at start but

held in check since FY2010

External debt Sound external debt position

Long-term fiscal adjustment Initial adjustment to Amended Compact achieved in Chuuk and Kosrae;

long-term fiscal frameworks prepared in all states to address decrement

management

Social security Reforms enacted and unfunded liability moving in direction of sustainability

Macroeconomic Monitoring Full set of statistics available for economic performance assessment

Public Financial Management

Public Expenditure & Financial

Accountability (PEFA)

External assessment completed; no implementation road map executed; not rolled

out to the states

Financial accountability Audits currently "unqualified"

Strategic Development Plan Completed at outset of amended Compact; monitoring and implementation

underresourced; draft 2023 Action Plan to revitalize key components

Medium-Term Fiscal Framework Not currently adopted in the FSM

Performance management Weak and no monitoring of outputs or outcomes

Information systems Captures financial information only

State Owned Enterprises

Subsidies Less than 0.5 percent of GDP

Divestment Fisheries coporations either defunct or under private management/ownership

Full cost recovery Utilties operate on cash-flow basis without setting aside funds for depreciation

SOE policy No FSM or state level SOE policy framework

Tax reform No progress after many years of active consideration; tax reform laws repealed by

FSM Congress

Regulatory Environment

FDI Reforms in late 1990s, but further improvements needed

Land Reform Some progress, but considerably more required

Doing Business Survey World Bank survey places FSM 145th out of 189


inform budget planning and implementation. The SDP was a quantitative document and

provided a series of matrices with output and results orientated indicators. While it is now

has been over 10 years since publication, the majority of the material remains relevant

(coded yellow).

190. The FSM has not adopted the standard approach or medium-term framework for

budget management. A medium-term fiscal framework, defining the fiscal envelope has

not been adopted, and although performance budgets (the expenditure framework) have

been prepared, they are not monitored or audited. As a result, there is no effective perfor-

mance management. Both the medium-term fiscal framework and performance manage-

ment items are code red. Financial management information systems provide adequate

accounting and audit data, but they do not provide a basis for measuring output delivery,

fiscal statistics or budgeting and are in need of replacement (coded yellow).

191. State-Owned Enterprises: The level of SOE subsidy in the FSM is less than 1

percent of GDP and the nation has avoided the financial pitfall experienced in many

countries (coded green). The SOE sector has undergone consolidation with liquidation or

sale of the large fisheries investments to private ownership r management. However,

other public entities would benefit from transformation to more efficient and effective

management (scored yellow). The utility services are run as state monopolies at less than

full cost recovery. Performance has been weak with frequent power outages due to lack

of maintenance and underpricing. Chuuk state is the one exception with a now reformed

management after receiving ADB support (scored yellow). An ADB TA was executed in

the early 2000s in an attempt to rationalize and transform the sector although no sector-

wide SOE policy framework was proposed (scored yellow).

192. Tax Reform: in the early 2000s an ambitious tax reform program was proposed

and adopted by the FSM, requiring action and coordination at both national and state lev-

els. After many years of activity two states: Pohnpei and Yap dropped out of the program

and the FSM Congress has repealed the tax reform legislation enacted earlier. Much time

and effort from advocates and donors has not borne fruit in an area of reform that the

FSM direly needs (scored red).

193. Private Sector Regulatory Environment: An attempt to rationalize the regulatory

environment for foreign investment was adopted in the early 2000s demarking the divi-

sion between the national and state levels. However, while laws were enacted, and the re-

gime put in place, Pohnpei opted to maintain a Foreign Investment Board as did subse-

quently Yap state in response to large scale investment interest in tourism. During the

amended Compact the FSM has failed to attract any significant foreign investment and is

scored red. As part of the ADB private sector development program legislation for long

term leasing of land was prepared to encourage development and mortgage-secured com-

mercial lending. Only one state enacted the legislation (scored yellow). The World

Bank’s “Ease of Doing Business Survey” ranks the FSM 148th out of 189 countries,

which is a poor performance and is scored red.

Policy Issues 77

194. Overall the policy, regulatory, and institutional environment needs much work if

the FSM is to be transformed into a growing economy as envisaged in the earlier Strate-

gic Development Plan. Economic performance during the first 12 years of the amended

Compact has been poor with weak implementation of the reform agenda. Much attention

during the first 12 years was in adjustment to the sector grant approach and subsequently

in the decrement management issue. For economic growth and development to acceler-

ate, the reform agenda needs to pick up momentum and a change in attitude and commit-

ment needed.

78

IV. THE COMPACT TRUST FUND

A Performance of the Compact Trust Fund (FY2004-FY2015 and projected to FY2023)

1 BACKGROUND

195. The establishment of the Trust Fund for the People of the FSM (CTF) was a ma-

jor feature of the amended Compact. The Trust Fund was created, according to the pref-

ace of the CTF Agreement, “to contribute to the long-term budgetary self-reliance of the

FSM… [and] to provide the Government of the FSM with an ongoing source of revenue

after FY2023.” The design features of the Trust Fund related to distributions to the FSM

from FY2024 and thereafter are specified in the CTF Agreement, article 16(7) (a) and (b).

The explicit linkage of distributions to the fully inflation adjusted value of the Compact

annual grant assistance provided in FY2023, has the potential to create expectations that

such levels of support from the CTF may be forthcoming. However, the U.S. Govern-

ment has made it clear that neither the terms of the amended Compact nor the terms of

the CTF Agreement make any guarantee, or even a commitment, that the Trust Fund will

be able to sustainably achieve distributions of any specific size.

196. Still, even the U.S. Government Accountability Office (GAO) in its June 2007

Report1 completed its analysis based on the assumption that distributions would equal the

above-described (maximum) level. When challenged on that assumption with the fact

that such levels of disbursement are neither required nor guaranteed, the GAO countered

that “[they] believe it is appropriate to undertake a projection of the likely disbursements

against that benchmark.2” The GAO also noted that “[they] believe that careful analysis

of the trust funds each year will help establish realistic expectations.3”

197. This section of our annual review is prepared in fulfillment of our general terms

of reference to describe key economic trends and describe policy options for considera-

tion by our readers, especially FSM leaders and officials engaged in Compact manage-

ment from the U.S. and the FSM. Given the immense importance of the CTF to the

FSM’s long-term prospects for achieving economic self-reliance, our review provides an

analytical perspective in addition to that provided through the published reports of the

FSM CTF Committee. The authors use the maximum level of distribution to complete

probability-based (stochastic) projections for the period after FY2023, while noting fully

the risk of falling short and the need for FSM leaders to continue to strengthen their pol-

icy focus on alternative measures to mitigate the risk of potential periodic (or even sus-

tained) fiscal shocks.

1. GAO-07-513, “Compacts of Free Association: Trust Funds for Micronesia and the Marshall Islands

May Not Provide Sustainable Income,” June 2007, www.gao.gov/cgi-bin/getrpt/GAO-07-513. 2 Ibid, Appendix V, p. 56. 3 Ibid, Appendix V, p. 56.

The Compact Trust Fund 79

198. As noted in previous reviews, the CTF Agreement includes certain technical char-

acteristics that are likely to become problematic during the distribution period. It is inar-

guable that the best interest of all parties would be served if, over the long-term, the real

value of the CTF is protected and robust mechanisms would ensure the relative stability

of annual distributions from the CTF to the FSM. Unfortunately, as currently specified,

and in the absence of stellar investment return rates or large additional contributions over

the remaining accumulation period, the real value of the CTF corpus has a high likeli-

hood (80 percent probability) of declining over the course of the distribution period; per-

haps more urgently, the stability of annual distributions will be at risk. Immense and re-

peated fiscal shocks are more likely to arise due to the specific characteristics agreed to

by the parties and enacted in U.S. law. The result is a high likelihood (greater than 76

percent probability) of at least one fiscal year in which zero distribution would be al-

lowed under prevailing rules. While amending these provisions is no easy task—espe-

cially since U.S. Congressional approval is required—the FSM CTF Committee, in col-

laboration with JEMCO and with the U.S. and FSM governments, may wish to consider

modifying: (a) problematic design characteristics of the buffer account mechanism; (b)

the distribution mechanism that conflicts with the prevailing practice of confirming an-

nual allocation decisions each August; and (c) distribution rules that could better protect

the real value of the corpus over the long-run while also reducing the volatility of distri-

bution levels and reducing the frequency of shortfalls in annual fiscal support to the FSM.

199. At a minimum, the “C” account could be more reliably functional if it were cre-

ated as a specific amount at the outset of FY2024, instead of the current mechanism

which provides no certainty with respect to the level of the buffer account at the outset of

the distribution period. Additionally, consideration could be given to the unavoidable fact

that annual return results cannot be finalized until the fiscal year is complete, in conflict

with the timing of allocations and awards under current procedures. Finally, considera-

tion could be given to specifying the basic annual distribution rules, since the current lan-

guage (the maximum distribution) provides no feedback mechanism to relate the annual

distribution rate to the actual achieved size of the CTF, increasing the likelihood that only

the nominal value of the corpus will be protected. Neither does the CTF have any feed-

back mechanism that would at least attempt to minimize year-to-year fiscal shocks (up-

wards or downwards). While a fundamental revision to the distribution mechanism would

require US Congressional approval, certain meritorious enhancements could be achieved

within the current terms of the CTF Agreement.

2 PERFORMANCE MONITORING

200. This review, for the seventh year, presents a CTF simple sufficiency estimate and

related analysis. That estimate is defined as the size the CTF would need to achieve by

the end of FY2023 in order to support a smooth and sustainable transition from US-ap-

propriated annual sector grants to fully inflation-adjusted annual CTF distributions to the

FSM. The simple sufficiency estimate is updated to reflect actual outcomes to-date, par-

ticularly with respect to the partial inflation adjustment that has been applied through the


FY2017 budget estimates and projected inflation going forward. Future inflation projec-

tions are linked to U.S. Congressional Budget Office (CBO) published projections

through FY20251. Using these assumptions, the level of Compact sector grants in

FY2023 is projected at $81.3 million. With full projected inflation (at 2.05 percent) for

FY2024, the $81.3 million is adjusted upward to $82.9 million.

201. It is assumed that the FSM CTF investment strategy at that time would need to

provide for a prudent balance of risk while allowing for long-term growth. From FY2024

onward, and for estimation purposes only, a balanced investment allocation is assumed,

as detailed in the following section. Over an 89-year period the real rate of return using

econometric estimation techniques is 5.0 percent. Thus, if inflation were to average 2 per-

cent, a nominal rate of return of 7 percent is implied. Dividing the $82.9 million (maxi-

mum) distribution by a 5.0 percent real rate of return yields a simple sufficiency target of

$1.67 billion.

202. Using the above-detailed assumptions, and starting with the end of FY2015 FSM

CTF value of $397,313,588, the rate of return required to achieve the simple sufficiency

estimate for the FSM CTF of $1.67 billion would be 14.3 percent annually for the eight

remaining years through FY2023. Such a sustained rate of growth is extraordinarily un-

likely to be achieved. Using probability analysis, the median projected level of the FSM

CTF at the end of FY2023 is $974 million or 58 percent of the simple sufficiency esti-

mate.

203. Still further gloom may be in order, since the long-term projected rate of return of

7.0 percent in nominal terms significantly exceeds the rate of return experienced by the

FSM CTF during the period it has been invested, FY2007 – FY2015. The experienced as-

set-weighted rate of return during that same period has been 5.37 percent.

204. The FSM has not funded the “D” account within the CTF mechanism; however,

the FSM has its own Trust Fund that may be used after FY2023 to support fiscal stability.

The purpose of the FSM Trust Fund is not well-specified in the law, but stated intentions

of the leadership have included a strong focus on “post-2023” concerns. As of the end of

FY2015 the value of that account was $58,761,675 as reported in the FSM final audit.

That amount is just less than 15 percent relative to the size of the FSM CTF (“A” plus

“C” accounts) at the same date. To the extent the FSM continues to dedicate significant

portions of its (national government) structural surplus, the FSM Trust Fund could grow

to become an important supplemental funding source to mitigate periodic or sustained fis-

cal shocks.

205. Consistent with recommendations in recent CTF annual reports, joint or unilateral

efforts to mobilize additional contributions—from domestic and external sources—to the

1 http//:www.cbo.gov/publication/45066, Economic Data and Projections, January 26, 2015, Table A-3,

prices (fiscal years)

http://www.cbo.gov/publication/45066


CTF would improve the FSM’s long-term fiscal stability and economic security. Simi-

larly, the FSM national government’s apparent ongoing commitments to aggressively ad-

dress post-FY2023 fiscal risks are both prudent and promising.

206. It should be noted that achieving a CTF size that matches the simple sufficiency

estimate—as unlikely as that is for the FSM CTF—does not, by any means, eliminate the

risks going forward of subsequent severe and repeated fiscal shocks. Periodic strong per-

formance of the CTF does not eliminate the urgency to consider opportunities to achieve

mutual agreement on a distribution policy or amendments to enhance the CTF agreement.

In the section of this review that follows, a more sophisticated, risk-inclusive form of

analysis is briefly summarized to analyze the range of outcomes that might prevail given

the volatility of market returns and the uncertainty of the sequence of those returns over

time. That analysis defines a “SAFER” alternative that, in effect, requires a larger fund

balance than the “simple sustainability” estimate. As shown in Figure 36 that estimate is

for a fund size of $2.79 billion. In essence, to manage the degree of volatility inherent to

the asset mix considered, the primary target needs to be increased by 67 percent.

207. A range of factors have combined to result in a CTF value that is now substan-

tially below the projected path to achieve the simple sufficiency estimate by the end of

FY2023. The most important factor is the investment climate that has prevailed from

FY2004 through FY2015. Addressing other factors, the authors provided a lengthy dis-

cussion on delays in establishment of the FSM CTF and further delays in implementing

an investment strategy (see the FY2011 report at http://www.econmap.org).

