Fiscal Year 2014
Economic Review
August, 2015
CURRENCY EQUIVALENTS
Currency unit
—
United States dollar (US$)
ABBREVIATIONS
ADB
ADF
—
—
AusAID
BGRT
BoP
c.i.f.
CIP
COFOG
Compact
—
—
—
—
—
—
—
CPI
CTF
EEZ
EIB
FAA
FDI
FEIM
—
—
—
—
—
—
—
FIB
FIC
FISIM
—
—
—
FMIS
f.o.b.
FSM
GDE
GDP
GFS
GNDI
GNI
HIES
ICT
IEG
IIP
—
—
—
—
—
—
—
—
—
—
—
—
Asian Development Bank
Asian Development Fund (concessional lending resources of the ADB)
Australian Agency for International Development
business gross receipts tax
balance of payments
cost, insurance and freight
capital improvement project
Classification of the Functions of Government
RoP Compact of Free Association with the United
States
consumer price index
Compact Trust Fund
exclusive economic zone
European Investment Bank
Federal Aviation Administration
foreign direct investment
Facility for Economic and Infrastructure Management
Foreign Investment Board
Financial Institutions Commission
financial intermediation services, indirectly measured
financial management information system
free on board
Federated States of Micronesia
gross domestic expenditure
gross domestic product
Government Finance Statistics
gross national disposable income
gross national income
household income and expenditure survey
information and communication technology
index of economic growth
international investment position
IMF
ISIC
MICB
NDBP
NGO
OCR
—
—
—
—
—
—
OEK
PCAA
PCC
PCSPTF
PEFA
PFTAC
PICRC
PNCC
PPUC
PVA
RMI
ROC
RoP
RPSSRF
RUS
SOE
TA
U.S.
USDA
VAT
WSIP
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
—
International Monetary Fund
International Standard Industrial Classification
Mega International Commercial Bank
National Development Bank of Palau
nongovernmental organization
ordinary capital resources (ordinary lending resources of the ADB)
Olbiil Era Kelulau (Palau’s national Congress)
Palau Community Action Agency
Palau Community College
Palau Civil Service Pension Trust Fund
Public Expenditure and Financial Accountability
Pacific Financial Technical Assistance Center
Palau International Coral Reef Center
Palau National Communications Corporation
Palau Public Utilities Corporation
Palau Visitors Authority
Republic of the Marshall Islands
Republic of China
Republic of Palau
Republic of Palau Social Security Retirement Fund
Rural Utilities Service
state owned enterprises
technical assistance
United States
U.S. Department of Agriculture
value added tax
Water Sector Improvement Program (ADB)
NOTE
The Republic of Palau government’s fiscal year (FY) ends on September 30.
iii
TABLE OF CONTENTS
Page
Foreword
I.
1.
1.
II.
xiii
Background and Summary
Background
Summary
xiv
xiv
xv
Review of Economic Developments
A.
Growth and Employment
1.
2.
3.
B.
1
Gross Domestic Product, Growth and Structural Change
Population, Incomes, Distribution and Poverty
Employment, Earnings and Wages
Developments in the Tourism Sector
1.
2.
C.
Trends in Arrivals and Plant Utilization
Impact of Booming Visitor Arrivals on the Economy
Monetary Developments and Prices
1.
2.
D.
Prices
Money and Banking
E.
Balance of Payments
Gross National Income and Gross National Disposable Income
Nominal and Real Effective Exchange Rates
External Debt and International Investment Position
Fiscal Developments
1.
2.
III.
A.
B.
16
18
21
25
25
29
30
32
Institutional Arrangements
Recent Fiscal Performance
35
39
Policy Issues
45
Fiscal Strategy and Responsibility
Tax Reform
External Debt Sustainability
Social Security and the Civil Service Pension Scheme
Public Financial Management
1.
2.
16
35
Fiscal and Financial Management
1.
2.
3.
4.
1
9
12
21
22
Balance of Payments and External Debt
1.
2.
3.
4.
1
45
45
48
53
54
56
The Palau Planning and Budget Framework
Public Expenditure and Financial Accountability
iv
56
57
C.
State Owned Enterprises and Public Infrastructure
1.
2.
3.
4.
D.
The Renewed Compact Oversight Mechanism
1.
2.
3.
E.
1.
2.
3.
F.
66
67
67
68
Private Sector Development
69
Tourism Sector Policy
The Annual Economic Symposium
The World Bank Doing Business Survey
The COFA Trust Fund Performance and Sustainability
A.
58
61
63
65
Deficit/surplus targeting
Size of government
Public sector payroll
Conclusion
IV.
69
71
72
73
77
Compact Trust Fund Performance (Analysis based on data through April
2015)
77
1.
2.
3.
4.
B.
1.
2.
3.
4.
5.
6.
V.
A.
Background
CTF performance
Benchmarking the performance of the CTF
Looking forward—the importance of the Compact Review
Agreement
77
78
79
Simulating the CTF through FY2044 subject to Market Risk
85
82
Market Risk
Trust Fund Principles
Benchmarks and Performance Measures
Trust Fund Simulations
Projected Value of the CTF and distributions Under the COFA
Rules
Defining Sustainable CTF Levels and Rules
85
86
87
88
The Medium-Term Outlook and Long-Term Prospects
96
Baseline Projection
1.
2.
3.
4.
5.
v
Telecom
Palau Public Utilities Corporation
The ADB Water Sector Improvement Program (WSIP)
The ADB Koror–Airai Sanitation Project
58
Assumptions
Economic Activity
Fiscal Projections
Balance of Payments
The Banking Survey
89
92
96
96
98
101
104
106
B.
A Reform Scenario
107
C.
The Tourism Scenario
109
Appendix 1
Technical Notes to the CTF Simulations
Market Financial Data and Simulations
Specification of the Moving Adjustment and SAFER Rules
110
110
111
Appendix 2
The Macroeconomic Fiscal Forecasting Framework Projection
Methodology
Production and GDP
Price and wage projections
GDP at current prices and the generation of income account
The household sector account
Gross domestic expenditure and demand
The fiscal account and external debt
The balance of payments
The banking survey
114
114
115
116
116
117
118
119
120
1.
2.
3.
4.
5.
6.
7.
8.
