Directors welcomed improvements in the fiscal balance. However, they stressed that a credible consolidation strategy, including a timely implementation of tax reform, improvements in tax administration, and tight expenditure control, especially on public sector wages, will be necessary to ensure fiscal sustainability and prepare for the expiry of Compact-related grants. Recognizing the difficulty in implementing these reforms, Directors encouraged the authorities to promote dialogue and coordination at the national level and among the four states. They also emphasized the need to protect critical social and infrastructure spending.

Directors agreed that a multi-year fiscal plan will help guard against spending pressures and guide the authorities’ consolidation efforts. They welcomed the steps taken to reduce unfunded liabilities of the social security system. Underscoring the need to reduce the debt, Directors cautioned against using savings to finance current expenditures and against contracting additional foreign loans.

Directors stressed that stepping up structural reforms will accelerate private sector development and support fiscal consolidation. They encouraged the authorities to relax FDI legislation, improve labor skills, and strengthen procurement practices to attract foreign investors. Enhancing the capabilities of the statistical office and the quality of economic statistics, particularly for the fiscal accounts, would also strengthen policy planning and evaluation.

Directors welcomed advances in oversight by the Banking Board and observed that granting it operational independence and a well-defined legal authority would further strengthen the supervisory framework. They recommended bringing the FSM Development Bank and other non-deposit taking financial institutions under appropriate regulation and supervision.

Background

The FSM’s economy is highly dependent on external aid, and private activity contributes little to growth. A renewed Compact of Free Association agreement (“Compact”) with the United States, effective since FY2004, steadily lowers transfers to the FSM through FY2023 and has stricter rules on the use of grants, which have proved difficult for the national and state governments to meet, holding back growth in the FSM economy in recent years.

In addition to delays in Compact grants disbursements, the surge in global commodity prices and the global financial crisis have taken a heavy toll on the FSM economy, with growth remaining in the negative territory for three consecutive years from FY2006 to FY2008. The economy stabilized in FY2009 (0.4 percent growth), mainly supported by infrastructure projects and the rise in subsistence agriculture. Inflation is estimated to have significantly slowed to 3.5 percent in FY2010, after reaching 7.7 percent in FY2009.

The consolidated fiscal balance has also improved, but with differences across states. Some state governments have reduced public employment and salaries in line with the annual decline in Compact grants. Fishing fees temporarily increased along with the rise in fish catch and general tax revenues have expanded thanks to improved tax administration. As a result, the consolidated overall balance recorded its first surplus in six years of 1.6 percent of GDP in FY2009. However, performance varied across states, with some struggling over a significant amount of debt and others drawing down their savings.

The current account deficit widened and external debt rose in FY2009. High fuel prices and grant-financed imports related to construction activities have worsened the current account. At the same time, external debt rose significantly in FY2009 mainly due to the $12 million borrowing by the FSM Telecom to finance fiber-optic installation, but the level of debt has remained relatively low at about 30 percent of GDP and is mostly on concessional terms.

The recovery will likely remain weak. Growth in FY2010 is estimated at 0.4 percent, supported mainly by infrastructure projects. The near-term outlook is overshadowed by sluggish private sector growth and the scheduled annual decline in Compact grants. Medium-term growth is estimated to increase slightly to 0.6 percent, supported by additional infrastructure projects in the pipeline. Structural impediments to private sector development and volatile commodity prices could hold back the recovery, and other long-term risks include the possible loss of fish stock and reduction of farmland due to climate change and growing outward migration.

Achieving long-term economic sustainability has become more challenging after the global crisis. Under current projections, lower than anticipated returns on the government’s trust fund imply a large projected revenue shortfall in FY2023, when the annual Compact grants are set to expire. Closing this revenue gap would require a substantial fiscal adjustment over the medium-term.