Figure 36 Projected FSM Trust Fund Value through FY2023

$0

$400

$800

$1,200

$1,600

$2,000

$2,400

$2,800

$397mactual value

9/30/15

$1.67bPRIMARY TARGET

$2.79bSAFER sustainability est

$974mPROJECTED VALUE FY2023

58% of SIMPLE EST35% of SAFER EST



B Trust Fund Principles and Market Risk

208. The FSM, RMI, and Palau Compact Trust Funds are described in substantial de-

tail in a separate Graduate School paper, “Compact Trust Funds in the Three Freely As-

sociated States: Mechanics and Stochastic Projections,” (forthcoming at

http://www.econmap.org).

209. For the FSM CTF we provide below a brief summary of the results of the projec-

tions for the distribution period under the existing rules as found in the Trust Fund Agree-

ment and as compared to various alternatives.

1 BENCHMARKS AND PERFORMANCE MEASURES

210. In this section we define some useful benchmarks and performance measures to

aid the analysis:

1. Target Distribution. This is defined as per amended Compact Trust Fund agree-

ment (Article 15.7(b)) as the FY2023 grant assistance level plus full inflation ad-

justment; described above as the maximum distribution.

2. Primary Target: The primary target fund estimate is defined as the value of the

CTF required to yield the target distribution in a given year based on the esti-

mated real geometric portfolio rate of return. Since the primary target is based on

a real (inflation adjusted) rate of return it also implicitly provides for reinvestment

of earnings necessary to maintain the real value of the Fund. This measure of the

Fund is a benchmark that assumes no market risk. In itself it is not a measure of

fund sustainability since it ignores risk, but nevertheless provides a useful bench-

mark.

3. Sustainability Adjustor: The sustainability adjustor is the percentage above the

primary target that the CTF must attain to accommodate an “acceptable” degree

of market risk. This is elaborated below.

211. Performance of the CTF is assessed against a series of benchmarks related to the

three CTF principles described in the referenced paper as those that are inherent to the

CTF arrangement. The simulations in the following sections are conducted over the re-

maining amended Compact period: FY2016-FY2023 and over the following 27 years

through FY2050. FY2050 is chosen as a terminal period under which long-run steady

state values are attained.

1. Protecting the Corpus:

a. Probability of attaining the primary target in FY2050.

b. Probability that the FY2050 real value of the CTF is above the FY2023

value.

2. Protecting Distributions:

a. Probability of attaining the target distribution in FY2050.



b. Average distribution through FY2024-FY2050 as a percent of the target

distribution.

3. Protecting against Volatility:

a. Probability of a zero distribution in the FY2023-FY2050 period.

b. Average variation in real drawdown between FY2049 and FY2050.

4. Performance indicator: The performance indicator is an average of the above 3

main categories with each sub-measure accorded equal weighting. Clearly, the

choice of the chosen performance measures is subjective, but those selected are

considered to be good indicators of the core CTF principles.

5. Sustainability: The outcome of any set of simulations, which attains a 95 percent

performance level is considered sustainable.

C Trust Fund Simulations

212. The analysis undertaken in this Review follows that in two other recent studies of

the amended Compact Trust Funds in the FSM and RMI by the GAO1 and by the ADB2.

Both studies deploy Monte Carlo simulation analysis to investigate the likely perfor-

mance of the two Trust Funds and capacity to meet their objectives. The analysis fol-

lowed here does not depart from this approach. The simulations are based on a simple

portfolio comprised of equities and bonds. Equities are comprised of the S&P 500 (35

percent), a global equities index (25 percent), and emerging markets (5 percent). Bonds

are comprised of U.S. Government Bonds (15 percent), U.S. Corporate Bonds (10 per-

cent) and World Government Bonds (10 percent). All indices are total return indices in-

cluding reinvestment of interest and dividends. Data covers the historical period 1925-

2015.3 Since the inflationary environment projected over the FY2013-FY2050 is ex-

pected to be lower than the historical series the simulations have been run in real terms

with inflationary expectations added. The inflationary factor is the U.S. GDP deflator and

the simulations adopt the projections made by the U.S. Congressional Budget Office.

Further details on the technical aspects of the simulation are provided in the referenced

paper.

213. The simulations start in FY2016 based on the value of the CTF at the end of

FY2015. The simulations are split into two periods: the accumulation phase between

FY2016 and FY2023, and the drawdown phase thereafter.

214. The results of the following analysis do not deviate from that of the prior studies

and further support the expectation that the CTF will be underfunded and distribution

1 See U.S. Government Accounting Office, Trust Funds for the Micronesian and the Marshall Islands May

Not Provide Sustainable Income, GAO-07-513, June 2007, Washington DC. 2 Asian Development Bank, Trust Funds and Fiscal Risks in the Federated States of Micronesia and the

Marshall Islands: Analysis of Trust Fund Rules and Sustainability in an Evolving Aid Relationship,

forthcoming, Manila. 3 Global Financial Data.


shortfalls will be frequent. However, this Review emphasizes the particularly adverse na-

ture of the existing Trust Fund mechanism, and investigates alternate rules designed to

provide a less volatile pattern of distributions to minimize the adverse impact on fiscal

management. It also investigates alternative possibilities for increasing contributions to

the Fund.

D Projected Value of the CTF and distributions in FY2023 and thereafter

1 TRUST FUND PERFORMANCE

215. Figure 37 provides a depiction of the simulated CTF at the end of FY2023 before

drawdowns commence. It indicates that from a value at the end of FY2015 of $397 mil-

lion the fund is likely to attain a value of $974 million by the end of FY2023 (the median

simulated value). The projected median value is far below the level of the Primary Target

of $1.67 billion. In fact, the probability of achieving the Primary Target is just 6 percent.

Further it must be born in mind that the Primary Target is only a benchmark and is based

on a risk free assumption. It is reasonable—even necessary—to begin planning for the

high risk that the FSM CTF will not be sufficiently funded to provide a steady and sus-

tained stream of benefits to support government operations in the FSM at the level that is

likely to prevail as of FY2023.

216. Table 12 provides statistics based on the performance criteria defined above for

the set of simulations undertaken in this Review. Focusing on the results for the “COFA”

simulations and the measures for the protecting the corpus, the chances of the CTF being

above the Primary Target value in FY2050 is 15.5 percent. The probability of maintain-

ing the real value of the corpus between FY2023 and FY2050 is 20 percent.

Figure 37 Probability Distribution of FSM Compact Trust Fund in FY2023

0 500 1,000 1,500 2,000 2,500

Median Value: $974 m

Primary Target: $1.67 b

6% probability


217. The second section of Table 12 indicates the nature of the annual distributions

that can be anticipated post FY2023. In terms of the average distribution throughout the

period the level is 70.4 percent of the target, while the probability of attaining the target

in FY2050 is 33.1 percent.

218. In terms of volatility, the probability of experiencing at least one zero distribution

year in the FY2024-FY2050 period is an extraordinarily large 76.6 percent while the av-

erage annual variation in FY2050 compared with FY2049 is 25.5 percent. These results

bring out the volatile nature of the COFA rules. There is a tendency to extremes of either

meeting the target, which is reflected in a moderate average drawdown of 70.4 percent, or

failing entirely, which is reflected in the high probability of experiencing at least one year

of zero distribution. Finally, the overall performance rating of the CTF under the COFA

distribution mechanism is 39.5 percent. On its own this benchmark has little value with-

out comparison to the alternative simulations, which are presented in the table and briefly

discussed below. These results confirm the previous studies that the projected CTF distri-

butions under the COFA rules will be highly volatile and are insufficiently likely to sup-

port fiscal stability and the operational needs of the FSM government.

219. In conclusion of this brief summary, Table 12 shows that there are ways to im-

prove the projected outcome under several scenarios. Perhaps most importantly, the sec-

ond results column shows that by simply changing the rules—and without additional re-

sources—there is a marked improvement in the overall performance rating from 39.5 to

69.6 percent. To the extent the performance comparison metric is accepted, this would be

tantamount to a win-win result for both the FSM and the U.S. at no financial cost.

Table 12 FSM Compact Trust Fund Simulated Results and Performance

Note 1 Under the +FSM scenario an extra $30 million is added annually from FY16-23 and the FSM Trust Fund

is integrated from its end of FY15 value.

2 Under the two-year extension the terminal period of the amended Compact is extended to FY2025 and drawdowns are simulated over the FY2026-Y2052.

Performance Measures Cofa SAFER +FSM +2 Yrs

% cases where CTF value > the Primary Target in FY50 15.5% 58.4% 73.2% 83.5%

% cases where real CTF in FY50 > above FY23 sim value 20.0% 80.6% 83.1% 86.2%

Average distribution through FY24-FY50 % target 70.4% 52.3% 93.4% 97.3%

Average distribution in FY50 percent target 33.1% 29.6% 73.4% 85.3%

Percent of zero distribution FY24 to FY50 76.6% 0.1% 0.0% 0.0%

% Variance bewteen FY49 and FY50 dist levels 25.5% 1.8% 0.3% 20.0%

Overall Performance Rating 39.5% 69.6% 87.1% 92.0%


220. Unsurprisingly, adding additional resources improves the results. Results columns

3 and 4 show the projected results of the FSM adding substantially more resources each

year and then, building further on those contributions, the results of a 2-year extension of

the terms of the amended Compact. This last test case is based on a request that emanated

from the first 5-Year Compact Review. Whether such an outcome is achievable, it is clear

that the fourth test case is the only one that begins to approach a score greater than 95

percent in terms of the overall performance rating.

87

V. STATE ECONOMIC DEVELOPMENTS

A Chuuk state

1 GDP

221. Economic performance during the amended Compact in Chuuk state has been dis-

appointing. GDP has declined by an annual average of 1.8 percent per annum, or 20 per-

cent overall. This outcome has been the consequence of adjusting to lower levels of Com-

pact grants, the need to conform to the sector grant approach, and weak fiscal manage-

ment. At the start of the amended Compact in FY2004, the economy declined due to vari-

ous factors. First, the state had to adjust to the reduction in Compact transfers from the

higher levels of Compact I. Second, the additional resources received in FY2003 for cy-

clone rehabilitation from Typhoon Chata’an were no longer available. Third, the

amended Compact entailed a loss of the energy grant, which led to contraction in the pub-

lic enterprise sector. Finally, the state continued to suffer from an ongoing financial cri-

sis, and delays in vendor payments adversely affected private sector profitability (see Fig-

ure 38).

222. With the initial adjustment to the amended Compact complete, a new administra-

tion took office in FY2006, and the state again went through another period of poor fiscal

management. Payroll numbers expanded by 20 percent, and the wage bill rose by 15 per-

cent. With continued pressure on the utility corporation, driven by increasing world en-

ergy costs, electricity prices soared, and the state consumer price index (CPI) rose by 5.5

percent. With an unsustainable expansion in public expenditures, fiscal stability came un-

der severe pressure, and arrears mounted. While the public sector expanded, boosted by

Figure 38 Chuuk state constant price GDP by sector, FY2004 prices (US$ millions)

FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15

Government 24 22 22 25 20 18 18 18 18 18 17 16 16

Private Sector 15 14 12 12 11 10 9 12 13 13 12 10 10

GDP 83 78 77 79 72 69 69 72 72 71 69 66 66

$50

$55

$60

$65

$70

$75

$80

$85

$0

$5

$10

$15

$20

$25

$30

$35Chuuk state GDP 20% ($16 million) below FY2003 level at start of amended Compact


unsustainable expenditures, the private sector contracted as the crisis hit. State GDP

grew, but this was short lived.

223. During FY2007 and FY2008, the state was required to phase out the use of non-

conforming activities from the capacity-building sector grant. While Chuuk had at first

been slow to respond credibly to the imminent crisis, the state leadership convened a con-

ference to adopt a comprehensive adjustment package. A RIF was the main component of

the adjustment, and the state targeted a reduction of 375 positions. A compensation pack-

age equivalent to one year’s salary, funded with a grant from the U.S., was paid to the

terminated workers. By FY2008 the full impact of the RIF had worked its way through

the economy, and a reduction of 317 positions was achieved. While state government

GDP contracted by 30 percent over the two years, the private sector also declined by 16

percent, reflecting not only reduced demand originating from the RIF but also the impact

of the world economic recession and rising commodity prices.

224. With the fiscal adjustment complete and without any further fiscal mismanage-

ment, government services and output stabilized over the remainder of the period. How-

ever, the economy was set for a period of improved performance in FY2010, as use of the

infrastructure grant expanded, and the FAA-funded AIP projects were implemented.

These forces were sustained in FY2011, but by FY2012 construction activity peaked, and

infrastructure projects failed to provide further stimulus. In FY2013 and FY2014 con-

struction activity declined, as the FAA projects were completed, and the Weno Road re-

building effort was coming to a close. By FY2014 the economy was at a lower point than

any during the amended Compact period. In FY2015 the decline had bottomed out and

GDP registered a slight 0.6 percent improvement.

i Industry Developments

225. Economic development in Chuuk state can be broken down into three periods: a

precipitous decline of 17 percent from FY2003 to FY2008, as the economy adjusted to

the terms of the amended Compact; a period of improved performance from FY2008 to

FY2011, when the state economy grew by 5 percent; and a final weak period through

FY2015, as the economy once again hit bottom, declining by 8 percent. Figure 39 indi-

cates the contribution of each industry to the reduction in economic activity of 20 percent

during the whole period. Both agriculture and fisheries followed the basic trends1, declin-

ing by an average of 0.7 percent and 1.0 percent per annum during the period. The tiny

manufacturing sector, however, has shown some signs of improvement since FY2005.

Electricity production declined by 7 percent per annum throughout the first eight years of

the amended Compact, but it has since improved with the reforms supported by the ADB.