LIST OF TABLES
Page
Table 1
Table 2
Table 3
Table 4
Table 5
Table 6
Table 7
Table 8
Table 9
Table 10
Table 11
Table 12
Table A1
Balance of Payments, current account
External Debt by loan
Palau International Investment Position
Major U.S. grants for operations and contributions to and
permitted drawdowns from the Compact Trust Fund
Comparative analysis of fiscal structure
Compact funds available for operations and emerging fiscal gap
Social Security Valuation, 2011
Palau: Ease of doing business, World Bank ranking
Summary of Palau Policy Reforms
COFA Trust Fund Investment Strategic Asset Allocation Strategies
Levels
RoP Compact Trust Fund Simulated Results and Performance
Comparison of baseline with alterative scenarios on the fiscal
balance
Financial Data Statistical Estimates of Means, Standard
Deviations, and Correlations
vi
26
32
34
36
41
48
54
73
74
78
90
107
110
LIST OF FIGURES
Page
Figure 1
Figure 2
Figure 3
Figure 4
Figure 5
Figure 6
Figure 7
Figure 8
Figure 9
Figure 10
Figure 11
Figure 12
Figure 13
Figure 14
Figure 15
Figure 16
Figure 17
Figure 18
Figure 19
Figure 20
Figure 21
Figure 22
Figure 23
Figure 24
Figure 25
Figure 26
Figure 27
Figure 28
Figure 29
Figure 30
Figure 31
Figure 32
vii
RoP real GDP growth
GDP by major expenditure categories and contribution to growth
RoP real GDP by private and public sector
Hotels, restaurants, and transport value added
Structure of the RoP economy by institutional sector
Structure of the RoP economy by industry
Population by Palauan and non-Palauans
GDP and GNDI per capita, constant prices 2005
Employment by citizenship
Employment in the private and public sectors
Palauan and non-citizen average wage rates
Average nominal and real wage rates in the private and public
sectors
Hotel occupancy by grade
Visitor arrivals by nationality
Average hotel room rates by nationality
Tourist Expenditure by market segment
Public sector revenue derived from tourism
Employment in tourism and other private sector activities
Change in CPI by selected major commodity groups
Commercial bank loans and deposits
Commercial bank credit by sector
Primary and secondary incomes
GDP, GNI and GNDI
Nominal and real effective exchange rate
Palau external debt and debt servicing
Palau consolidated revenues and expenditures
Expenditures on payroll, goods and services and non-financial
assets
Comparison of Palau’s tax regime with tax reform principles
External debt and debt service projections
Social Security Fund balance, contributions and benefits
The Palau Planning and Budget System
PNCC, net operating profit and net income
1
3
3
5
7
8
9
10
12
13
14
15
17
17
18
19
20
21
22
24
25
29
30
31
33
39
43
51
53
55
56
59
Figure 33
Figure 34
Figure 35
Figure 36
Figure 37
Figure 38
Figure 39
Figure 40
Figure 41
Figure 42
Figure 43
Figure 44
Figure 45
Figure 46
Figure 47
Figure 48
Figure 49
Figure 50
Figure 51
Figure 52
Figure 53
Figure 54
Figure 55
PPUC, net operating profit and net income
Water and sewer operations
Public sector payroll: hourly rates and equivalent man-years
Original projected CTF values –vs– actual
Comparison of CTF values with benchmark
CTF projections completed at end of 15th year
CTF projections with and without approved review agreement
Return on Investment in U.S. Stocks and Bonds
Probability Distribution of FSM Compact Trust Fund in FY2023
CTF Projected Real Values at Selected Percentiles
Overall CTF Performance at different levels of funding to the
Primary Target
Probability of Reduction in Distribution Compared with Target
under the Sustainability Rule
Probability of Reduction in Distribution Compared with Target
under the SAFER Rule
Sources of growth
Baseline projection GDP and tourism growth
Distribution of Income: share of wages in DGP and real wages
growth
Revenues and expenditures percent GDP
Overall fiscal deficit percent GDP
Projected value of the CTF in constant prices
Balance on goods and service, primary and secondary incomes
Monetary projections
Impact of the reform scenario on the fiscus
Tourism scenario: visitor arrivals and GDP growth
62
63
69
79
81
83
84
86
89
91
92
94
95
99
99
100
101
103
104
105
106
108
109
LIST OF APPENDIX TABLES
Table 1a
Table 1b
Table 2a
Table 2b
Table 2c
Population by major centers, percent of population and growth,
1986-2012
Working age population, economically active, and not
economically active, 2000, 2005 and 2012
RoP income measures in current prices and real terms, FY2000FY2014
Current and constant price GDP, GDP per capita, 2000-2014
Palau Constant price GDP by industry, FY2000-FY2014
viii
1
1
2
3
4
Table 2d
Table 2e
Table 2f
Table 2g
Table 2h
Table 2i
Table 2j
Table 2k
Table 2l
Table 2m
Table 2n
Table 2o
Table 2p
Table 2q
Table 2r
Table 2s
Table 2t
Table 2u
Table 2v
Table 2w
Table 2x
Table 2y
Table 2x
Table 3a
Table 3b
ix
Palau Constant price GDP by industry, annual % growth, FY2000FY2014
Palau Constant price GDP by industry, contribution to change,
FY2000-FY2014
Palau Current price GDP by industry, FY2000-FY2014
Palau Implicit GDP price deflators by industry, FY2000-FY2014
Palau Share of GDP by industry, current prices, FY2000-FY2014
Constant price GDP by institutional sector, FY2000-FY2014
Constant price GDP by institutional sector, annual percent growth,
FY2000-FY2014
Current price GDP by institutional sector, FY2000-FY2014
Implicit GDP price deflators by institutional sector, FY2000FY2014
Share of GDP by institutional sector, current prices, FY2000FY2014
GDP by income component, current prices, FY2000-FY2014
GDP by income component, constant prices, FY2000-FY2014
Current price GDP by institutional sector and income components,
FY2000-FY2014
Constant price GDP by institutional sector and income
components, FY2000-FY2014
Palau Constant price GDP by expenditure, FY2007-FY2014
Palau Constant price GDP by expenditure, annual % growth,
FY2007-FY2014
Palau Constant price GDP by expenditure, contribution to change,
FY2007-FY2014
Palau Current price GDP by expenditure, FY2007-FY2014
Palau Implicit GDP price deflators by expenditure, FY2007FY2014
Palau Share of GDP by expenditure, current prices, FY2007FY2014
Palau Summary of Household Consumption Expenditure, FY2007FY2014
Palau Summary of Government Final Consumption Expenditure,
by Product, FY2007-FY2014
Palau Summary of Government Final Consumption Expenditure,
by Institution and Component, FY2007-FY2014
Employment by institutional sector, numbers, FY2000-FY2014
Employment by institutional sector, wage costs, FY2000-FY2014
5
6
7
8
9
10
10
11
11
12
13
13
14
15
16
17
18
19
20
21
22
23
23
24
24
Table 3c
Table 3d
Table 3e
Table 3f
Table 3g
Table 3h
Table 3i
Table 3j
Table 3k
Table 3l
Table 3m
Table 3n
Table 3o
Table 3p
Table 3q
Table 3r
Table 3s
Table 3t
Table 3u
Table 3v
Table 3w
Employment by institutional sector, average wage and salary rates,
FY2000-FY2014
Employment by institutional sector, average real wage and salary
rates, FY2000-FY2014
Employment by institutional sector, numbers, Palau citizens,
FY2000-FY2014
Employment by institutional sector, wage costs, Palau citizens,
FY2000-FY2014
Employment by institutional sector, average wage and salary rates,
Palau citizens, FY2000-FY2014
Employment by institutional sector, average real wage and salary
rates, Palau citizens, FY2000-FY2014
Employment by institutional sector, numbers, Foreign citizens,
FY2000-FY2014
Employment by institutional sector, wage costs, Foreign citizens,
FY2000-FY2014
Employment by institutional sector, average wage and salary rates,
Foreign citizens, FY2000-FY2014
Employment by institutional sector, average real wage and salary
rates, Foreign citizens, FY2000-FY2014
Employment by industry, numbers, FY2000-FY2014
Employment by industry, wage costs, FY2000-FY2014
Employment by industry, average wage and salary rates, FY2000FY2014
Employment by industry, average real wage and salary rates,
FY2000-FY2014
Employment, by industry, numbers, Palau citizens, FY2000FY2014
Employment by industry, wage costs, Palau citizens, FY2000FY2014
Employment by industry, average wage and salary rates, Palau
Citizens, FY2000-FY2014
Employment by industry, average real wage and salary rates, Palau
citizens, FY2000-FY2014
Employment, by industry, numbers, Foreign citizens, FY2000FY2014
Employment by industry, wage costs, Foreign citizens, FY2000FY2014
Employment by industry, average wage and salary rates, Foreign
citizens, FY2000-FY2014
x
25
25
26
26
27
27
28
28
29
29
30
31
32
33
34
35
36
37
38
39
40
Table 3x
Table 4a
Table 4b
Table 4c
Table 4d
Table 4e
Table 4f
Table 5a
Table 5b
Table 5c
Table 5d
Table 6a:
Table 6b:
Table 6c:
Table 6d:
Table 6e:
Table 7a
Table 7b
Table 7c
Table 8a :
Table 8b :
Table 8c :
xi
Employment by industry, average real wage and salary rates,
Foreign citizens, FY2000-FY2014
National government employment by department, FY2010FY2014
National government wage costs by department, FY2010-FY2014
National government average wage and salary rates by department,
