2013 Staff Visit to the Republic of Palau: Concluding Statement of the IMF Mission

Palau’s economic performance has been strong driven by robust tourism. The near-term prospect is positive, albeit with some risks due to Palau’s heavy reliance on tourism, grants, and food and fuel imports. The fiscal position continued to improve, and gradual adjustment over the medium term remains critical to ensure long-term fiscal sustainability. Promoting private sector development is key to sustaining growth in view of the needed fiscal consolidation.

I. Recent Developments and Outlook

1. Palau’s economic performance has been strong driven by robust tourism (Table 1). Real GDP grew by about 6 percent in fiscal year (FY) 12 owing to increased tourist arrivals as a result of new flight routes from Asian countries. The current account balance also improved, largely financed by stable foreign grants and strong tourism receipts, while the real effective exchange rate remained in line with its long-term average. Average inflation increased to 5½ percent (year-on-year) in FY12 due to higher international food and fuel prices.

2. Preliminary data indicate that the fiscal position continued to improve. Revenue collection was strong mainly due to economic buoyancy, although spending was also higher than expected with the passages of supplementary budgets. The current fiscal deficit (excluding grants) is estimated to have narrowed further by 2 percentage points (PPT) of GDP in FY12, in line with the medium-term fiscal consolidation path. The government cash buffers excluding the Compact Trust Fund (CTF) increased to about 5 percent of GDP.

3. The near-term outlook is positive although Palau’s heavy reliance on tourism, grants, and food and fuel imports carries substantial risks. Growth is projected at 3½ percent this year along with a moderation in tourism activities after a strong rebound in FY11–12 and limited hotel capacity. Average inflation is expected to moderate to 3 percent. However, weaker-than-expected global growth could hurt tourism, and an increase in food or fuel prices could raise inflation, depress domestic demand, and weaken fiscal and external positions. Building the government fiscal buffers is imperative to mitigate the potential adverse impact of these risks.

II. Policy Recommendations

4. Continued fiscal adjustment over the medium term would help ensure long-term fiscal sustainability. These adjustments are needed to achieve self-sufficiency, as otherwise, domestic revenue and earnings from assets accumulated in the CTF will not be sufficient to maintain a steady level of public expenditures when the Compact grants expire in FY24. To prevent a sharp policy correction, gradual reduction in the current fiscal deficit (excluding grants) by 1½ PPT of GDP annually on average until FY19 would bring down the current deficit to a sustainable level by the time the Compact grants start to wind down. This would gradually raise the overall fiscal balance to a surplus of about 5 percent of GDP over the medium term.

5. The mission welcomed the authorities’ efforts to continue reducing current fiscal spending in terms of GDP in FY13. This task is more challenging due to additional spending to mitigate the impact of Typhoon Bopha that hit Palau in December, and the mission advised that Bopha-related spending should be targeted or offset by spending cuts elsewhere. In addition, the mission recommended raising domestic revenue by about ¾ PPT of GDP to further reduce the current fiscal deficit (excluding grants) by 1½ PPT of GDP. The mission emphasized the importance of strengthening revenue administration, particularly tax enforcement and compliance, to mobilize revenue.

6. Moving ahead, implementing comprehensive revenue and expenditure reforms are needed to support medium-term fiscal consolidation and reduce fiscal risks. On the revenue side, moving forward with comprehensive tax reforms would be critical to improve revenue collection, which remains low in terms of GDP relative to other Pacific Island countries. In line with past recommendations, these reforms should include eliminating import duty exemptions, moving to CIF (cost, insurance, and freight) valuation, replacing the gross revenue tax with a corporate income tax, and adopting a value-added tax (VAT). On expenditure, the mission welcomed the authorities’ plan to continue limiting the growth of the wage bill, including by reducing redundancy in government services and promoting outsourcing, while ensuring adequate resources for essential government functions, such as budget, planning, and statistics.

7. Strengthening budget and cash management and continued efforts in reforming public utility companies would improve public finances. The mission welcomed the authorities’ plan to update the medium-term fiscal framework and implement the medium-term budget framework to improve budget credibility and transparency. Progress in commercializing water and sewer services with the assistance of the Asian Development Bank should continue by raising tariffs as scheduled and restructuring the corporate arrangements to ensure sound commercial basis. The mission also encouraged the authorities to address the large unfunded liabilities in the pension and social security funds, including by seeking technical assistance, and to continue their efforts in reconciling and clearing domestic arrears.

8. Promoting private sector development remains key to sustaining growth in view of the needed fiscal consolidation. The recent implementation of the secured transactions registry in the financial sector is a positive step. The mission encouraged the authorities to step up their efforts to diversify the economy and attract FDI, including by simplifying investment processes, promoting a level playing field for foreign and domestic companies, and making land leases more secure.

9. The mission welcomed progress made in improving macroeconomic statistics supported by technical assistance provided by IMF and other donors. However, ensuring sufficient resources to the Office of Planning and Statistics remains critical to strengthen its capacity to produce quality and timely statistics.

10. The mission proposed to schedule the next Article IV consultation in early 2014.

The mission would like to thank the authorities for their warm hospitality and constructive discussions.