Chuuk now benefits from a 24-hour electricity supply, after many years of power outages

and load sharing, and value added has reverted to its level at the start of the amended

Compact.

1 Estimated from log-linear regression.

State Economic Performance 89

226. Nontraded activities—wholesale and retail, hotels, transport and other services—

followed the pattern of the economy as a whole, declining in the initial period through

FY2008, revealing a brief period of respite as construction activity buoyed demand, but

declining since that time. The only private sector activity not subject to this trend has

been construction, which grew rapidly between FY2009 and FY2011, as the FAA-funded

airport renovations commenced, and the state was able to start drawing on the infrastruc-

ture grant. Construction peaked in FY2012 and then declined through FY2014, almost

back to level of FY2003, with the completion of the FAA projects and reduced level of

infrastructure products. In FY2015 there were some minor improvements.

227. The provision of public administration fell sharply in the first half of the amended

Compact and was the driving force behind the declining economy. However, it stabilized

once the RIF and adjustment were complete, and it has maintained its level since

FY2009. With protected funding levels, education managed to expand through FY2009

but has dropped since that time, reflecting teacher certification issues and weak manage-

ment. As shown in Figure 39, health services are the only industry to make a positive

contribution to the economy (apart from construction), and it grew steadily through

FY2012, by an annual average rate of growth of 4.5 percent, but has slid back by 9 per-

cent since that time.

2 EMPLOYMENT AND GOVERNMENT PAYROLL

228. Figure 40 indicates changes in private and public sector employment. The graph

clearly reveals the reduction in public sector jobs, with the onset of the second step down

in Compact I funding in the late 1990s. There was a misguided attempt to boost public

sector employment in the early 2000s, which was unsustainable. However, the need to

Figure 39 Chuuk state contribution to GDP growth by industry, FY2003-FY2015

(percent)

-8.0%

-7.0%

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

Total 20 percent loss in GDP during amended Compact


phase out the use of the capacity building grant to fund general government led to a fur-

ther downsizing in FY2007 and FY2008. From that period forward public sector employ-

ment has continued to decline but at a reduced rate. Overall, there has been a loss of

nearly 1,904 jobs or half the workforce since the mid-1990s. It is no wonder then that

there has been significant external migration to Guam, Hawaii and the U.S. mainland. In

the private sector, reductions in employment coincided with public sector contractions,

but there was a rebound in FY2010 and FY2011, with the construction of the infrastruc-

ture projects. However, since that point, as in the economy at large, private sector em-

ployment has contracted.

229. Trends in Chuuk state government payroll are indicted in Figure 41. The state was

highly successful in reducing both numbers and the total wage bill through the end of the

Public Sector Reform Program (PSRP). However, the fiscal crisis of the early 2000s un-

dermined the state’s commitment and led to an increase in wage costs per employee and

the hiring of contract workers. The implementation of the amended Compact required the

state to phase out the use of the capacity-building grant for nonconforming purposes,

which, in turn, necessitated the RIF in FY2007—and over 300 public servants were re-

trenched. As a result of these developments, the number of civil servants in FY2010 was

significantly below what it was at the completion of the PSRP. However, wage costs per

employee rose significantly between FY2008 and FY2010, by 32 percent, but have since

stabilized. This spike in wage costs originates from two main factors. First, the state re-

turned many of the workers to an 80-hour pay period. Second, wage rates in the educa-

tion and health sectors rose sharply, by 42 percent, compared with 21 percent for general

fund employees. While the number of civil servants in FY2016 is now 644 below the pre

RIF level in FY2007, the impact of rising average wage costs per employee has offset the

gains in reduced numbers, and the wage bill is now only $0.4 million below the pre-RIF

Figure 40 Chuuk state employment in private and public sectors

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

Public Sector

Private Sector


levels. However, trends since FY2010 indicate that both number of civil servants and av-

erage wages costs have been declining and, hopefully, will continue to moderate from

this point forward.

3 FISCAL PERFORMANCE

230. Chuuk has been the least well managed of the five FSM governments, and fiscal

performance has oscillated from one extreme to the other. While the state has the capac-

ity for significant periods of fiscal mismanagement, it has also displayed the ability to

rein in expenditures when needed to restore fiscal balance. Between FY2004 and

FY2006, because of difficulties adjusting to the new regime of the amended Compact,

along with a lack of financial discipline, the state registered overall significant deficits of

$12.8 million, $5.8 million and $5.5 million, respectively, or 17 percent, 7 percent, and 7

percent of state GDP in each period (see Figure 42). From FY2007 onward the state has

managed to maintain fiscal balance, attaining an average $0.1 million surplus.

231. Tax revenues have grown by an average trend value of 4.1 percent per annum

during the amended Compact, which is above the nominal GDP trend rate of 1.3 percent,

and thus have provided a buoyant source of revenue. This has been the result of improve-

ments in tax administration at the state level. Of the FSM-wide taxes, the gross receipts

tax has been the most buoyant, and collections have trended at 1.9 percent, which is

slightly above the rate of nominal GDP growth. Both import duties and wage taxes have

shown marginal gains of 0.2 percent and 0.7 percent per annum, respectively. Taken col-

lectively, the FSM-wide taxes displayed a buoyancy ratio of 0.59 and indicate the need

for tax reform. Chuuk state has been an active supporter of the FSM-wide tax reform ef-

fort, passing the necessary state-level legislation. The major area of growth has been in

Figure 41 Chuuk state government payroll and wage bill

1,200

1,400

1,600

1,800

2,000

2,200

2,400

2,600

2,800

3,000

10.0

12.0

14.0

16.0

18.0

20.0

22.0

24.0

Number

s of

Public Ser

van

ts

Wag

e Bill (U

S$m

illions)

Public Servants

Wage Bill

wage costs contained since RiFs in FY09


state sales taxes, which have increased by an annual average of 7.4 percent, and collec-

tions have risen from $1.2 million to $2.0 million during the period. This has resulted

from better enforcement through support from an AusAID tax advisor. The other main

source of revenue is Compact and other grants. This has displayed an upward trend, with

an average growth rate of 2.6 percent, reflecting increased absorptive capacity. Combin-

ing tax revenues, grants and the remaining miscellaneous sources, overall revenues have

grown by 2.8 percent during the amended Compact.

232. On the expense side Chuuk was required in FY2007 to make the first of three an-

nual reductions in nonconforming uses of the Compact capacity-building sector grant;

each reduction amounted to $0.9 million. After a slow start, the leadership confronted the

pending financial crisis and implemented a RIF of 317 state employees, funded through a

U.S. grant and implemented over a two-year period. In response to the fiscal crisis and

implementation of the RIF, state expenses were cut from $37.7 million in FY2006 to

$29.4 million in FY2007 and further reduced to $26.5 million in FY2008. By FY2015

they had risen to $35.1 million, representing an overall 0.1 percent annual decline in ex-

pense during the amended Compact. Payroll costs were significantly reduced through the

RIF, but as indicated through Figure 42, they returned to former levels in FY2010, and

have been held in check since that time. In effect the reduction in payroll numbers and

cost savings enabled the state to return all workers to an 80-hour, bi-weekly pay period

and cover increased wage rates in education and health. Until FY2009 the auditors did

not provide details of other expenses, lumping all into one category. There is insufficient

series since that time to draw conclusions, but the use of goods and services appears to

have been held in check since that time.

Figure 42 Chuuk state consolidated revenues and expenditures (US$ millions)

0

5

10

15

20

25

30

35

40Expenditures

Revenues Chuuk maintains fiscal discpline since FY07


233. During the first three years of the amended Compact, the accumulated deficit of

$24.1 million was financed through drawdowns on foreign assets of $23.2 million. Dur-

ing the next nine years, FY2007-FY2015, the state accumulated a surplus of $0.2 million.

However, with improved fiscal circumstances the state paid down $12.5 million of ac-

counts payable and arrears. This was financed by reducing accounts receivable by $4.7

million, and drawing on $10.7 million of foreign assets. To close the account there was a

buildup of cash reserves of $3.9 million.

234. After long periods of financial mismanagement, the state appears to be on a tight-

but-even keel. However, appropriated liabilities of $12.4 million plus an equivalent

amount of unappropriated liabilities remain including pending court cases and land

claims. In previous financial crises, Compact funds could be set aside to repay creditors.

But the current structure prohibits the use of the new sector grants for purposes other than

those specified. The state can restore solvency only through savings of local revenues—

which are under considerable stress already—to fund activities that are no longer eligible

for Compact sector grants. As noted above the state has paid down $11.7 million of lia-

bilities since FY2007, which is a significant achievement. There is still a considerable

way to go before the state can be considered solvent. However, recent trends indicate that

Chuuk is on the right track to eventually repay outstanding liabilities.


B Kosrae state

1 GDP

235. Economic performance in the small state of Kosrae exhibited a declining trend

during the first five years of the amended Compact (see Figure 43). Provision of govern-

ment services held relatively constant, as the state delayed the adjustment required to

phase out nonconforming uses of the capacity-building sector grant. However, the loss of

the Compact I energy sector grant, along with rising world fuel prices during the period,

had a strong impact on the utility sector, and public enterprise output fell by 7.4 percent

per annum over four years. The impact of higher prices during this period, along with the

lower rate of Compact transfers, reduced demand for the small private sector, which con-

tracted by 4.2 percent per annum. Overall, the Kosrae economy went into decline during

the first four years of the amended Compact and fell by an annual average of 1.4 percent.

236. By FY2007, phasing out the use of the capacity-building sector grant for noncon-

forming purposes could not continue to be postponed. It was no longer possible to sustain

the level of public expenditures of Compact I. In the run-up to the FY2008 budget, the

state was confronting imminent collapse. However, in a leadership conference in mid-

2007, the state decided to remedy the deteriorating fiscal position by implementing an ad-

justment program, cutting expenditures and raising revenues. Supported through a retire-

ment package equivalent to one year’s salary and funded through a U.S. grant, the state

was able to implement a RIF of 110 positions. While the impact of the salary payout

stimulated demand, it was insufficient to compensate for the reduction in the public sec-

tor, and the economy contracted by 0.4 percent.

Figure 43 Kosrae state constant price GDP by sector, FY2004 prices (US$ millions)


Government 7.1 7.0 7.2 7.2 7.2 6.8 6.6 6.5 6.6 6.6 6.4 6.3 6.3

Private sector 5.3 5.2 4.6 4.6 4.4 4.3 5.2 5.1 6.0 7.3 5.0 3.9 3.9

GDP 17.2 16.8 16.4 16.3 16.2 15.4 16.2 16.0 17.3 18.7 15.9 14.4 14.6

$10

$11

$12

$13

$14

$15

$16

$17

$18

$19

$20

$0

$1

$2

$3

$4

$5

$6

$7

$8

$9

$10

Kosrae state GDP 15% ($2.6 million) below FY2003 level at start of amended Compact


237. In FY2008 the state felt the full impact of the RIF, and government declined by

6.6 percent. Despite the impact of the reduced level of public sector demand and the on-

set of the world recession, the private sector grew by 3.3 percent, reflecting the state’s in-

creasing utilization of the infrastructure grant and commencement of the FAA-funded air-

port renovation projects. Overall, the economy fell by 4.9 percent.

238. During the period since FY2008 and after the reforms, two main forces have ex-

erted themselves. The public sector continued to show a gradual decline of 0.9 percent

per annum, reflecting consolidation, implementation of the state decrement management

plan, and the tight fiscal circumstances. However, the private sector displayed a period of

rapid growth and decline. With improvement in the use of the infrastructure grant, the

FAA-funded airport renovations and repaving of the runway, the private sector boomed,

growing by 27 percent and 26 percent in FY2011 and FY2012, respectively. However, in

FY2013 the majority of the FAA-funded airport renovations were complete, and, in the

absence of other stimulus, the private sector contracted by a whopping 35 percent. Gov-

ernment activity also declined, and the economy collapsed, contracting by 15 percent. If

this was not bad enough, FY2014 saw continuation of the same trends, as construction

activity virtually collapsed, and the economy fell a further 10 percent. By FY2015 the

economy had bottom out and although the private sector contracted further, there was

growth in the public sector and the economy grew by 1.5 percent.

239. As with Chuuk, the conditions of the amended Compact have not been kind:

Kosrae’s GDP fell by an average of 1.4 percent per annum, or 16 percent over the period.

From FY2008 through FY2012 it looked as though the economy was on an upward and

reinvigorated path. However, the economy went into a tail spin in FY2013 and FY2014.

With the reduction in construction activity, it reverted to a point below the level at the

start of the amended Compact, the lowest attained during the period. While it is hoped

that construction activity will resume, with the hospital project and others, once the infra-

structure grant management and compliance issues have been resolved, the FY2014 level

indicates a base level of economic activity that might be expected to continue without pri-

vate sector initiative.


240. At the industry level, Kosrae state experienced many of the same developments as

in Chuuk (Figure 44). The primary and secondary industries of agriculture, manufactur-

ing and electricity all endured a downward trend during the amended Compact period.

The main sector bucking this trend was fisheries, which expanded by an annual average

rate of 3.6 percent. In FY2009 fisheries grew by 14.2 percent, with the reopening of the

old freezing plant. While the construction sector showed strong growth after FY2007,

with greater use of the infrastructure grant and airport renovation, output levels in

FY2015 were only half of that prevailing in FY2003. Nontraded services—wholesale, re-

tail, hotels, transport and business services—all experienced reduced demand, as the

economy adjusted to the amended Compact. Output for these activities fell by 3.2 percent

per annum from FY2003 through FY2008 but have effectively stabilized since then.


241. Public administration contracted by an annual average rate of 6.1 percent during

the first part of the amended Compact—less than in Chuuk—reflecting the impact of the

RIF, but since FY2008 public administration has held steady. Offsetting the decline in

public administration, output in the protected sectors of education and health has in-

creased. Provision of education services grew during the first part of the amended Com-

pact through FY2007, but has contracted by 10 percent over the remainder of the

amended Compact, as teacher levels declined with the increased need for certification.