FY2010-FY2014
National government employment by COFOG1, FY2010-FY2014
National government wage costs by COFOG, FY2010-FY2014
National government average wage and salary rates by COFOG,
FY2010-FY2014
Visitors to Palau by usual residence (tourists plus business):
FY2000-FY2014
Length of stay, visitors to Palau by year and purpose of visit:
FY2008-FY2014
Visitor Nights spent in Palau by year and purpose of visit:
FY2008-FY2014
Palau Summary of Tourism Expenditure and Revenue, current
prices, FY2007-FY2014
Assets and liabilities of deposit money banks, December 2009 December 2014
Deposits by type and institution, December 2009 - December 2014
Lending by Industry December 2009 - December 2014
Income and expense of deposit money banks, CY2009 - CY2010,
FY2011 - FY2014
Interest Rates on deposits and loans, deposit money banks,
December 2009 - December 2014
Palau Consumer Price Index (CPI) all items by major groups,
2000-2014
Palau Consumer Price Index (CPI) domestic items by major
groups, 2000-2014
Palau Consumer Price Index (CPI) imported items by major
groups, 2000-2014
Republic of Palau: Imports by HS Sections, FY2007-FY2014
Republic of Palau: Imports by Broad Economic Classifaction
(BEC), FY2007-FY2014
Republic of Palau: Imports by Region and Main Countries of
Origin, FY2007-FY2014
41
42
42
43
44
45
46
47
47
48
48
49
50
51
52
53
54
55
56
57
58
59
Table 8d
Table 8e
Table 8f
Table 8g
Table 8h
Table 9a
Table 9b
Republic of Palau: Balance of payments (summary), FY2000FY2014
Republic of Palau: Balance of payments (detail), FY2000-FY2014
Republic of Palau: International investment position, FY2000FY2014
External debt and debt service, Republic of Palau, national
government and state owned enterprises, FY2004-FY2014
External debt by loan by borrower, lender, original value, and
outstanding principle by loan
Republic of Palau government finances (GFS 2001 format,
summary), FY2000-FY2014
Republic of Palau government finances (GFS 2001 format, detail),
FY2000-FY2014
xii
60
62
65
66
67
68
69
FOREWORD
This review, the third of its kind for Palau, has been developed to assist the Republic of
Palau (RoP) in preparing for anticipated renewed terms of economic assistance under the
Compact of Free Association with the United States. This document has been developed
under a grant from the U.S. Department of the Interior and is administered through the
Graduate School USA. It is intended to assess the RoP’s economic performance and policy environment and to present a comprehensive set of economic statistics.
This review contains four chapters: (i) a description of economic developments in the
RoP; (ii) a discussion of policy and reform issues; (iii) a chapter on the COFA Trust
Fund, performance and simulations; and (iv) a chapter on economic prospects and impact
of reforms over the medium and long term. The descriptive section takes a standard macroeconomic approach and includes: economic growth and employment; monetary developments and prices; the external sector; and fiscal developments. The policy section discusses a selected set of public and private sector reform issues facing Palau. It covers fiscal strategy and responsibility over the long term, the Palau planning and budget framework, tax regime, and state owned enterprise (SOE) issues focusing on information and
communication technology (ICT) and water and sewer sector reforms. The renewed
Compact oversight requirements are discussed and a brief section on the environment for
the private sector is included.
A new Chapter on the Compact Trust Fund (CTF) has been included with an assessment
of the performance of the Fund (CTF) and simulations to assess the probability of attaining the objectives of the CTF subject to market risk. The medium-term outlook and longterm prospects chapter analyzes likely economic developments in the-near term and
emerging fiscal threats in the longer-term. A reform scenario is developed to correct for
the structural imbalances and policies to support fiscal sustainability. Finally, a high
growth tourism scenario is presented urging the need for policy reform.
This review and statistical appendix have been prepared by Mark Sturton. Special thanks
go to: Casmir Remengesau, Director of Planning and Budget; Rhinehart Silas, Director of
Tax and Customs; Muriell Sinsak of the Department of Planning and Statistics; Ruth
Wong in Treasury; and many other businesspeople from the RoP, who all supported the
preparation of the report and statistical appendix.
This review is available online at http://econ.pitiviti.org/.
xiii
I.
BACKGROUND AND SUMMARY
1. BACKGROUND
Palau completed a review of its Compact of Free Association with the United States, culminating in the signing of an Agreement for renewed terms of economic assistance, in
September 2010. The legislation required to enact the Review Agreement has been submitted to the U.S. Congress; however, all parties are still awaiting approval. As part of
the renewed arrangements, Palau will be required to monitor its economic performance
and policy regime more actively than in the past. An advisory group will meet biannually
to review the economy and assess progress toward any identified reforms. It has been
with this objective in mind that this review has been developed to assist Palau to improve
economic monitoring in general and, more specifically, to meet its future obligations.
The review contains four main chapters: (i) a review of economic developments; (ii) a
chapter on policy issues; (iii) a chapter on the COFA Trust Fund, performance and simulations; and (iv) a chapter on economic prospects and impact of reforms over the medium
and long term. This review is the third of its kind and will analyze economic performance
from the start of the 2000s. Since the statistical estimates are more robust after the mid2000s, greater attention will be focused on the period since FY2005, including the recent
financial recession, recovery and recent boom in tourism. The review of economic developments follows a standard macroeconomic approach: growth and employment; monetary developments and prices; the balance of payments and external debt; and fiscal developments.
The policy issues chapter of the review has two objectives in mind: to initiate a general
policy debate and to provide a preliminary set of possible issues for monitoring by the
Compact advisory group, once it is established. The first section discusses Palau’s fiscal
strategy and the need for a long-term policy and fiscal responsibility framework. Palau’s
planning and budgeting system is discussed together with the tax reform regime that has
been under consideration in Palau. The state owned enterprise (SOE) sector is small in
Palau, but reform has been initiated by the World Bank and Asian Development Bank
(ADB) in the areas of information and communication technology (ICT), water supply
and sanitation. The renewed Compact includes a new oversight mechanism with the creation of an advisory group. The list of proposed areas and targets for monitoring are discussed. A brief section of private sector issues is presented, including the need for regulatory reform and planning in the tourism sector, as well as a review of the World Bank’s
“Doing Business Survey” assessment for Palau.
In Chapter 3 the performance of the Compact Trust Fund (CTF), which has been in existence since the onset of the Compact, is reviewed. A new section has been developed to
assess the impact of market risk on the attainment of the objectives of the CTF with statistical simulations based on Monte Carlo techniques.
xiv
The final chapter of the review analyzes likely economic developments in the-near term
and emerging fiscal threats in the longer-term. A baseline scenario is developed based on
the current policy regime. In the near-term with the booming tourism economy, strong
growth generates large fiscal surpluses, but these mask a set of underlying fiscal threats.
A reform scenario is developed to redress these weaknesses and place the nation on a fiscally sustainable path. Finally, a high growth tourism scenario is presented, highlighting
the need for regulatory reform and planning in the tourism sector.
1. SUMMARY
As the world economy fell into recession in FY2008, the Palau economy suffered a severe contraction. The nation’s economy fell by 5 percent in FY2008, and in FY2009 it
further contracted by a massive 10 percent. Not only did tourism arrivals fall with declining world demand, but also the Compact Road project neared completion. In FY2011 and
FY2012, the tourism economy rebounded, and the economy grew by 4.7 and 3.2 percent,
respectively. In FY2013 the economy contracted by 1.8 percent reflecting completion of
public construction projects in FY2012, and a reduction in tourism due to a variety of
structural factors. In FY2014 the economy boomed with record growth of 5.8 percent.