Delivery of health services grew strongly through FY2011 by 18 percent, but has con-

tracted since by 6 percent.


242. Figure 45 indicates trends in private and public sector employment. Unlike Chuuk

there has been a gentler downward trend in the reduction of public sector employment, as

the economy adjusted to the second step-down of Compact I. However, the phasing out

of the use of the capacity building grant from general administration led to a large reduc-

tion in FY2008. Part of the burden of adjustment in Kosrae state has been through a re-

duction in working hours. Thus, the number of employees has been maintained, while

pay checks have been reduced. However, by FY2015 a total of 280 jobs, or 28 percent of

the public sector workforce, had been retrenched since the peak in FY1996. As in the

case of Chuuk, it is no wonder there has been large external migration to Guam, Hawaii

and the U.S. mainland. The trend in private sector employment reflected an upward ad-

justment in the second half of the 1990s, and has declined by an average 2.7 percent per

annum during the amended Compact. The growth in construction activity generated a sig-

nificant temporary boost to employment, but as the effect wore off private sector employ-

ment continued its downward trend.

Figure 44 Kosrae state contribution to GDP growth by industry, FY2003-FY2015 (per-

cent)

-7.0%

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%Total 15 percent ($2.6 million) loss in GDP during amended Compact


243. In terms of reducing the size of the government workforce, Kosrae has been the

most successful in the FSM (see Figure 46). The number of civil servants fell by 19 per-

cent during the PSRP. After some slippage in the early 2000s, the number dropped an-

other 17 percent between FY2006 and FY2009, when a RIF was imposed as part of the

effort to phase out the use of the capacity-building sector grant for nonconforming pur-

poses. In terms of the wage bill, there was a significant reduction as part of the PSRP, but

the savings had largely disappeared by the start of the amended Compact. The RIF in

FY2007 yielded significant cost savings. However, by FY2016 payroll costs had grown

and were trending to the pre-RIF levels. While the workforce size has been significantly

reduced, this has been offset by increases in average wage costs per employee, which

have grown by 25 percent overall, or 1 percent per year since the mid-1990s. The small-

but-annual increase in average wages reflects the composition effect of the reductions in

the workforce and the annual unsustainable 5 percent step increase in Kosrae.


244. At the outset of the amended Compact, the structure of Kosrae’s fiscal accounts

had been altered the least of all five FSM governments, tax effort was weak, and the local

economy was the most dependent on Compact funds. These conditions indicated a lack of

capacity to adjust to the provisions of the amended Compact. In FY2004 the state experi-

enced cash flow management problems, revealing an underlying stressed fiscal position.

After adjusting for the contribution to the CTF, a structural deficit of $2.4 million, 14 per-

cent of state GDP, was recorded (Figure 47). Matters failed to improve in FY2005 and

FY2006, and the state continued to run overall deficits of $1.6 million and $1.7 million,

or 10 percent of GDP in both years, respectively. From FY2008 through FY2013, after

implementation of the fiscal adjustments, the state kept a tight rein on expenditures and

Figure 45 Kosrae state employment in private and public sectors

0

200

400

600

800

1,000

1,200

Public Sector

Private Sector


maintained fiscal balance. However, in FY2014, the state recorded a significant deteriora-

tion in discipline and ran a significant deficit of 6 percent of GDP, which was to be fol-

lowed in FY2015 by a similar large deficit of 5 percent of state GDP.

245. Tax revenues have grown by an average trend rate of 2.7 percent per annum dur-

ing the amended Compact and very close to the nominal rate of GDP of 2.8 percent, and

thus have provided a satisfactory buoyant source of revenue. This has been the result of

enhanced revenue effort to increase state taxes. Of the FSM-wide taxes, the gross receipts

tax has been the most buoyant, and collections have trended at 6.7 percent, which is

above the rate of nominal GDP growth. Both import duties and the wage taxes have been

weak performers, declining by 1.9 percent and 1.7 percent per annum, respectively.

Taken collectively, the FSM-wide taxes displayed a buoyancy ratio of 0.11 a very poor

performance and indicate the need for reform. Kosrae state has been an active supporter

of the FSM-wide tax reform effort, passing the necessary state level legislation.

246. The major growth area in revenues has been in state excises, which have grown

by an annual average of 15 percent. Collections have risen from the low base of $0.16

million to $0.40 million during the period. The increase reflects the decision of the state

leadership to increase tax effort as part of the FY2007 fiscal adjustment. During the dis-

cussion on how to respond to the fiscal crisis, the municipalities agreed to forgo their

constitutional share of the increase in tax rates; in Kosrae state taxes are shared 50-50 be-

tween municipalities and the state government. Although this aided the state during the

crisis, there was a return to the 50-50 revenue share mandated by the constitution in

FY2011. The other main form of revenue is Compact and other grants. These have grown

in nominal terms by an average 0.9 percent, and the rate of growth includes the impact of

Figure 46 Kosrae state government payroll and wage bill

400

450

500

550

600

650

700

750

800

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

7.0

Number

s of

Public S

erva

nts

Wag

e Bill (U

S$m

illions)

Wage Bill

Public Servants

Upward pressure on wage costs since RiFs in FY09


the annual decrement and partial inflation adjustment. Combining tax revenues, grants

and the remaining miscellaneous sources, overall revenues have grown by 0.6 percent

during the amended Compact.

247. On the expense side, total expense has declined by an annual average tend rate of

1.2 percent during the amended Compact, reflecting the mid-period fiscal adjustment. In

2007 the state convened a leadership conference and adopted a program of reform to in-

crease revenues and phase out, in an orderly manner, nonconforming uses of the Compact

capacity-building sector grant. The main instrument of adjustment was a RIF, and in

FY2009 payroll expenses were reduced by $0.9 million or 14 percent of the prior-year

level. Use of goods and services, which makes up the remaining bulk of expenses (pay-

roll and use of goods and services account for 97 percent of total expenses), has oscillated

during the cycle, but in the last two years deteriorated significantly and was one of the

main reasons for the deteriorating fiscal position.

248. During the first three years of the amended Compact, the accumulated deficit of

$7.4 million was financed through a variety of sources. Domestic accounts receivable de-

teriorated by $2.7 million, but this was offset by drawing on foreign assets and invest-

ments of $7.5 million. The balance of financial requirements was made up of domestic

borrowing of $1 million and an increase in accounts payable of $1.4 million. During the

next seven years, FY2007-FY2013, the fiscal situation was almost exactly in balance.

The major financing changes involved a drawdown of domestic deposits of $2.6 million,

offset by an increase in accounts receivable of $1.3 million, a further domestic loan draw-

down of $1.6 million, and a reduction in accounts payable of $2.4 million.

Figure 47 Kosrae state consolidated revenues and expenditures, (US$ millions)

6

7

8

9

10

11

12

13

14

Expenditures

Revenues

emergence of Significant fiscal deficit in FY14


249. The emerging fiscal deficits in FY2014 and FY2015 of $1.2 million and $1.0 mil-

lion, or 6 percent and 5 percent of state GDP, respectively, marks a departure from the re-

cent discipline Kosrae has displayed. While revenues were largely unchanged on the

prior year’s levels, there was a considerable deterioration in both compensation of em-

ployees and use of goods and services. Payroll expense rose by 7 percent, and goods and

services by 29 percent. During the last two years the accumulated fiscal deficit of $2.2

million was financed by drawdown of domestic deposits of $0.7 million, a use of foreign

assets of $0.5 million, domestic loans of $0.4 million and increase in accounts payable of

$0.6 million. Although 2014 was an election year in Kosrae, the fiscal deterioration con-

tinued into FY2015. With its finely balanced fiscal equation, the small state cannot afford

to get off the rails, having few other sources of finance to redress the imbalance. The ex-

cesses in the last two years need to be addressed by cutting expenses to their former lev-

els to restore fiscal balance.


C Pohnpei state

1 GDP

250. The Pohnpei economy weathered the implementation of the amended Compact in

FY2004 without any undue adverse impact (see Figure 48). Unlike Chuuk and Kosrae,

Pohnpei had in the mid-1990s phased out the use of the energy grant to subsidize utility

prices and thus avoided the associated reduction in public enterprise value added.

Pohnpei state hosts the national government, which was largely unaffected by the decline

in Compact resources. The more-developed nature of the state economy and the higher

revenue effort meant that the state was able to make the adjustment to the new Compact

regime without suffering the negative impact of the transition to a sector grant approach.

During the amended Compact the Pohnpei economy has grown by 1.2 percent annum, a

respectable rate in comparison with the other FSM states. In the initial years through

FY2007, the economy expanded by 1.7 percent per annum and then flattened out during

the international recession years. In FY2010 and FY2011 it picked up speed, as the FAA

and infrastructure projects gained momentum, but then fell back, as these projects were

completed or held up by non-compliance and project management weaknesses. In

FY2015 the state economy grew strongly, surpassing earlier levels, reflecting strong

grow in fisheries.

251. The private sector declined by an average of 0.5 percent per annum making a neg-

ative contribution to economic growth during the amended Compact, but underwent peri-

ods of changing fortunes. As Figure 48 indicates the private sector was relatively flat

through FY2008. However, it was hit hard in FY2009 by the inflationary impact of the

international recession on demand. Production picked up in FY2010 and FY2011, with

Figure 48 Pohnpei state constant price GDP by sector, FY2004 prices (US$ millions)


Government 34.7 34.6 35.2 36.1 36.3 36.7 36.4 37.5 38.1 37.6 37.2 37.2 37.5

Private sector 26.7 27.2 28.0 27.2 27.8 27.8 25.3 28.7 30.2 26.3 25.3 24.0 25.1

GDP 101.9 102.6 106.5 106.5 109.2 108.9 108.8 114.0 116.9 113.1 112.1 111.3 117.8

$60

$70

$80

$90

$100

$110

$120

$20

$25

$30

$35

$40

Pohnpei state GDP 16% ($9.1 million) Above FY2003 level at start of amended Compact


increased construction activity but then declined significantly from FY2012 through

FY2014, as construction output fell. In FY2015 the private sector gained back some of

the lost ground reflecting improvements in many industries.

252. The public sector, however, has played a more dominant role, contributing a total

of 7.3 percent to the overall growth in GDP of 15.6 percent. Both public enterprise and

government have shown increases in output. In the case of public enterprises, Caroline

Fisheries Corporation (CFC) and the state-owned fish loining plant have made positive

contributions. Public sector enterprises grew strongly through FY2012 and contributed

4.6 percent of the total growth. Government activities, both state and national, which

have not been subject to the same restrictions as in Chuuk and Kosrae, have grown above

the economy average. The household sector has made a very significant contribution to

the Pohnpei result, contributing 5.7 percent to the overall increase in GDP. This reflects

increases in subsistence production, as measured between the two most recent household

income and expenditure surveys.

253. Overall the results for Pohnpei have been barely satisfactory, with the private sec-

tor making a negative contribution to the result. The reliance on the public sector and the

increase in household production for own consumption does not reflect a vibrant econ-

omy. From FY2012 through FY2014 economic growth was negative, mirroring falling

demand for infrastructure. While hopefully compliance and project management issues in

the use of the infrastructure grant will be overcome, the result indicates the vulnerability

of an economy reliant on a few driving forces and the need for more active policy initia-

tive.


254. The contribution of various industries in Pohnpei to overall economic growth dur-

ing the amended Compact is shown in Figure 49. Due to an increase in subsistence pro-

duction, agricultural output improved during the amended Compact, registering an annual

average growth rate of 2.9 percent. As previously noted, this rate is derived from the re-

sults of recent household income and expenditure surveys. The results may reflect

changes in survey methodology as much as economic trends, although they are consistent

with a weak economy. The fisheries sector has provided a positive engine of growth, av-

eraging 4.1 percent per annum, but it varies from year to year, depending on fishing con-

ditions and prices. In FY2013 dry docking of the three CFC boats negatively impacted

the fish catch, but all were back in service in FY2015, together with two new boats that

were commissioned at the end of the fiscal year. Output of the small manufacturing sec-

tor has remained static, but electricity production has followed a downward trend due to

higher prices. More recently, power outages caused by poor management and mainte-

nance have adversely affected output.

255. Construction demand was weak in the initial years but proved to be a strong

source of growth from FY2008 to FY2011, with airport renovations, the runway exten-

sion and increased use of the infrastructure grant. From FY2012 through FY2014 output


contracted, with the completion of the airport renovations and delay in disbursement of

the infrastructure grant. Wholesale and retail trade has shown a downward trend during

the amended Compact declining by an annual average of 1.1 percent, which comes as a

surprise, given the overall growth in the economy. However, the availability of products

in the local supermarkets compared with other Micronesian economies reflects a lack of

competition and an inefficient sector. As in all states, including Pohnpei, the tourism sec-

tor has shown poor results. It declined by an annual average of 1.4 percent during the

amended Compact and performed worse than all other major economic sectors. For the

activity that has more natural advantage than any other in the FSM, this is very disap-

pointing.

256. Delivery of public administration declined in the early years of the amended

Compact through FY2007, but has subsequently shown some erratic signs of growth.

Both education and health have increased by annual averages of 1.0 percent and 3.9 per-

cent, respectively. In the case of education, growth was concentrated before FY2007 and

reflects the shift to the sector grant approach, which provided more funds to education.

More recently problems with teacher certification and accreditation at the COM have

constrained output. In the case of health, delivery has grown steadily over the period.