This was mainly driven by large increases in tourist activity, but other sectors in the economy also contributed significantly to the growth.
The population of Palau consists of Palauans and a large number of foreign workers,
mostly Filipinos. Since 1986 the Palauan component of the population has grown by 0.3
percent, after allowing for external migration, reaching 12,814 in FY2012. The number of
foreign workers has grown from 1,550 to 4,631 over the same period, reflecting the increased need for tourism industry workers. GDP per capita has risen by 1.1 percent per
annum since FY2000. Gross National Income attained a level of $13,357 in FY2014,
placing Palau slightly above the upper-middle-income ceiling of the World Bank’s classification of $12,746. The labor market in Palau is close to full employment, and employment has risen by 0.3 percent annually since FY2000.
Palau has generally maintained a prudent fiscal policy. Since FY2005, it has recorded a
fiscal balance in the range of +3.5 to -2.1 percent of GDP. With the onset of the economic
recession in FY2008 and FY2009, the fiscal balance turned negative. However, since the
recovery in FY2011, the government has recorded surpluses in each year with a large surplus of 3.5 percent in FY2014 reflecting the booming tourism economy. While the fiscal
position has generally returned to a favorable status, the government accumulated a sizeable array of short term debt during the economic downturn, primarily in the form of accounts payable. While much of this has been paid down, a significant proportion remains.
On the external front, Palau has a favorable position, with external debt equivalent to just
28 percent of GDP in FY2014.
The rapid growth in tourism has presented special challenges to Palau. With total visitor
arrivals expected to climb by 33 percent in FY2015 the government imposed a reduction
in charter flights of 50 percent to limit market disruptions and address environmental
xv
concerns. However, the limited implementation of this policy has yet to reduce the number of visitors from China from the pre-reduction recorded levels. With a further 260
rooms coming on line in the near future, it is difficult to see how such a policy will be effective, unless these new rooms remain unoccupied. Palau has adopted a policy to attract
high value tourists, but the recent growth and new hotels are catered to the package tour
segment. It would be useful for the policy of banning or numerically restricting charters
be re-visited and perhaps replaced with more effective, economic incentive-related policies to ensure the appropriate signals are sent to current and potential investors in the Palau tourism sector and in allied investment opportunities. A tourism policy should be developed that clearly lays out the an effective set of regulations, ensures the administrative
capacity to implement them, and particularly initiates land zoning controls so that as Palau can effectively processed with its high value tourism concept.
A second area of concern is the government’s apparent failure to proceed with the ICT
reforms that have been proposed to implement a new fiber optic connection to the country’s internet backbone. Palau has a deeply under-developed and under-performing internet architecture in relation to its otherwise impressive level of development. The current
proposal to establish a Belau Submarine Cable Company with financing from the ADB
provides a unique opportunity to piggy back onto the SEA-US cable project linking Indonesia, the Philippines, Palau, and Yap to Guam, Honolulu and the U.S. mainland. The
connection offers a low cost opportunity, with scheduled connection to go live in early
2017, and well managed maintenance. The projected cash flow will fall below the current
expensive satellite connections during the grace period of the loan, and thereafter will incur an annual cost increase ($0.5 million), which should be more than covered by a rapidly expanding business that is currently depressed by very high prices. Internal politics
need to be set aside so that Palau can proceed with a mission critical piece of infrastructure.
A series of further reform issues confront the nation. The tax reform initiative, which appeared to have traction, has progressed as expected. Given the nation’s rapid growth in
tourism, Palau needs a modern tax system that is suited to a tourist economy. A VAT, the
center piece of the reforms, is exactly what is needed, as it will equally divide the tax
base between Palauans and tourists. It is not envisaged that this initiative will resurface
until after the 2016 elections. The Civil Service Pension Fund also presents a significant
challenge, which is projected to be depleted in 10 years. No action is currently under consideration, but reforms are needed with government transfers to shore up the current 15
percent funded ratio to pension liabilities. The recent transfer of water and sewer operations to the PPUC (Palau Public Utilities Corporation) will require significant increases in
rates (estimated 3 fold) if full cost recovery is to be achieved. In its absence, the government is likely to incur large annual subsidies.
Near the end of FY2010 Palau signed the Compact Review Agreement with the U.S.
Subsequently the Agreement was submitted to the U.S. Congress where it remains, five
years later, awaiting approval. The terms of the renewal for Palau, though less than what
xvi
had been requested, would still be considered favorable. The key enhancements involve a
further 15 years of financial assistance. Current grant assistance will also continue, although at a declining level. Additional resources will be provided to support the Compact
Trust Fund, infrastructure maintenance and capital projects. A new feature of the renewed
Compact is the creation of an advisory group comprising five members: two from each
country and one by mutual agreement. The purpose of the advisory group is to contribute
to the long-term economic sustainability of Palau by recommending economic, financial
and management reforms.
An enlightened feature of the original Compact was the creation of a Trust Fund. The
CTF was intended to provide $5 million annually from FY1999-FY2009 and then $15
million annually for government operations through the Compact’s fiftieth year in
FY2044. However, these projections were based on the CTF achieving an annual return
of 12.5 percent. As it turned out the CTF achieved a 7.4 percent return through FY2009.
This result was consistent with market returns, but based on projections done at the end
of FY2009 would have resulted in failure of the CTF to achieve its original objectives, if
the terms of the Compact had remained unchanged. As a result of the required Compact
section 432 Review, an agreement was reached to renew the economic assistance terms
of the Compact, to reduce planned withdrawals, and to deposit additional funds into the
CTF over the period from FY2010-FY2023. If the Agreement is approved, current projections indicate a strong likelihood that the CTF will achieve the original objectives and
persist, albeit at a slowly declining level, beyond FY2044.
Palau’s economy is expected to continue on a high growth path over the medium-term
with rates of 6.7, 4.4 and 6.7 projected for FY2015 through FY2017, respectively. This
favorable outturn reflects continuing strong tourism growth with the completion of several hotels in the next few years. In addition the Airai-Koror Sanitation Project funded by
the ADB will provide a significant stimulus to the economy. Should the renewed Compact become effective, it is likely that the use of the capital grant component will further
stimulate the economy.
The nation continues to face several longer-term challenges which could lead to a deterioration of the current favorable fiscal position, including the Civil Service Pension Fund
(CSPF), water and sewer subsidies, and reduction in the real level of Compact funding.
On the current path, the fiscal balance is projected to turn negative by FY2024 when the
CSPF is projected to become exhausted. A policy reform scenario is considered at the
end of this Review to return the nation to long-run fiscal balance, address the long-term
decline in real Compact transfers, and address the need to shore up the COFA Trust
Fund.
xvii
II.
REVIEW OF ECONOMIC DEVELOPMENTS
A.
Growth and Employment
1. GROSS DOMESTIC PRODUCT, GROWTH AND STRUCTURAL CHANGE
i
Overall trends in economic activity
1.
The first part of the 2000s, FY2001 through FY2004, was a buoyant and positive
period for the Palau economy (Figure 1). The economy grew by an average annual rate of
2.9 percent, reflecting both large construction projects and strong tourism growth. Of the
average annual economy-wide growth of 2.9 percent, construction (primarily the $149
million Compact Road project) contributed 1.0 percent and tourism activities (accommodation, meals, diving and tours) 0.8 percent. Tourist arrivals grew from a level of 56,501
to 85,004, an annual growth rate of 8.5 percent.
2.
In the subsequent three years (FY2005 through FY2007), the economy bottomed
out and then turned largely stagnant before the oncoming global financial crisis of
FY2008. The main forces that drove the economy in the early 2000s no longer sustained
growth. The increase in construction activity had peaked and was now on the wane. Tourism growth was also weak during this period, falling in FY2005 and FY2006 and only
just returning to the FY2005 level three years later.
3.