257. Figure 50 indicates the changes in private and public sector employment in

Pohnpei state. In the public sector, employment contracted in the later parts of Compact I,

as the state implemented the early retirement program of the PSRP. However, growth in

the number of public servants in the national and state governments and agencies made

up for the loss before the onset of the amended Compact and has remained largely con-

stant since that time. Both the national and state governments were spared any need to

Figure 49 Pohnpei state contribution to GDP growth by industry, FY2003-FY2015 (per-

cent)

-2.0%

-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0% Total 16 percent Growth in GDP during amended Compact


further reduce staffing levels. In the case of the private sector, 962 new jobs were created

between FY2003 and FY2011. This is a 33 percent increase—significantly higher than

the private sector GDP increase of 13 percent during this period. The increase reflects the

creation of an additional 445 jobs in construction and 281 in wholesale and retail trade.

258. Pohnpei state implemented the early retirement program of the PSRP and

achieved significant success (see Figure 51). By FY1999 the number of civil servants fell

Figure 51 Pohnpei state government payroll numbers and wage bill

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

9.0

10.0

11.0

12.0

13.0

14.0

15.0

16.0

17.0

18.0

Number

s of

Public S

erva

nts

Wag

e Bill (U

S$m

illions)

Wage Bill

Public Servants

Wage costs Stabilized since FY06

Figure 50 Pohnpei state employment in private and public sectors

2,000

2,500

3,000

3,500

4,000

4,500

Public Sector

Private Sector


by 20 percent, and the wage bill was reduced by 23 percent. However, during the follow-

ing years, increases in payroll numbers, unconstrained by the need to adjust to the

amended Compact, neutralized much of the earlier achievements. The number of civil

servants has risen and now stands only 9 percent below the pre-PSRP levels, while the to-

tal wage bill is 7 percent below former levels. In FY2008 a COLA of $30 per employee

per pay period was awarded. Since that time, however, the wage bill has remained steady.

3 FISCAL

259. Pohnpei has operated a finely balanced fiscal policy. At the start of the amended

Compact in FY2004, a deficit of $6 million (6 percent of GDP) was recorded (see Figure

52). However, this outturn hides the state’s contribution of $7.5 million to the CTF and

an unusual increase—of about $5 million—in nontax revenues. Adjusting for these non-

recurring features, the state ran an underlying deficit of $4 million (4 percent of GDP).

Unlike her sister states, Pohnpei did not require any phase-out of the use of the capacity-

building sector grant for nonconforming purposes. The structure of the economy and state

budget prevented a shortfall in funds for public administration, and Pohnpei was able to

enter the amended Compact period with a fiscal structure in alignment with the sector

grant approach. Figure 52 indicates that after the initial year of the amended Compact, the

fiscal equation was closely balanced.

260. Tax revenues have grown by an average rate of 3.5 percent per annum during the

amended Compact, which is below the nominal GDP rate of 4.2 percent, and thus have

not provided a buoyant source of revenue. The gross receipts tax has trended at 5.5 per-

cent, which is above the rate of nominal GDP growth, while import taxes have grown by

2.6 percent. Neither the wage tax nor especially the state sales tax has provided buoyant

revenue, the former growing by 2.5 percent and state sales tax actually declining by 1.1

Figure 52 Pohnpei state consolidated revenues and expenditures (US$ millions)

0

5

10

15

20

25

30

35

40

45

Expenditures

Revenues

Pohnei runs deficits in all but one year during amended Compact


percent. Pohnpei state has been reluctant to participate in the tax reform initiative, but

lack of buoyancy in the current outmoded regime suggests the state would be well ad-

vised to reconsider, if it wishes to avoid declining funding to support services. The other

main form of revenue is Compact and other grants. These have displayed an erratic trend

with an average 0.5 percent growth rate, reflecting the partial indexation and annual dec-

rement. Combining tax revenues, grants and the remaining miscellaneous sources, overall

revenues have grown by 1.0 percent during the amended Compact (excluding FY2004).

261. On the expenditure side wage costs grew rapidly at the start of the amended Com-

pact through FY2008. In FY2008 Pohnpei awarded a cost-of-living adjustment (COLA)

to state government employees, but wage costs have stabilized since that time. Overall

wage costs have grown by an annual average of 1.6 percent during the amended Com-

pact. Outlays on use of goods and services have been erratic and largely remained un-

changed in nominal terms. This suggests that fiscal balance has been achieved through

squeezing complementary inputs. Wages and purchases of goods and services takes up

about 90 percent of total state expense, and other costs have been held in check. Overall

state expenses have grown modestly through the amended Compact. Outlays on nonfi-

nancial assets average less than $1 million, since all state Compact infrastructure projects

are billed to the national government.

262. Pohnpei has operated a very finely balanced budget and has recorded a deficit av-

erage of 1.2 percent of state GDP since FY2004. Over the period (excluding FY2004,

when the state made transfers to the CTF), the accumulated deficit of $17.4 million has

been financed through a reduction in accounts receivable of $3.8 million, a drawdown of

external investments of $11.1 million and an increase in accounts payable of $3.0 million.

As in the other FSM governments, the continuing reduction in real Compact flows places

mounting pressure on fiscal operations. The unassigned general fund balance of $0.2 mil-

lion in FY2015 indicates that the flexibility to support the continuing deficits is running

out.


D Yap state

1 GDP

263. Like Pohnpei the Yap economy weathered the implementation of the amended

Compact in FY2004 without any undue adverse impact. Yap had managed to avoid any

significant fiscal adjustment or requirement to downsize the public sector workforce. The

state also in the mid-1990s phased out the use of the energy grant to subsidize utility

prices and thus avoided the associated reduction in public enterprise value added. While

the state was required to phase out the use of the capacity building sector grant, it man-

aged to do this without disruption. However, unlike Pohnpei, the state economy has de-

clined significantly, by 12 percent overall or a trend annual average decline of 1.1 percent

(see Figure 53). This result is largely similar to Chuuk and Kosrae, but after the favorable

result of Compact I, the outcome during the amended Compact is a disappointment.

264. The start of the amended Compact saw the departure of the two garment factories,

and private sector value added declined by 26 percent per annum over the first three

years. However, with the departure of the factories complete, the private sector continued

to decline between FY2006 and FY2015 by an annual average of 3.4 percent. Of the

overall reduction in GDP of 12.1 percent during the amended Compact, the decline in the

private sector was responsible for 12.9 percent, i.e. the loss in private sector value added

was greater than the fall in overall GDP. Public enterprises, including both the local utili-

ties, the Yap State Public Service Commission (YSPSC), and Diving Seagull, the state-

owned-but-private-sector-managed purse seine operation, also declined during the period.

The two entities contributed 0.9 percent to the overall drop. The major forces sustaining

economic activity were the government and households, which counter balanced the

Figure 53 Yap state constant price GDP by sector, FY2004 prices (US$ millions)


Government 8.5 8.3 9.7 9.4 9.3 9.4 9.4 9.7 9.6 9.4 9.3 9.1 9.3

Private sector 13.0 12.7 11.4 9.6 9.4 9.4 9.9 9.1 8.7 8.5 8.1 7.4 7.0

GDP 46.6 43.6 45.8 43.3 42.6 42.2 44.2 44.0 41.9 41.0 39.5 39.5 40.9

$35

$37

$39

$41

$43

$45

$47

$5

$7

$9

$11

$13

$15

$17 Yap state GDP 12% ($65.7 million) Below FY2003 level at start of amended Compact


losses incurred by the private and public enterprise sectors. In the second year of the

amended Compact, government grew by 17 percent, but it has stabilized since that time.

Households contributed 3.7 percent to overall growth during the period.

265. Figure 53 also reveals significant oscillations through the period. The decline in

FY2004 represents the impact of Typhoon Sudal, which destroyed crops and depressed

agricultural output. FY2004 was also a poor year for the local purse seine operation,

which further led to falling output. The spike in FY2005 reflects the Typhoon rehabilita-

tion and return to normal agricultural output. However, the closure of the garment facto-

ries restricted GDP from returning to its pre-Sudal levels. The jump in FY2009 was due

to a temporary boost to construction activity.


266. At the industry level, the Yap state economy shows an overall weak performance,

with most industries declining during the amended Compact (Figure 54). Agriculture has

shown modest growth of 2.2 percent, reflecting household survey and population data,

upon which the agricultural GDP estimates are based. As noted agricultural output fell

and rose in response to Typhoon Sudal at the start of the period. Fisheries output showed

a declining trend through FY2013, averaging 1.8 percent per annum, but showed a favor-

able result in the following two years FY2014 and FY2015. Manufacturing all but disap-

peared in FY2005, with the closure of the two garment factories. While the factories

made a significant contribution to GDP, most of the employed labor consisted of foreign

workers. State gross national income (GNI), which adjusts for compensation of nonresi-

dents, would show a more stable pattern.

Figure 54 Yap state contribution to GDP growth by industry, FY2003-FY2015 (percent)

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

Total 12 percent loss in GDP during amended Compact


267. Reflecting the general forces prevailing in the FSM, electricity production re-

vealed a downward trend during the early part of the amended Compact, the result of the

closure of the garment factories and weakening demand in the face of rapidly rising

prices. Construction output has varied in proportion to public investment demand. It rose

very strongly in FY2005, due to cyclone rehabilitation, and again in FY2009, with the

FAA-funded airport renovation. Yap benefited less than her sister states from the FAA

projects, since runway repaving had been completed prior to the amended Compact. In

FY2010 the airport improvements came to an end, but construction output was boosted

by Compact infrastructure projects and state-financed road repairs. Reflecting the general

trends in the economy, wholesale and retail trade has declined during the amended Com-

pact, by an average 2.4 percent per annum. Tourism, as in Yap’s sister states, performed

abysmally and fell by an average annual rate of 4.8 percent, greater than any other indus-

try. Yap has considerable tourism potential with good tourism infrastructure, but the lim-

ited flight schedule has inhibited growth.

268. Government administration has been variable, surging by 14 percent in FY2010

and then gradually receding through FY2015 to previous levels at the start of the

amended Compact. In FY2006 education services grew rapidly, reaching a new plateau,

benefiting from the sector grant approach. However, in FY2010 the sector suffered sig-

nificant reductions in each of the following years through FY2015 reverting to the level

of service at the start of the amended Compact, reflecting the need to improve teaching

standards and teacher certification to qualify for continued Compact education sector

grants. The health services sector has been the strongest performer in the amended Com-

pact, following the pattern in other states, and has grown strongly in most periods, aver-

aging 5.4 percent a year.


269. Figure 55 indicates trends in employment in both the private and public sectors.

The private sector reveals the upward trend toward the end of Compact I, with jobs cre-

ated in the garment factories, although this was largely represented by foreign labor. At

the start of the amended Compact, the factories closed and employment fell sharply.

Since FY2006 private sector employment has dropped by an annual average of 1.6 per-

cent. Yap participated in the PSRP, as did all the FSM states, and the public sector work-

force was reduced in the FY1998-FY1999 period. It remained at the post-reform levels

for several years but then rose at the start of the amended Compact and has gradually de-

clined since FY2005.

270. Recent payroll performance in Yap has been a disappointment (see Figure 56).

The state was one of the best achievers of the PSRP, but weak management at the start of

the amended Compact under a new administration eroded the former success. At the end

of the PSRP, the number of civil servants had fallen by 21 percent, and the total wage bill

had been reduced by 19 percent. Current employment numbers are 9 percent below PSRP


levels, but the wage bill is 20 percent above. In FY2005 civil servant numbers rose

sharply by 27 percent, the result of additional hiring and Typhoon Sudal, but, after a

slight decline in the following two years, have remained largely steady. Yap had the low-

est wage rates in the FSM, but in FY2006 a wage rate adjustment was awarded, and wage

costs per employee rose 25 percent, bringing it closer in line with Chuuk and Kosrae but

which remained 24 percent below those of Pohnpei in FY2015. As a result of these devel-

opments, the total wage bill has risen by 73 percent since the beginning of the amended

Compact, but in the last four years since FY2012 it has largely stabilized.

Figure 55 Yap state employment in private and public sectors (labor hours)

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

Public Sector

Private Sector

Figure 56 Yap state government payroll and wage bill

0

200

400

600

800

1,000

1,200

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

9.0

10.0

Number

s of

Public Ser

van

ts

Wag

e Bill (U

S$m

illions)

Wage Bill

Public Servants

Wage costs Stabilized since FY10



271. The existence of a large pool of external investments accumulated during the orig-

inal Compact has presented Yap with a different fiscal environment compared to the

other FSM governments. While the state was faced with the same problem as Chuuk and

Kosrae—the need to phase out the use of the capacity-building sector grant for noncon-

forming activities—Yap maintained operational expenditures within the fiscal envelope

without the need for an adjustment program or reduction in personnel. However, capital

outlays and nonrecurring expenses have been funded through the drawdown of financial

investments. The ability to fund infrastructure projects out of the state’s own resources is

something that has not been available to the other FSM states. As a result, Yap has oper-

ated a fiscal deficit in all but one of the years of the amended Compact (see Figure 57),

without endangering financial stability.

272. After adjusting for the contribution to the CTF in FY2004, the state recorded

overall persistent fiscal deficits from FY2004 to FY2015, averaging $2.0 million, or 4.1

percent of GDP. The gross operating balance (revenues less expenses), on the other hand,

averaged a deficit of close to zero. The accumulated overall deficit during this period of

$24.1 million was financed through a drawdown of foreign assets of $24.1 million to

fund investments in infrastructure of $24.5 million. In effect, Yap has operated fiscal pol-

icy under what is sometimes referred to as the “golden rule,” which means using financial

reserves only for investment purposes.

273. Tax revenues have declined by an average trend 1.4 percent per annum during the

amended Compact, below the trend nominal GDP rate of 1.6 percent, and thus have pro-

vided a very weak and underperforming source of revenue. All national government taxes

have been weak performers in Yap. The GRT has declined by an annual average trend of

Figure 57 Yap state consolidated revenues and expenditures, (US$ millions)

0

5

10

15

20

25

30

Expenditures

Revenues

Yap runs deficits in all but one year during amended Compact


1.3 percent, wages tax has declined 1.1 percent, and customs duties rose by 0.4 percent.

The worst performer, as in the other FSM states, has been the state excise, which has

fallen by an average of 3.0 percent. The poor performance of the tax system suggests, as

in the case of Pohnpei, that Yap state should take a long hard look at the tax reform pro-

posal, since the current outmoded regime does not provide an elastic source of revenue

and has in fact declined while nominal GDP has risen. The other main form of revenue is

Compact and other grants. After the poor start to the amended Compact, when grants re-

ceipts were artificially low, the trend has been downward, averaging 0.9 percent, and re-

flects the partial indexation and annual decrement. Combining tax revenues, grants and

the remaining miscellaneous sources, overall revenues have fallen by an annual average

trend value of 0.6 percent during the amended Compact (excluding FY2004).

274. On the expense side payroll expense grew rapidly at the start of the amended

Compact, but while stabilizing in FY2006, has continued to grow; overall payroll costs

have increased by an average 2.2 percent. Use of goods and services, which together with

payroll accounts for 88 percent of total expense, has been largely stationary, although it

has exhibited significant variation at times. Overall total expense has declined by 0.6 per-

cent per annum during the amended Compact.

4 POLICY ISSUES

275. Tourism Development and ETG: In March 2011 Yap was approached by the Ex-

hibition and Travel Group (ETG) with a proposal for tourism development and construc-

tion of a 10,000-room casino and golf resort complex. The development sent the Yap

leadership into a tailspin and divided opinion, with some favoring economic development

and others concerned with the impact on culture and tradition. The state administration

issued a business license and foreign investment permit. However, motions were set in

place to recall the governor, and the Yap State Legislature passed restrictions on foreign

investment. ETG was requested to scale back the development, and the proposal was cut

to 4,000 and subsequently to between 1,000 and 1,500 rooms, with the casino and golf

course dropped from the concept. Clearly, the original scale of the investment was far too

large, comparable to that of Guam. Even the reduced size of 1,500 rooms is close to plant

size in neighboring Palau. Although ETG still has a presence in Yap, interest has waned.

The ETG initiative raised important issues of economic development, culture and tradi-

tion. However, the experience was divisive, splitting the state leadership and resulting in

the passage of anti-reform legislation.

276. Foreign Investment Law and Land Registration: As a result of the ETG pro-

posal, the state Legislature enacted measures to restrict foreign investment and introduce

a foreign investment board. This was a backward step from the PSRP reforms in the late

1990s, which had introduced a state and national regime with the intention of streamlin-

ing the approval process in a simple and transparent manner. A green, amber and red sys-

tem was designed with the idea of removing bureaucratic intervention from the process.

The creation of a foreign investment board effectively thwarts this process. Efforts to im-


prove land legislation have also failed to gain traction. As part of the ADB-sponsored Pri-

vate Sector Development Program (PSDP), a measure was drafted to enable land registra-

tion. This was submitted to the Legislature in 2007 and reintroduced during the 8th Legis-

lature. The policy supports land leasing and private sector development.

277. Tax Reform: Yap’s failure to participate in the tax reform process was an issue of

concern. The holdup was on interpretation of the constitution, which states that “the

power of taxation shall never be surrendered, suspended or contracted away.” The FSM

tax reforms involved the creation of a Unified Revenue Administration (URA), which

would collect all taxes in the FSM on behalf of the national and state governments. The

state Legislature took the position that the state constitution conflicts with Yap’s partici-

pation in the URA and, therefore, Yap could not contribute to the reforms. Legal opinion

has been issued that the URA is not in conflict with the constitution, but the Legislature

has failed to accept this position. It appears that apart from this issue, the Legislature had

no objection to the reforms in and of themselves. As noted above Yap state needs a mod-

ern and efficient tax system to support the state’s development and to maintain a buoyant

source of revenue. At the present time the tax reform initiative has lapsed. However, as

indicated in this review, the current tax system is ill-suited to meet the FSM’s needs. At

some point the reforms are likely to be reconsidered, and Yap’s position will need to be

revisited.

278. Yap State Public Service Commission: The YSPSC was one of the best run utili-

ties in the Micronesian region, but action taken by the Legislature in FY2008 to address

rapidly rising fuel prices has forced the entity to adopt weak management and financial

practices. In FY2008 the state Legislature barred the use of a variable fuel charge, which

was enacted in FY2006 by the YSPSC to cover increases in fuel costs. From an average

level of 17 cents per unit in FY2005, prices rose to 31 cents in FY2007. However, in

2008 the new law forced the corporation to return average prices to their prior levels. As

a result, the YSPSC was put into a dire financial position: once one of the most efficient

utilities in Micronesia, it was forced into operating one of the largest deficits in the re-

gion. In FY2007 gross revenues were $5 million, with costs of an equal amount. By

FY2008 the utility was required to repay $3.1 million in revenues to customers, resulting

in an operating loss of $5.7 million.

279. In order to enable YSPSC to honor the liabilities forced on it, the state Legislature

loaned the utilities $1.6 million in FY2009. In February of that year, the YSPSC imple-

mented a revised tariff that built fuel cost into the base rate, with an average price of 32

cents per unit. While the revisions to the tariff improved the financial position of the util-

ity, they were insufficient to cover costs. As a result, the utility needed to charge govern-

ment departments a higher rate—70 cents per unit—to make up the shortfall.

280. In 2009 with DOI support, a fuel tariff study was conducted which recommended

a fuel cost component to allow tariffs to adjust to cost. The YSPSC introduced a new tar-

iff in FY2012. However, the state Legislature froze the fuel cost element, thus once again


impeding the corporation’s ability to adjust tariffs to costs. The DOI study surprisingly

recommended the continuation of the cross subsidy from government. This recommenda-

tion led JEMCO to reduce the level of the education and health sector grants by an

amount equivalent to the subsidy. In the FY2012 management report, the YSPSC indi-

cated the lack of reserves available to undertake routine maintenance and the risk of a

generator breakdown and power outages. In FY2013 the state Legislature forgave the re-

maining unpaid portion of the $1.6 million facility extended in FY2009.

281. Since the introduction of the current tariff in FY2012, YSPSC sustained operating

losses through FY2014, averaging $0.5 million, roughly 8 percent of revenues. In the cur-

rent year with a reduction in fuel costs from $4.58 prevailing in FY2014 to $3.50 in

FY2015 the utility managed to break even taking advantage of the reduction in interna-

tional fuel prices and without the legislature intervening to reduce prices to the consum-

ers. However, even with the current reductions YSPSC operates well below full cost re-

covery. The YSPSC saga has yet to reach a satisfactory conclusion that allows the entity

to operate on a commercial basis, and is subsidized by the state only where there is

clearly defined community service obligations (CSO).

282. YSPSC has entered into an interesting renewable energy program with the ADB

for $9 million entailing a wind farm that is expected to generate 18 percent of the main

islands power needs. The project includes grid-connected solar panels which will be in-

stalled on 21 government buildings equivalent to 4 percent of production needs. In addi-

tion, a new fuel efficient generator will replace existing plant which will reduced fuel

consumption and work to supplement capacity of the renewables when wind and solar

power fall below operating needs. The project is expected to be implemented over the

next few years.

283. Yap State Investment Trust Fund: In FY2010 Yap enacted special legislation to

create the state Investment Trust Fund (ITF). Yap transferred $30 million to the new

fund, which stood at $42.5 million at the end of FY2015. Effectively, the ITF has been

isolated from the general fund and may not be drawn on except through further legisla-

tion. At the end of FY2015, the general fund had accumulated investments of $21.8 mil-

lion, with $11.6 million unassigned and available for disbursement. While the state has

executed recurring fiscal deficits through the amended Compact period, it has adopted a

fiscal “golden rule” and only drawn down on its financial investments to fund infrastruc-

ture projects.

284. Conclusion: Yap state has in the past been well managed and reform minded, set-

ting the standard for strong leadership and development in the FSM. However, in recent

years, with the divisive nature of the ETG proposals, lack of clarity on issues such as tax

reform, foreign investment, and utility pricing, the state departed from its sense of direc-

tion. There has been a change in leadership in Yap since the start of 2015, with changes

in administration and the state Legislature. Dialogue between the branches of government

has been opened, and it is hoped that the current leadership can come together and return


to the reform agenda to encourage economic development at a reasonable rate without

threatening Yapese culture and tradition.

116

VI. ECONOMIC PROSPECTS TO THE END OF THE AMENDED

COMPACT AND BEYOND

285. In the FY2013 Economic Review, the FSM Macroeconomic and Fiscal Forecast-

ing Framework (MFFF) was presented. The MFFF represented the evolution of a set of

projections over the medium term of GDP by industry of the four states and the fiscal ac-

counts of the five governments, including the balance of payments and projections of the

banking survey for the nation. The modeling structure incorporates the economic flows

and interrelationships of the economy, starting from production and supply, to the genera-

tion of factor incomes, to the institutional sectors (households and government), and

through derivation of demand. Demand is in turn allowed to flow back into supply. In

this Review the MFFF provides projections through the end of the amended Compact and

beyond to FY2030 in order to capture the post amended Compact adjustments that may

be required to maintain financial stability. The MFFF comes under the class of models

known as financial programming developed by the IMF. A write-up of the MFFF is pro-

vided in Appendix 1. A set of projection tables and the spreadsheet model can be down-

loaded from www.econmap.org.

286. The first objective of the MFFF is to enable the creation of a set of realistic and

plausible projections of the FSM economy over the remainder of the amended Compact,

given the current policy environment and experience of the first 12 years of the period.

The discussion in this chapter focuses on the likely path of growth the economy will take,

and the emerging fiscal outturn at the national and state levels. With attention being fo-

cused on the potential shortfall of resources from the Compact Trust Fund, the second ob-

jective is to closely define the level of fiscal resources that may be available, and the size

of the adjustment that may be required in the post amended Compact years. The results of

the CTF simulations referred to in Chapter 3 and explained in a forthcoming paper1 are

drawn on to define a sustainable distribution policy without subjecting the FSM to the po-

tential erratic implications of the existing CTF agreement.

A Economic Prospects

1 ASSUMPTIONS

287. The major factors affecting the baseline projection of economic activity relate to

the fisheries sector, infrastructure investment, and the provision of public sector services.

288. Fisheries: While the size of the FSM EEZ would suggest fisheries could play a

major driving force in the economy, the attempt to expand the activity through public in-

vestment in the late 90s failed. Although the receipt of fishing royalties has grown dra-

1 The FSM, RMI, and Palau Compact Trust Funds are described in substantial detail in a separate Graduate

School paper, “Compact Trust Funds in the Three Freely Associated States: Mechanics and Stochastic

Projections,” (forthcoming at http://www.econmap.org).



Economic Prospects to the end of the Amended Compact and Beyond 117

matically, domestic production of the industry is now based on two private public part-

nerships and remained largely stagnant through FY2014. With the increase in fishing

fleet from 3 to 5 vessels and doubling of fish catch potential of the Caroline Fishing Cor-

poration, output is expected to grow strongly in FY2016. There has been growth in off-

shore, but domestically registered fishing companies to take advantage of the lower fish-

ing royalties paid by the domestic fleet, but these are not considered as part of GDP. Fish-

ing royalties are projected to remain constant in real terms but an allowance for inflation

has been included in the projections. The evidence on hand suggests that the PNA has

been successful in conserving the skipjack tunery and that risk to fishing stocks is low.

However, the recent trends to increase the domestic fleet through local incorporation of

foreign vessels under flags of convenience may well pose a serious threat to sustaining

the current levels of fees. This has not been incorporated into the projections.

289. Infrastructure: As discussed in earlier parts of this review utilization of the infra-

structure grant has fallen to very low levels in recent years reflecting issues with fulfilling

the terms of the grants and management problems. In FY2015 out of a total available $24

million, only $7 million was draw on. Of the $277 available for use during the amended

Compact through FY2015 only $112 million has been used leaving $165 million availa-

ble. In the MFFF projections it is assumed that use of the grant rises to 30 percent of the

annual available funding in FY2016 and rises by 25 percent per annum until it reached an

absorptive capacity level of 150 percent in FY2021. Use of the grant continues post

FY2023 until remaining resources are used up in FY2028. Use of backlog funds is thus

spread evenly to avoid front loading and periods of boom and bust. The MTFF also as-

sumes the FAA Chuuk runway renovation project of $33 million is constructed FY2016-

FY2018.

290. Provision of public services and government expenditures: Implementation of

the Long-Term Fiscal Frameworks (LTFF) or Decrement Management Plans (DMP)

adopted by the FSM states level is assumed to be averted in FY2017 through the realloca-

tion of the national government’s share of Compact resources. In fact, this implies an in-

crease in funding for the states in FY2017, but without any inflation adjustment in

FY2018 and FY2019 as proposed in the original LTFF framework. It is further assumed

that the third decrement cut of 6 percent is implemented in FY2020 with a cut in public

payroll and use of goods and services of the same amount. Use of the national govern-

ment fiscal surplus is assumed to follow the trend set in FY2016: $10 million is allocated

to the FSM trust fund for state sub-accounts, $10 million to state level priority infrastruc-

ture projects, $5 million to the national government account of the FSM trust fund, and

an increase in national government legislative projects of $0.25 million per senator, total

of $3.5 million. The states also continue to benefit from the re-allocation of 20 percent of

domestic tax revenue share to the state trust fund sub-accounts. These allocations have

been adopted in the absence of any agreed rational plan on the use of the fiscal surplus

but reflects the current ad hoc policy. It could thus be subject to change.