In FY2008 the financial crisis hit, and GDP dropped by 4.8 percent. FY2009 was
even worse, with the economy contracting by a further 10.5 percent. Several negative
forces occurred at the same time. Construction of the Compact Road, which had buoyed
economic growth in the early 2000s, came to an end. That was the dominant negative
10.0%
7.5%
5.0%
2.5%
0.0%
-2.5%
-5.0%
-7.5%
-10.0%
-12.5%
FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14
Real GDP 4.2% 6.4% -6.0 7.4% 1.5% -2.6 0.0% -4.8
Figure 1
RoP real GDP growth (percent)
1
-10.
3.7% 4.7% 3.2%
-1.8
4.9%
2
RoP Economic Review—FY2014
force, responsible for 5.8 percent of the two-year loss in GDP of 14.8 percent. Tourism
demand, reflecting the onset of the financial crisis, also turned negative, and contributed
2.1 percent to the overall decline. Finally, the combined impact of these forces and high
rates of inflation of 10 and 5 percent in FY2008 and FY2009, respectively, further eroded
demand.
4.
By FY2010 the impact of the financial crisis had bottomed out and the economy
began to recover. The economy grew by 3.7 percent, of which 1.3 percent was due to
growth in tourism activities. FY2011 and FY2012 saw continued expansion and the economy grew strongly in FY2011 by 4.7, the highest since FY2004 and again by 3.2 percent
in FY2012, of which tourism activities contributed 2.5 and 1.8 percent of the overall
growth in the two years. Visitor arrivals soared by 26 percent in FY2011, and the number
surpassed 100,000 for the first time. In FY2012 numbers grew by a further 13 percent
and visitor arrivals reached a record 116,856. By the end of FY2012, the higher end of
the hotel and accommodation industry was operating at near capacity, and tourist prices
were rising.
5.
The economy peaked in FY2013, and visitor arrivals declined by 7 percent to
110,608. Overall economic growth declined by 1.8 percent of which 0.2 percent was due
to tourism. The major impact on the economy in FY2013 was from a reduction in public
sector infrastructure projects, which contributed to a 1.3 percent fall in economic growth.
In FY2014 the economy bounced back and economic growth recorded 4.9 percent. Tourism activities accounted for 2.4 percent of the total and visitor arrivals reached a record
125,417. The sources of economic growth in FY2014 were widespread with retailing,
professional and financial services, and public administration all making important contributions.
6.
The sources of growth by expenditure component of GDP1 are revealed in Figure
2. The major driving forces of the economy are clearly seen to be tourism and
investment, both of which have had a dominant impact. In FY2008 and FY2009 the
completion of the Compact Road had a stronger impact than the financial crisis and
reductions in tourism. Between FY2010 and FY2012, clearly tourism was the driving
force, but in FY2013 declines in both public investment and tourism resulted in
reductions in GDP. In FY2014, while tourism is generally considered the main driving
force, it was renewed investment in hotels that had the more significant impact. Figure 2
indicates the impact of economic performance on household final consumption
expenditures was signficant in FY2009, and that government expenditures have been
stable, contributing little to economic change.
ii GDP by institutional sector
7.
Figure 3 illustrates the overall level of constant price GDP and the performance
and contribution of the private and public sectors. A major observation from Figure 3 is
1
Note: imports, which make up the difference to GDP growth, have not been included.
3
Economic Developments
Gov Exp
Hsld Exp
Investment
Trsm Exp
GDP
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
-10.0%
-15.0%
-20.0%
-25.0%
Figure 2
GDP by major expenditure categories and contribution to growth, FY2005
prices (US$ millions)
that despite the recent growth in tourism, the level of GDP remains below that attained in
FY2005, and is 4.1 percent lower. While the recent resurgence in tourism and investment
has led to rapid growth during the last five years, it has failed to regain the ground
achieved 10 years ago. The figure also clearly reveals the impact of the recent economic
developments on the private sector, the growth in the early 2000s peaking in FY2004, the
impact of the recession, and the recent improvements with the setback in FY2013.
Public sector
GDP
240
100
220
80
200
60
180
40
160
20
140
0
120
Figure 3
RoP real GDP by private and public sector, FY2005 prices (US$ millions)
US$ '000
US$ '000
Private Sector
120
4
RoP Economic Review—FY2014
8.
The public sector, on the other hand, has remained very stable during the period,
underpinning economic activity. During this time, the public sector has grown by an annual average of 0.7 percent. The public sector is represented by the national government,
state owned enterprises (SOEs), the state governments and government agencies. While
the national government has actually contracted by 0.6 percent, growth in the other components of the public sector has been more rapid, averaging 2.8 percent. Taken as a
whole, these other components of the public sector represent 80 percent of the national
government by size. To its credit, the government has avoided development of a large
SOE sector dependent on government subsidies.
9.
It is clear from Figure 3 that variability in economic performance has come from
the private sector and that responsible policies have held the public sector in check, allowing the engine of growth to be focused on private initiative. This has not come without cost, as dependency on a narrow range of economic activities brings significant risks
in terms of downturn in periods of weak demand. However, given the size of the Palauan
economy and resource constraints such risks are largely unavoidable.
iii GDP by industry
10.
Agricultural production is small in Palau, accounting for 1.4 percent of GDP. It is
represented by a few commercial farms, informal growers, subsistence production for
household consumption and government extension activities. Little is known about noncommercial production, and estimates are projected in relation to population change.
With the recent estimated declines in population, production estimates are down, although backward linkages from the tourism sector would afford opportunities for increased output.
11.
The fishing sector is small in Palau compared with neighboring Micronesian
economies. In economic statistics the fish that are caught and owned by foreign fishing
businesses (the sashimi grade fish for export to the Japanese market) are not considered
part of GDP. The on-shore fish based activities to package and re-export the fish from Palau are considered part of service exports, and do contribute to GDP although the activity
is small. Taking the industry as a whole, including shore based activities, aquaculture,
fish for the home market, and the tourism industry, together with a small contribution
from subsistence production, represents just 2.2 percent of GDP and has declined by an
annual average of 0.8 percent since FY2000.
12.
The manufacturing sector is very small. Although garments were produced for export at the start of the 2000 period, those operations closed in 2001. The utilities sector is
now completely operated by the Palau Public Utilities Corporation (PPUC) since completing the amalgamation of the water and sewer operations previously under the government Bureau of Public Works. Electricity production has remained stable during the past
five years, despite the growing economy, as rising prices have dampened demand. Water
was supplied through the Bureau of Public Works, but this agency has now been amalgamated into the PPUC as part of the ADB Water Sector Improvement Program (WSIP).
5
Economic Developments
13.
Construction has been a leading industry in Palau. Initiatives have included a series of large public sector projects with the Japan-Palau Friendship Bridge at the start of
the 2000s, the Compact Road during the early and mid-2000s, the Capitol complex during the same period and various airport improvement projects. Hotel construction has
also been significant as new plant has been added through the period. However, much of
hotel construction is undertaken as “own account” or produced by the owners and is not
represented in the construction statistics. At the start of the 2000s, construction represented 10 percent of GDP. It rose to a peak of 15 percent in FY2002 and has since fallen
to 3 percent in FY2014. It is likely that much of the economic activity associated with the
two hotel projects completed in FY2014 are not yet included in the construction series.
14.
The wholesale and retailing sector is dependent on demand from the local and
tourist economies. It comprises two major components: fuel importers and general merchandisers. Value added from fuel imports, although growing during much of the 2000s,
dropped in FY2009-FY2010, reflecting restructuring in the sector as the original distributers left the market and new firms entered with lower margins. Once the new owners became established, value added has returned to its former levels and needs of the economy.
General merchandising has responded to the general well-being in the economy, growing
in the 2000s with the large construction projects and growth in tourism. During the recession output declined, but has since picked up over the last four years with the revival in
tourism.