291. In terms of economic activity, the above assumptions imply that at the state level

the provisions of goods and services remains constant in real terms, but is cut by 6 per-

cent in FY2019. State priority infrastructure projects also boost the state economies. At

the national level government expenditures continue in real terms at their FY2015 levels

including the $7 million blow out in contractual services (personnel contracts) in

FY2015. Increases in legislative projects also boost economic activity.

2 ECONOMIC ACTIVITY

292. The projected growth path of the FSM economy is indicated in Figure 58. The

strong performance experienced in FY2015 is anticipated to continue into FY2016. Fish-

eries production is anticipated to grow with the increases in the capacity of the domestic

fishing fleet. While it is assumed that the use of the Compact infrastructure grant remains

at much the same level as in FY2015, national government funded state level priority in-

frastructure projects and the Chuuk airport renovation project boost construction output.

This feeds back in demand for jobs and household incomes. These trends continue into

FY2017 and GDP grows by a further 4.2 percent as the economy records a full year of

operation of the expanded fishing fleet, use of the infrastructure grant improves, and the

Chuuk airport renovation reaches a peak. In FY2018 economic growth moderates with no

additional boost from fisheries and the Chuuk runway project is completed. In FY2020,

the final step down of the LTFF is implemented, which depressed delivery of government

services and economy records negative growth of 0.5 percent. From this point on the

economy bottoms out through the remainder of the amended Compact.

293. At the start of the post amended Compact period the economy contracts by 2.5

percent reflecting the need for fiscal compression. However, it is assumed, as discussed

Figure 58 FSM economic prospects, FY2015-FY2030 (US$ millions)

FY15, 3.8%

FY16, 4.2%

FY17, 4.2%

FY24, -2.0% FY29, -3.2%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

8.0%

$180

$200

$220

$240

$260

$280

$300

$'s m

illion

Projected growth 1.1 percent duringlast nine years of amended Compact; and -1.0 percent thereafter

GDP Growth

GDP Level


in greater detailed below in the fiscal section, that government operations in the states are

maintained through transfers from the national government’s fiscal surplus. However,

while the FSM is able to maintain the level of public services, other expenditures are cut.

The national government funded state level priority infrastructure projects are no long

sustainable. While the level of Compact infrastructure spending is assumed to continue

due to the backlog of unused funds, construction activity falls due to the termination of

the state level priority infrastructure projects. In FY2029 the backlog of unused Compact

infrastructure projects runs out and the GDP falls by 3.2 percent reflecting the down turn

construction activity, although some projects are maintained through reduced drawdowns

from the CTF.

294. Figure 59 indicates the sources of growth during the remaining years of the

amended Compact. Clearly, Gross Fixed Capital Formation is a dominant factor, both on

the upswing and downside. Once again, this reinforces the need to resolve project man-

agement issues, so the economy will not be held back due to administrative inefficien-

cies. Household expenditures mirror those in the economy, stimulating growth on the up-

swing and the reverse on the downside. Government expenditures play a relatively minor

role, with the exception of the 2020 decrement adjustment. Exports, mostly fish, are an

important contributor to growth in the early part of the period, and could be a source of

expansion in the future although this is not projected. Other exports have been assumed

to remain largely unchanged, echoing the weak policy environment for private sector de-

velopment, and play little role in improving economic performance.

295. Over the period the FSM economy is projected to grow by 1.1 percent during the

remainder of the amended Compact. While this is a low rate of growth, it represents a

significant improvement over the first 12 years. The projections indicate a spurt of

growth averaging 4.2 percent during the FY2016-FY2017 period, reflecting fisheries ex-

pansion and the resumption of construction activity. During the remainder of the

Figure 59 Sources of growth through FY2030

-8.0%

-6.0%

-4.0%

-2.0%

0.0%

2.0%

4.0%

6.0%

Government expenditure

Gross Fixed Capital Formation

Household expenditure

Exports

GDP


amended Compact period the economy stagnates but declines in FY2020 with the imple-

mentation of the final decrement adjustment. During the post amended Compact period

the economy is projected to decline by an average 1.0 percent per annum, reflecting the

fiscal adjustment from sector grants to sustainable transfers from the CTF.

296. Figure 60 indicates economic prospects at the state level. During the remaining

years of the amended Compact the state economies perform in varying degrees, but man-

age to outperform the weak performance of the first 12 years. However, the post FY2023

era is negative across the nation. Pohnpei state grows favorably in the near term with the

expansion in fisheries at CFC and greater use of the Compact infrastructure grant. In

FY2020 the final decrement adjustment is made with negative consequences for the econ-

omy, but the state manages to maintain its gradual upward path through FY2023. Reflect-

ing the adjustments in FY2023 and depletion of infrastructure grant money in FY2029,

the economy records negative growth in both periods.

297. Chuuk state grows in the near term with the airport renovation and greater use of

the infrastructure grant. However, once the airport project is complete and with the final

decrement reductions, the state economy declines in FY2019 and FY2020. Overall the

state economy grows by an average of 0.6 percent during the final part of the amended

Compact. From that point the state performs poorly declining by an average of 1.7 per-

cent during the post amended Compact years. The Pattern is somewhat similar in Kosrae

although the impact of the release of the infrastructure grant on a small economy has

greater positive impact. Conversely the impact of the decrement adjustment is stronger.

During the remaining amended Compact years, the state economy manages to barely

keeps its head above water. During the post amended Compact period the impact of the

adjustments is felt more strongly and declines by an annual average rate of 2.0 percent

over the 7-year period. Yap state is similar to Kosrae, but with a slightly larger economy

Figure 60 Economic prospects at the state level, FY2015-FY2023 (US$ millions)

80.0

90.0

100.0

110.0

120.0

Chuuk FY15-FY23 0.6%; FY23-FY30 -1.7%

Kosrae FY15-FY23 0.0%; FY23-FY30 -2.0%

Yap FY15-FY23 0.0%; FY23-FY30 -1.1%

Pohnpei FY15-FY23 1.8%; FY23-FY30 -0.4%


and funding of projects from its own investments, performs better than both Chuck and

Kosrae in the post FY2023 period.

3 FISCAL PROJECTIONS

298. The major assumptions of the allocation of resources between the state and na-

tional governments during the remaining years of the amended Compact have been dis-

cussed at the start of this chapter. Post FY2023 in the CTF distribution phase, it has been

assumed that the FSM moves to the adoption of the SAFER rule outlined in chapter 3.

This implies an annual draw down of approximately $30 million a massive drop from the

current $80 million grant allocation. Maximum allocation of distributions under the exist-

ing CTF agreement would prove highly disruptive with wild oscillations reflecting the

underfunding of the CTF and market vagaries. While a distribution policy has not yet

been determined, it is assumed that JEMCO would adopt a rule similar to SAFER, which

would preserve a stable but sustainable drawdown, albeit at considerable lower levels that

the existing annual grants.

299. It is assumed that the national government would maintain state government ex-

isting operational needs through allocation of part of its fiscal surplus, but not the Com-

pact grant allocation for infrastructure. This implies an inflation indexed transfer of $40

million from FY2024 onwards. In order to fund the transfer, the 20 percent revenue share

allocated to the states reverts to the national government. Further contributions to the

FSM Trust Fund either on behalf of the national government or states are terminated, as

is the $10 million allocation of funds to state priority infrastructure projects. The growth

in the FSM Trust Fund enables a SAFER drawdown of $9 million to be sustained infla-

tion adjusted post FY2023. It has been assumed the distinction between national and state

accounts in the FSM Trust Fund are ignored and the full drawdown is distributed to the

states according to the existing distribution formula.

300. The results of these adjustments and transition to the new post amended Compact

regime are revealed in Figure 61. During the remainder of the amended Compact reve-

nues grow smoothly by 0.8 percent per annum. Although grant revenues remain constant

in nominal terms, growth in nominal GDP supports a slow improvement in tax revenues.

On the expense side civil service staffing levels are projected to remain constant although

historical patterns of wage drift are projected to continue on trend. Both the Pohnpei and

Kosrae have low rates of wage drift, while Chuuk and Kosrae have been more expansion-

ary. Use of goods and services are also projected to remain constant in real terms. As a

result of these assumptions state government expenditures are projected to rise more rap-

idly than revenues. However, the decrement adjustment in FY2020 restores the emerging

deficit so that by FY2023 the state economies are in fiscal balance. At the state level, and

largely reflecting the state level wage policy, Pohnpei runs a fiscal surplus in FY2023,

while Kosrae is in balance and both Chuuk and Yap are in deficit.


301. In FY2024 the new regime kicks in, drawdowns from the CTF are reduced com-

pared with existing sector grants, but are supplemented by drawdown from the FSM

Trust Fund, with the national government making up the shortfall. The assumptions result

in a fiscal balance within 1 percent of the FSM GDP at the state level.

302. The results for the national government are revealed in Figure 62. During the re-

maining amended Compact years, the national government is projected to run continuing

surpluses rising from $19 million in FY2017 to $23 million by FY2023, which is in-

vested in the FSM Trust Fund. However, the true size of the structural surplus includes

Figure 61 State government revenues and expenditures, FY2015-FY2030 (US$ mil-

lions)

75.0

100.0

125.0

150.0

Expenditures

Revenues

Figure 62 National government revenues and expenditures, FY2015-FY2030 (US$ mil-

lions)

100.0

125.0

150.0

175.0

Expenditures

Revenues


expenditures on state and national legislative projects of $20 million, and the recent blow

out in contractual services of $7 million. The structural surplus in FY2017 is thus pro-

jected to be $50 million and rising over time towards FY2023. It is out of these funds that

the national government is able to support government operations at the state level post

FY2023. Figure 62 indicates that post FY2023 the national government surplus is elimi-

nated and the fiscal position is in balance. However, there still remains a projected $10

million in national government public projects and the large increase in contractual sur-

plus. There thus remains considerable room for fiscal adjustment at the national govern-

ment to sustain public services at the state level in the event of the revenue projections

underperforming.

4 POLICY IMPLICATIONS

303. The projections in this section indicate that the FSM economy can be expected to

grow modestly through the end of the amended Compact albeit at a modest rate of aver-

age growth of 1.1 percent. In the post amended Compact period the economy is projected

to decline by an average 1.0 percent as Compact funds are replaced by trust fund draw-

downs at a lower rate. Based on the revenue projections in the MFFF, the FSM should be

able to maintain fiscal stability without the need for outside assistance. However, the rev-

enue projections assume that fishing fee receipts, captive insurance tax collections, and

market returns on investments perform at historical rates. Any one of these assumptions

is subject to varying degrees of risk. While the PNA appears on solid ground the arrange-

ments could fragment, the global forum could “blackball” the FSM with the collapse of

the captive insurance market, and market returns may perform poorly. All of which indi-

cate that FSM economic and financial stability is fragile.

304. Figure 63 indicates the median expected level of the CTF in FY2023. It also indi-

cates, the impact of the additional contributions sourced from the FSM towards the estab-

lishment of its own Trust Fund. Based on a SAFER yield from the funds, the FSM can

expect to enjoy $29 million from the COFA fund and $9 million from its own resources.

In order to attain a SAFER target trust fund corpus level sufficient to replace the annual

grants in FY2024, the funds would need to be nearly double their existing projected lev-

els. While this is probably an unattainable target, the MFFF projections indicate that there

still remain considerable resources at the national government that could be invested to

improve this outturn. The current level of structural surplus not invested in the FSM CTF

is about $27 million and would if accumulated, significantly augment the position in

FY2024.

305. During the last administration, a 2023 action plan was proposed, but has, since

this time, gone on the back burner. While some of the elements of the plan were of ques-

tionable economic value, the plan did provide a rational approach to the allocation of the

national government’s fiscal surplus during the remainder of the amended Compact. The

FSM would be well advised to revisit the approach, if not the content, to ensure the best

use of the funds rather than the current ad hoc allocations. Further the plan could provide


an opportunity to revisit some of the structural reforms that would enhance private sector

growth potential, and improve the nation’s economic growth potential. This would reduce

the risk inherent in relying on economic rents from fishing fees and the captive insurance

market, together with trust fund earnings from international financial markets.

Figure 63 Projected Trust Fund values FY2014-FY2023

0

250

500

750

1,000

1,250

1,500

1,750

2,000

COFA and FSM Funds Median level projected = $$1,291m

SAFER Target estimate = $2.78m

COFA Trust Fund Median level projected = $$974m

Primary Target estimate = $1,67m

COFA Trust Fund

FSM Trust Fund

125

APPENDIX 1 THE MACROECONOMIC FISCAL FORECASTING

FRAMEWORK PROJECTION METHODOLOGY

306. This appendix provides a description of the projection methodology of the MFFF

to enhance understanding of the results. The MFFF comes under the class of models

known as a Financial Program (FP) developed by the International Monetary Fund. The

model is based on the four macroeconomic accounts of a nation: the national accounts,

statement of government operations, balance of payments, and monetary survey. Each of

the four accounts is related to one another and relies on simple projection techniques that

can be modeled in spreadsheets. Each of the accounts is modeled for each of the FSM

states, with the exceptions of the balance of payments and the monetary survey, which

are only projected at the FSM level. While this is appropriate for the balance of pay-

ments, projection of the monetary system by state is limited to the information available.

This appendix provides a description of each of the major components of the MFFF

framework. While it would be possible to specify the model algebraically, the approach

adopted is to describe the major elements of the system, and refer the reader to the

spreadsheet model, which contains notes and can be downloaded from

www.econmap.org. Four main methods of forecasting have been deployed. These in-

clude:

trend, either linear, exponential or growth factor;

constant or moving average;

exogenous, based on policy variables or known factors, such as project implemen-

tation, investment intentions, etc.; and

endogenous, which is linked to other economic variables in the system.

1 PRODUCTION AND GDP

307. Production and GDP have, for the most part, been projected in constant prices,

with the current price series estimated through application of appropriate price indices.