15.
The hotel accommodation, restaurant and transportation industries have been
leading sectors in the economy as shown in Figure 4. Value added in the two industries
displays a period of growth in the early 2000s, stagnation and contraction in the mid to
30
Hotel/Rest
Transport
16
14
25
12
10
15
8
6
10
4
5
2
0
Figure 4
0
Hotels, restaurants and transport value added, FY2005 prices (US$ millions)
US$ '000
US$ '000
20
6
RoP Economic Review—FY2014
end 2000s, and then a sustained period of growth between FY2009 through FY2014. The
transportation sector includes the operation of water-based tours/diving, land transportation and the operation of the local airport. The overall contribution of the two industries
has risen from representing 12 percent of GDP in FY2000 to 17 percent in FY2014—an
indication of significant structural change.
16.
The communications sector includes the Palau National Communications Corporation (PNCC), an SOE, and other providers of communications services. The telecommunications output of the PNCC has grown rapidly since the early 2000s reflecting the
buoyancy of the telecom industry internationally. Demand for cell phones and internet
has been buoyant, despite poor service quality and exceptionally high cost due to a lack
of connectivity to the Internet backbone. Performance in the financial intermediation sector has been erratic. This sector is made up of commercial banking, the National Development Bank of Palau (NDBP), and other financial service providers, such as insurance
and money transfer companies. Performance in the commercial banking sector has been
erratic. Factors have included: weak regulation in the early 2000s, collapse of the Pacific
Savings Bank in FY2007, restructuring, better regulation and a return to improved performance in recent years. The NDBP grew rapidly through the 2000s but has declined since
output peaked in FY2010. Other financial services are small in magnitude and have not
displayed growth.
17.
Real estate activities are an important component of the economy, represented by
both ownership of dwellings and commercial rentals. The former category is estimated in
line with population growth, which grew up to 2005 but thereafter has declined (based on
the recent “mini” census.) Commercial renting is a significant component of economic
activity in Palau due to the large number of foreign nationals, slightly larger than 25 percent of the population. In the early 2000s, renting grew rapidly with the need to house a
growing number of foreign workers in the construction and tourism industries. After the
completion of the Compact road output adjusted downwards but once again has grown
strongly since that time with increased demand form tourism. In the revised International
Standard Industrial Classification (ISIC) Version 4 currently used in Palau, business services are separated into professional, administrative and support services, and make a minor contribution to GDP.
18.
Public administration is made up of the national government, government agencies, such as the Palau Community Action Agency and the Palau International Coral Reef
Center, state governments, and social security funds. The national government public administration has experienced a downward trend of 0.4 percent since FY2000. While Koror state government has grown rapidly by 4.9 percent reflecting buoyant revenues derived from Koror State Park, other local government has grown more modestly at an annual average of 1.7 percent. Local government represents 32 percent the size of national
government administration while the remaining agencies cover 8 percent.
Economic Developments
7
19.
Education services are provided by the national government, Palau Community
College (PCC) and nongovernment schools. Services provided by the public sector have
declined by 1.3 percent through the period, while those of the private sector are small but
have grown by 1.6 percent. Health services, which are predominantly provided by the national government, display erratic movement but have improved in the last two years.
The provision of private health services has grown strongly since FY2009. In addition,
there are a number of private services provided to households, including entertainment,
recreation, arts and employment within households.
20.
GDP also includes the receipt of indirect taxes and payment of subsidies to the
SOE sector. There are three major categories of indirect taxes: import taxes, the business
gross receipts tax (BGRT), and additional taxes on products (hotel occupancy tax). The
path of all of these categories has mirrored that of the GDP and the economic cycle—rising in the early 2000s, declining during the global financial recession, and, lastly, growing with the recent expansion in the tourist industry. Subsidies to the SOE sector, namely
to the utilities (PPUC), have generally been small in economic terms.
21.
Finally, an adjustment is made to GDP for “financial intermediation services, indirectly measured” (FISIM), which is the difference between interest receipts and payments of the banking sector relating to productive activities. The trend has generally been
increasingly negative.
iv Structure of the RoP economy
22.
The structure of the RoP economy is presented in two parts: by institutional sector
and by industry. Changes in the structure of the economy by institutional sector between
50%
FY00-FY01
FY13-FY14
40%
30%
20%
10%
0%
-10%
Figure 5
Structure of the RoP economy by institutional sector
8
RoP Economic Review—FY2014
FY2000 to FY2014 are indicated in Figure 5. The main observation is that institutional
change has been minor. For the most part the picture presents a healthy structure, with
private enterprise representing 45 percent of economic activity. Government activity, including the national and state governments plus agencies, currently represents 23 percent
and has fallen by nearly 4.2 percent during the period. This is an appropriate level for a
small developing economy, and is considerably less than the large public sectors in the
Federated States of Micronesia (FSM) and the Republic of the Marshall Islands (RMI).
The role of the public sector in commercial activity is limited to utilities and telecommunications, but has increased its share by 3.2 percent and represents 9.4 percent of GDP.
23.
The financial sector has undergone significant restructuring following the closure
of several banks and the collapse of the Pacific Savings Bank. Overall, the financial sector is small and now represents only 2.3 percent of the economy. Its share has fallen by
1.8 percent, reflecting the changes in the industry, structural weaknesses in the lending
environment, and a lack of a proactive business culture of the remaining banks. The share
of the household sector has grown by 1.6 percent and makes a significant contribution to
GDP in both marketed and non-market production. Market production consists of mixed
incomes derived from agriculture and fishing. Non-marketed production (for household
subsistence or own consumption) mainly entails home ownership but also includes agriculture and fishing. Lastly, the share of indirect taxes has grown by 2.0 percent and represents 11.2 percent of GDP. The increase reflects changes in the structure of the economy
rather than changes in discretionary tax rates.
24.
Figure 6 provides an indication of the structural changes in the economy but from
an industry perspective. Unlike the institutional structure, there has been significant
FY00-FY01
FY13-FY14
25%
20%
15%
10%
5%
0%
Figure 6
Structure of the RoP economy by industry
Economic Developments
9
change in the industry composition. The importance of the construction industry clearly
fell as the infrastructure, Capitol and hotel projects were completed. Conversely, tourist
activities in hotels, restaurants and transportation have grown rapidly, from 12 to 22 percent of GDP. Clearly, the change indicates the transformation of the economy into one
highly dominated by and dependent on tourism. While Palau has benefited from tourism
growth, the substantial size of the industry indicates the potential risks of being dependent on one industry. The share of merchandising, wholesaling and retailing has maintained its share of GDP, while the share of “other” services has grown by 7 percent and
risen in line with the growth in tourism. The share of public administration has declined
as anticipated from the previous discussion. Likewise, education and health have dropped
as well.
2. POPULATION, INCOMES, DISTRIBUTION AND POVERTY
25.
Figure 7 displays recent trends in population as recorded by population censuses
from 1986 onwards. For Palauans, population remained largely unaltered between 1986
and 1995. However, it grew by 1.3 percent annually between 1995 and 2000 and by 1.5
percent annually between 2000 and 2005. During the last seven years, the Palauan population declined by an annual average of 1.9 percent. It is difficult to provide explanations
of the trends. During the first period (1986-1995), it would appear that there was significant out-migration, but between 1995 and 2005, people preferred to stay home. Certainly,
the economy was expanding during this period. Between 2005 and 2012, it appears that
out-migration again accelerated as large numbers of people left the country. This would
be consistent with severe recession in the economy from FY2008 through FY2010. However, while population trends respond to economic incentives, the later period was also
one where opportunities were less favorable overseas. While there is some question of the
Palauan
Non-Palauan
Total
20,000
18,000
16,000
14,000
12,000
10,000
8,000
6,000
4,000
2,000
0
Figure 7
Population by Palauan and non-Palauans, 1986-2012, constant prices
2000 (US$)
10
RoP Economic Review—FY2014
credibility of the population trends, it is hoped the coming 2015 census will provide a
more definitive picture.