The economy can be divided functionally into sets of industries that behave in a similar

manner. The methodology for projecting the majority of GDP is covered below, but for

those not covered the spreadsheet model contains further details.

i. Production for home consumption: Subsistence or household nonmarketed pro-

duction, including ownership of dwellings, is related to the level of population,

which has been declining in recent years. Household production (agriculture and

fishing) for the market (mixed income) is also projected on the basis of population

change.

ii. Nontraded production for the home market: Much of private sector production is

driven by the level of aggregate demand and assumes no capacity limitations. The

group includes: commercial agriculture, manufacturing, wholesaling and retailing,

general transport, financial intermediation, commercial real estate, business ser-

vices, and other private services.



iii. Tourism: Tourism is projected on trend, although this has been negative in many

states during the amended Compact.

iv. Construction: Current price forecasts are made for Compact infrastructure, FAA

projects, and state and national legislative projects. The Compact sector grants are

allocated to the states according to the FSM internal distribution formula. Resid-

ual private sector construction is estimated through a three-year lagged accelerator

principle. The constant price series is derived through deflation of an index of

construction costs.

v. Government services: Government nonmarketed production is considered a pol-

icy variable and projected exogenously. In the base scenario national and state

government employment are projected to remain constant, except in the case of

the third phase of the DMP, when a 6 percent reduction is projected. Current price

projections for government services utilize the wage projections in the MFFF (see

below).

vi. NPISH: Nonprofit institutions serving households (NPISH) and various other mi-

nor activities have been projected as moving averages.

vii. Taxes less subsidies on imports and products: Taxes on products have been pro-

jected in relation to the tax base: import taxes are estimated in relation to aggre-

gate demand, Gross Receipts Taxes (GRT) to private sector GDP value added

projections, and other taxes on products in relation to the constant price value of

the “cash” components of the economy (i.e. excluding items produced for home

consumption). State-owned enterprises (SOEs) have received only minor subsi-

dies in the FSM and have been projected in relation to the growth in the utilities

sector.

2 PRICE AND WAGE PROJECTIONS

308. Model prices are projected exogenously on the basis of the “small country as-

sumption.” While this is a simplifying assumption, and nontraded goods prices would be

domestically determined, it is not realistic to endogenize prices, given the very small size

of the FSM. Consumer prices are derived as a composite index of consumer prices (Con-

gressional Budget Office (CBO) long-term forecasts of the U.S. CPI), food and fuel

prices weighted by the FSM CPI weights. Projections of the U.S. GDP deflator are also

taken from the CBO. In the case of commodity prices, the World Bank provides a very

handy set of projections for the major commodities affecting the FSM: food, fuel, and co-

conut oil. Fish prices comprise long-line Sashimi grade fish and Purse Seine Skip Jack

prices. Projections are made based on long-term trends, which have been rising during

the last 11 years.

309. In the case of wages, the model assumes that past trends are likely to continue into

the future. Wage rates are projected on trend by institutional sector. In a more compre-

hensive model, wage rates would reflect labor market conditions, but in the simplified

world of the MFFF, wage rates are projected exogenously, with a policy adjustment for

the public sector, if necessary, to indicate likely trends.

Appendix 1: The Macroeconomic Fiscal Forecasting Framework Projection Methodology 127

3 GDP AT CURRENT PRICES AND THE GENERATION OF INCOME AC-

COUNT

310. The projection of GDP at current prices is a relatively straightforward affair, with

the change in GDP at constant prices being indexed to the respective price or wage indi-

cator. In general, the constant price traded goods industries of the economy are inflated

by the appropriate world price. For private sector nontraded goods, the FSM CPI is used.

In the case of general government, the constant price series is multiplied by the projected

wage rate change. The sum of all industry current price estimates provides the estimate of

current GDP at basic prices. To this the value of taxes less subsidies on products must be

added. These are projected in relation to the corresponding estimates in the fiscal ac-

count. The total of all industrial production and taxes less subsidies on imports and prod-

ucts provides the estimate of GDP at purchaser’s values.

311. The generation of income account is the allocation of value added between com-

pensation of employees, operating surplus, and taxes less subsidies on imports and prod-

ucts. An estimate of compensation of employees is made by industry through multiplica-

tion of the prior period compensation estimate by the increase in industry constant price

GDP and the respective wage index. The model thus implicitly assumes fixed factor pro-

portions and allows for no factor substitution or productivity change. Estimates of operat-

ing surplus are derived residually through subtraction of compensation from value added.

Other taxes and subsidies on production are minor, not known with any degree of accu-

racy, and may be ignored for practical modeling purposes.

4 THE HOUSEHOLD SECTOR ACCOUNT

312. We are now in a position to bring together the various components of the house-

hold sector account and move toward estimating household disposable income. House-

hold income is generated from a series of value added components: compensation of em-

ployees from domestic production, mixed income from production, and withdrawals from

quasi corporate income. Compensation of employees and mixed income from production

are taken directly from the GDP estimates. Withdrawals from quasi corporate enterprises

is estimated from the operating surplus derived in the generation of income account.

313. Turning to primary incomes, households receive interest on savings and time de-

posits, and make payments on loans. On the secondary distribution of income account,

there are major receipts and payments to the Social Security Administration. Social Secu-

rity payments are projected to grow in line with the growth in compensation of employ-

ees. Social Security benefits are based on the actuarial report provided to the SS Admin-

istration. Households pay wages taxes, fees and fines and receive certain social benefits

from government. These are linked to the fiscal account. A significant element of grants

is received from Pell grants and is projected as a moving average. Households send and

receive remittances to and from the rest of the world, which are derived from the BoP.


314. Adding up all the transactions enables an estimate of total household disposable

income, which is either saved in fixed proportion to income (based on historical behav-

ior) or consumed. From deflating nominal household disposable income by the CPI, an

estimate of real disposable incomes is derived.

5 GROSS DOMESTIC EXPENDITURE AND DEMAND

315. The GDE account is built from a mixture of current and constant prices and then

either deflated or inflated to derive the corresponding series. Government final consump-

tion expenditure is the sum of the national, state, agency and municipal governments. For

the national and state governments, the current price series is derived from the fiscal ac-

counts and based on changes in compensation of employees and use of goods and ser-

vices. Municipal governments are assumed to remain constant in nominal terms, and

agencies are related to the GDP current price series. The constant price series for the five

governments is deflated by a composite index of wages and cost of operations index

(CPI). Municipalities and agencies are deflated by the CPI.

316. Household final consumption expenditure is composed of three elements: house-

hold acquisitions or cash expenditures, ownership of dwellings and production for own

consumption (subsistence). Household acquisitions are indexed to the change in real

household disposable income from the household account times an estimate of the mar-

ginal propensity to consume. Estimates for ownership of dwellings and other items pro-

duced for own consumption are indexed to population growth. The current price series is

derived through inflation by the respective elements of the CPI. The estimation of con-

sumption of Non Profit Institutions Serving Households (NPISH) is driven by the growth

in the NPISH sector GDP growth in current and constant prices.

317. Gross Fixed Capital Formation (GFCF) is broken down into construction and

other (mainly equipment). The construction component is linked to the GDP current price

series, and constant prices are derived through deflation of a composite index of the

World Bank’s Manufacturing Unit Value Index (MUV) and the U.S. CPI. The current

price equipment series is also driven by the growth in construction activity, while the

constant price series is deflated by the construction cost composite index. The assumed

constant ratio between construction and equipment is clearly open to question, but in the

absence of any better assumption has been adopted. Change in inventories are not pro-

jected.

318. Trade in goods and services is estimated from the sum of export and imports. Ex-

ports comprise exports of goods (largely fish in Pohnpei and Yap), re-exports (fuel), ser-

vices and tourism. These are projected in current prices and deflated by the CPI, while

tourism is projected in constant price terms, which is consistent with the production ac-

count. Imports are projected for four major categories: food, fuel, general, and services.

The series is generated in constant prices and linked to real household incomes for food


and the level of real aggregate demand for the others. The series includes a set of as-

sumed income elasticities. The current price import estimates, as elsewhere, are inflated

by a matching price index.

319. Adding up final government and household consumption expenditures plus gross

fixed capital formation provides an estimate of Gross Domestic Expenditure (GDE).

Changes in inventories are not modeled. Adding in the trade account to the GDE esti-

mates offers an estimated Gross Domestic Product by Expenditure, GDP(E). Aggregate

demand is projected as the sum of GDE plus exports and is used to drive many of the se-

ries in the MFFF. Finally, the difference between GDP(P) and GDP(E) is the national ac-

counts discrepancy and provides an estimate of the overall reliability of the MFFF series.

6 GOVERNMENT FINANCE

i State Governments

320. The fiscal account is comprised of revenues less expense, outlays on nonfinancial

assets and financing. Revenues include two major categories: taxes and grants. Taxes are

linked to an estimated series of the tax base: wage tax estimates are projected in relation

to the compensation of employees’ estimates, GRT in relation to those industries in cur-

rent price GDP paying GRT, imports to import demand, and state sales taxes to the cur-

rent price GDP estimate of wholesaling and retailing. Buoyancy ratios were utilized in

Pohnpei and Chuuk where the estimates were plausible but ignored in Kosrae and Chuuk.

Grants, mainly Compact, were estimated from the projected level of grant assistance un-

der the Compact times two-thirds of the GDP deflator estimates. Other grants were as-

sumed to remain constant in nominal terms.

321. Government expense is comprised of compensation of government employees,

use of goods and services, subsidies, debt service, and transfers. Compensation of em-

ployees has been assumed to grow in relation to the current price GDP estimates of pub-

lic service providers: no change in real employment levels, but allowance is made for the

historical trend increase in wage rates. Use of goods and services is also held constant in

real terms, but allowance for cost increases is included through inflation by the U.S. CPI

projections. Other items on the expense account are minor. Accumulation of nonfinancial

assets at the state level (with the exception of Yap) is restricted to minor outlays, as both

the use of the Compact infrastructure grant and FAA airport improvement projects are

booked to the national government.

322. On the financing side for Chuuk, Kosrae and Pohnpei, debt service on existing

loans, mainly on-leading of ADB loans from the national government, are projected as

moving averages, reflecting the lack of new borrowing in recent years. For these states

the residual on the fiscal account is reflected in the drawdown of domestic deposits. For

Yap the state has financed a significant volume of projects through drawdown of the

state’s reserves and trust funds. It has been assumed that the state will continue to invest


in public infrastructure, and the residual for Yap is reflected in the drawdown of foreign

securities from the state’s investments.

ii National Government and External Debt

323. The fiscal equation of the national government is significantly different from that

of the states. In addition to the normal array of FSM taxes, the national government re-

ceives money from the corporate tax (Japanese captive insurance domiciles) and from the

sale of fishing licenses. Corporate tax collected from the FSM domicile is projected to

grow on linear trend. Fishing fees are projected on the basis of current Vessel Day

Scheme (VDS) rates and a general allowance over time for fish prices (assumed to be

CPI). The use of operational Compact sector grants is set to decline to $1 million by

FY2017, following a JEMCO resolution. While the use of the infrastructure grant and

FAA projects all occur at the state level, these are booked to the national government. On

the expense side, the projections are formed on a similar basis to the states. The only dif-

ference is debt service interest payments, which are linked to the debt module. Acquisi-

tion of nonfinancial assets reflects the use of capital grants (infrastructure plus FAA), and

an allowance for FSM Congress legislative projects is assumed to remain constant at

$10.5 million, and state level priority infrastructure projects.

324. The fiscal accounts include a debt module, which is comprised of existing debt

obligations and projections for the incurrence of future debt. The existing debt profile is

known with precision, and incurrence of future obligations has been projected at 1 per-

cent of GDP, the historical rate. The result is that the nominal value of debt remains

largely unchanged through FY2023. Taking into account state debt servicing channeled

through the national government, the residual on the national government’s fiscal account

is treated as the acquisition of foreign securities.

7 BALANCE OF PAYMENTS

325. Exports and imports are linked to the GDP(E) current price projections. The ma-

jor items of primary income receipts are fishing fee royalties and interest and dividend

earnings on overseas investments. The former is linked to the fiscal projections, while al-

lowance has been made for increases in interest and dividend earnings in future years, as

the world economy recovers. The main item of primary income payments is dividends of

foreign companies in the FSM, which has been projected in line with nominal GDP. Sec-

ondary income flows are dominated by grants and receipt of Compact and other grants,

and are consistent with the fiscal account. Household remittances, both inward and out-

ward, and receipt of Pell grants have been projected in line with the household account.

The other major secondary income receipt is tax receipts from the Japanese corporation

domiciles, which have been projected to be consistent with the fiscal account.

326. The capital account inflows are dominated by Compact flows, and FAA airport

improvement grants, which are linked to the fiscal account. On the finance account, FDI,

reflecting the poor investment climate, has been negligible in recent years and has been


projected as a moving average. Portfolio investments have been projected to rise, mirror-

ing the large national government surpluses, which have been assumed to be invested in

the FSM Trust Fund. Other investments reflect the growing level of commercial bank de-

posits and the lack of lending opportunities in the local economy. Incurrence of external

debt by the national government is consistent with the fiscal account of the national gov-

ernment, which is derived from the external debt module.

8 BANKING SURVEY

327. The banking survey has been included in the MFFF for comprehensiveness, alt-

hough the projections are simple. Deposits are projected in line with the growth in nomi-

nal GDP, reflecting the monetary approach implicit in financial programming. Commer-

cial loans are indicated to remain flat, consistent with recent performance, and are pro-

jected as moving averages. Consumer loans are projected in line with the growth in com-

pensation of employees. Foreign assets are the residual on the account.

COUNTRY ECONOMIC REVIEW - PITI-VITI · Fiscal Year 2015 Economic Review October, 2016. CURRENCY...

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Transcript of COUNTRY ECONOMIC REVIEW - PITI-VITI · Fiscal Year 2015 Economic Review October, 2016. CURRENCY...