26.
For non-Palauans, which are strongly represented by Filipinos, the trends are
more in accord with economic developments and reflect the demand for alien labor. Demand rose from the mid-1980s, as the economy grew with both a significant increase in
the size of the public sector and tourism during these early days. In the first part of the
2000s, there was strong demand for foreign labor to support the building of the Compact
Road and tourism infrastructure. As these projects came to a close, demand slackened,
and the number of non-Palauans has fallen by 838 between 2006 and 2012. Overall, taking both Palauans and non-Palauans together, the population rose more smoothly between
1986 through 2005 but subsequently fell by 2,462 over the last seven years, an annual average decline of 1.9 percent.
27.
Figure 8 indicates the changes in constant-price GDP and real Gross National Disposable Income (GNDI) per capita in 2005 prices. The first important observation is that
the relatively high level of GDP per capita places Palau in the high-income group of the
World Bank classifications. In 2013 in current prices, Palau had a Gross National Income
(GNI) per capita of $13,357, above the World Bank’s high-income threshold of $12,746.
28.
Constant price GDP per capita rose during the FY2000-FY2007 period in most
years and peaked at a level of $9,739 per capita in FY2005 prices. The level fell precipitously in FY2009, losing over $1,120 in value since FY2005 as a result of the 15 percent
loss in economic activity. In the following three years, the situation righted itself as economic activity recovered, and GDP per capita attained a level of $10,481 in FY2014.
GDP per capita
GNDI per capita
$12,000
$11,000
$10,000
$9,000
$8,000
$7,000
$6,000
Figure 8
GDP and GNDI per capita, 2000-2014, constant prices 2005 (US$)
Economic Developments
11
However, recent rises in GDP per capita have been partly due to the large reduction in
population rather than increased economic activity. In a sense, this is a perverse outcome:
living standards were maintained because a large number of people emigrated.
29.
Figure 8 also includes the trend in GNDI per capita from FY2000. Real GNDI
measures the sum of GDP adjusted for terms of trade changes, plus primary and secondary incomes from the balance of payments. In Palau, the two measures are generally in
close proximity and move in parallel to each other. Primary income includes interest and
dividend earnings on foreign investments less dividend outflows. Dividend outflows are
large in Palau, due to the large foreign investment component in the economy. Secondary
incomes are composed of grant incomes from the rest of the world, which is substantial,
less remittance transfers of foreign workers. Throughout the period GNDI is greater than
GDP per capita, indicating grant incomes outweighed profit and other remittances. During the recession investment earnings dropped while grant levels held constant, and the
gap between GNDI and GDP widened. These forces reversed between FY2009 and
FY2012 as the economy rebounded, but in FY2013 terms of trade and appreciation of the
U.S. dollar offset the decline in GDP. In general the gap between GDP and GNDI widens
during weak points of the cycle and narrows during boom times.
30.
Based on the 2006 household income and expenditure survey (HIES) an analysis
of poverty and basic needs was conducted by the UNDP1 Pacific Centre (Suva, 2008).
The study indicated that 18.4 percent of households existed on a level of expenditure below a Basic Needs Poverty Line (BNPL). Given that Palau is now estimated to be in the
World Bank’s high income group this is a large number. The result is perhaps surprising
in that rates of unemployment in Palau based on the recent mini census are estimated at
less than 5 percent.
31.
The UNDP study also indicates that the Gini coefficient based on average household expenditures was 0.25. (The Gini coefficient is a measure of inequality with perfect
equality having a coefficient of 0 and total inequality is 1.) Based on recent work on the
distribution of gross wages collected under the Social Security Administration, Palau has
a Gini coefficient of 0.49, which is relatively high by international standards. For Palauans disregarding non-citizens, the Gini coefficient falls to 0.40 and reflects the large
number of low income foreign workers in the country. However, both measures of inequality are only partial as they are not based on a full analysis of all sources of income.
The UNDP study is based on household expenditures and not incomes. The Social Security Administration study is based on individuals and does not capture subsistence or
business incomes. The results of the 2014 HIES, currently under analysis, will hopefully
shed further light on these important issues.
32.
Other interesting indicators of distribution can be derived from the factorial distribution of income in the national accounts (share of wages and profits in GDP). At the
1
UNDP, Pacific Centre, “Analysis of the 2006 Household Income and Expenditure Survey”,
Suva, Fiji, 2008.
12
RoP Economic Review—FY2014
start of the 2000s, the share of wages in GDP averaged 61 percent from 2000 to 2002 but
then trended downward, averaging 50 percent at the end of the 2012-2014 period. The reduction in the share of wages and commensurate increase in the share of operating surplus reflects the changing structure of the economy. As the tourism economy has grown
relative to the public sector and other labor-intensive activities, profit-earning activities
have increased their share.
3. EMPLOYMENT, EARNINGS AND WAGES
i
Employment
33.
Recent trends in employment are based on quarterly data collected by the Republic of Palau Social Security Retirement Fund (RPSSRF). The figures are estimated from
the returns submitted to the RPSSRF by employers, and employment is measured by a
count of individuals. Individuals who transfer from one job to another during the quarter
or turnover in migrant labor will tend to overstate the numbers. However, the information
is the best available at this time and considered to be representative of actual trends.
34.
Figure 9 indicates recent trends in employment of both Palauans and non-citizens.
Citizenship employment has displayed a stable trend over time and grown from a level of
4,755 to 4,933 during the last 13 years. There was a slight peak in the mid-2000s, reflecting the additional demand for labor to complete the construction projects. Citizenship
employment fell with the poor economic performance in FY2009, but has subsequently
strengthened with the recent tourism led growth. The pattern for non-citizenship employment reveals a significantly different story. There was rapid growth in the early 2000s to
work on the growing tourism industry and construction projects, and the use of foreign
Palauan Employment
7,500
7,000
6,500
6,000
5,500
5,000
4,500
4,000
Figure 9
Employment by citizenship
Non-Citizen Employment
Economic Developments
13
labor surpassed that of Palauans. However, with the completion of the projects, the demand for foreign labor fell and the workers returned home. In the past two years the demand for foreign labor has picked with the booming economy.
35.
Figure 10 indicates the level of employment in the private sector, national government, and a third group comprising the SOEs, government agencies and state governments. Trends in the private sector indicate growth in the early 2000s, with the additional
demand for labor for the infrastructure projects. However, the private sector declined
from FY2005 through FY2010, with the completion of the projects and the onset of the
recession. Demand for private sector labor increased between FY2011 and FY2014 as a
result of the resurgence in the tourism industry, although less strongly than the growth in
visitor numbers. This implies greater capacity utilization of facilities and growth in
productivity. Excluding the construction industry from the private sector figures yields a
far smoother more or less stationary trend over the period.
36.
Employment in the national government indicates an average level of 2,369 during the FY2000-FY2004 period but then shows a dip in FY2005 and a gradual decline
thereafter. Compensating for the reduction in national government, employment in the
SOEs, state governments and government agencies has grown rapidly from a level of
1,172 in FY2000 to 1,742 in FY2013 or at an annual rate of 2.9 percent. Taken as a
whole, the level of employment in the public sector has grown modestly by an annual average of 0.7 percent. Fiscal policy and employment in the public sector has followed a
cautious track, protecting Palau from the pitfalls experienced by other Micronesian econ-
National Government
SOEs + agencies + State gov
8,000
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
Figure 10
Employment in the private and public sectors
Private Sector
14
RoP Economic Review—FY2014
omies, which led to painful adjustments and reductions in public sector employment during cyclical downturns. At the same time, the cautious public sector employment policy
has allowed resources to flow to the private sector and reduce distortions in the labor
market.
ii Wage rates
37.
Figure 11 provides an indication of the trends in Palauan and non-citizen wages.
The strong divergence between the two series could be taken to infer that non-citizen labor is paid less than citizen labor. However, more detailed analysis suggests that the story
is more complex. In the private corporate sector, citizen wages are currently 21 percent
higher than those for non-citizens, although in the non-corporate private sector citizen
wages are 67 percent higher. In banking and the national government, the pattern is the
other way around, with non-citizen wages being 12 percent higher than citizen earnings
in banking, and 10 percent higher in the national government. Clearly, wages reflect the
required skill set, scarcity and qualifications in the different sectors.
38.
For Palauans, nominal wages have risen through the period by an average rate of
2.4 percent annually. The annual rate of increase moderated in FY2009 with the onset of
the recession, but resumed the upward trend thereafter. In FY2014 the data indicates a
rapid growth in wages of 8.3 percent, and strong wage growth in the private sector and
state governments. This reflects tightening of the labor market and the strong fiscal position of Koror State. For the non-citizen segment, nominal wages were relatively stable
through FY2009, but since that time they have shown an upward trend reflecting the increasing growth in tourism, rising by 4.6 percent per annum. In FY2014 wage growth
was 6.8 percent but not as strong as in the Palauan segment.
Palauan
Non-Citizen
14,000
13,000
12,000
Nominal Wage Rates $'s
11,000
10,000
9,000
8,000
7,000
6,000
5,000
4,000
Figure 11
Palauan and non-citizen average wage rates
Economic Developments
15
39.
Figure 12 indicates the level of average real and nominal wage rates in the private
and public sectors. Clearly, the public sector pays the highest rate of remuneration, with
rates of pay exceeding the private sector by more than 75 percent in FY2014. While it
might be inferred that public sector wage policy is distorting the market through paying
higher wages, such conclusions as in the comparison between Palauans and non-citizens
may not be warranted. The skill set in the two sectors is different. Government administration, education and health workers require a higher level of skills than employees in
the tourism sector. Wage rates in the public sector have risen by an annual average rate of
1.8 percent during the period, in comparison with a rise of 2.2 percent in the private sector.
40.
While nominal wages grew economy-wide by 2.0 percent in the 14 years under
discussion, the same is not true of real wages (the level of nominal wages adjusted for
changes in inflation or CPI). For the economy real wages fell by an average of 0.9 percent, with public sector real wages falling by 1.1 percent and the private sector by 0.7
percent, respectively.
41.
In April 2013 the Palauan Congress, known as the Olbiil Era Kelulau (OEK),
passed a revised minimum-wage bill, increasing the minimum wage from $2.50 an hour
to $2.75 beginning October 1, 2013. The bill stipulated that the minimum wage would increase by 25 cents in the subsequent years until it reached $3.50. The bill also permitted
employers to take into account reasonable deductions for cost of housing and food provided to an employee. The bill applies to both citizen and “non-residential” employees.
Exemptions from the minimum wage apply to farm labor, domestic helpers, NGO employees and a few other selected groups. At the current time, $20 per day is a rule of
16,000
Public sector (nominal)
Private Sector (nominal)
Public Sector (real)
Private Sector (real)
14,000
12,000
10,000
8,000
6,000
4,000
Figure 12
Average nominal and real wage rates in the private and public sectors
16
RoP Economic Review—FY2014
thumb for domestic help, which equates to the old $2.50 per hour. While this group is exempt from the new minimum wage, the new standard is likely to increase low-end wages
and reduce demand for unskilled labor. However, given the high rate of employment in
the economy, the new rate should not have a great impact on increasing unemployment.
B.
Developments in the Tourism Sector
1. TRENDS IN ARRIVALS AND PLANT UTILIZATION
42.
Towards the end of 2014 Palau began to experience a very large influx of visitors
from the People’s Republic of China, suggesting that growth in arrivals during FY2015
was likely to surpass the level of visitors attained in FY2014 of 125,417 and reach a record level of 180,000—a 44 percent increase. These developments led to an active debate
in Palau that tourism growth was proceeding too rapidly, causing adverse impacts on existing operators, local infrastructure, and the environment. As a result, the President of
the Republic, through executive order, placed a limit on the number of charter flights
originating from China. A brief analysis examines these recent trends to shed light on
their impact.
43.
Figure 14 indicates recent quarterly trends on visitor arrivals by nationality.
Clearly, the Chinese market has exploded, reaching over 25,000 during the first quarter of
2015, which is well above the next group of visitors from Japan. There is some evidence,
although inconclusive at this stage, that the rapid growth of Chinese visitors has deterred
other groups. The Japanese market, Palau’s favored source of higher spending tourists,
fell during the last quarter of 2014 and first of 2015 compared to the same period a year
previously. However, such fluctuations are not uncommon, and it is worth nothing that
lower spending tourists from Taiwan declined during the same period. The U.S. market,
which is heavily focused on diving, has maintained levels. There is thus some support for
the observation that advance booking of accommodation has limited room availability for
visitors from other sources, although determination of clear trends of displacement requires further data and analysis.
44.
Palau tourism plant includes a variety of different grades and categories ranging
from higher quality to more basic facilitates, including small operators in remoter parts of
the country and dive boat “live-aboards.” In total at the end of 2014, there were 1,593
rooms available in Palau. While no formal grading of tourism plant has been established
in Palau, for the analysis presented in this review, hotels have been graded in consultation
with industry representatives. High-end facilities include the Palau Pacific Resort and the
Palau Royal Resort. Three other grades have been categorized B through D. Based on immigration statistics and hotel of destination of visitors, estimates of occupancy rates can
Economic Developments
17
30,000
25,000
20,000
China
Taiwan
15,000
10,000
Japan
South Korea
5,000
USA
0
Figure 14
Visitor arrivals by nationality
be made assuming an average number of persons per room of 1.8 (based on tourist expenditure survey information).
45.
Figure 13 presents a picture of the changes in occupancy since the second half of
2007. Historically many of the operations at the low end of the scale have been run at
very low occupancy and the D grade group has averaged 25 percent over the last five
PPR & PRR
B Grade
C Grade
D Grade
100.0%
90.0%
80.0%
PPR & PRR
B Grade
70.0%
60.0%
50.0%
C Grade
40.0%
30.0%
20.0%
D Grade
10.0%
0.0%
Figure 13
Hotel occupancy by grade
18
RoP Economic Review—FY2014
years. Occupancy rates improve with the grade of establishment and at the higher end resorts have typically sustained occupancy rates greater than 75 percent. Including all establishments, occupancy rates have risen from 31 percent during 2009 after the international recession to 61 percent in 2014, a significant increase. The recent increase in visitor arrivals has been accommodated by both an increase in occupancy rates of C grade
hotels, and the addition of new plant, 200 rooms, in the B grade group.
46.
Further light can be shed on these developments by estimating the average room
spend per visitor, by nationality. Matching the gross sales of each establishment with the
number of visitors staying in them provides an estimate of average room price per visitor.
These rates can then be applied to the immigration data to derive average room prices
typically paid by each of the major nationality groups. This information is provided in
Figure 15. The outturn indicates that the Japanese and South Korean segment of the
market typically stay at the upper end of Palau’s facilities, while vistiors originating from
China and Taiwan are accomadated in the lower grade establishments. The average room
price paid in 2014 by Japanese and Korean visitors was $142/night, which is over 50
percent higher than the $93/night paid by visitors originating from China and Taiwan.
The recent influx of tourists from the PRC is thus clearly associated with greater plant
capacity utilization at the lower end of the spectrum.
2. IMPACT OF BOOMING VISITOR ARRIVALS ON THE ECONOMY
47.
Prior discussion on economic developments during FY2014 indicated the strong
growth in the economy of 4.9 percent. Approximately half the expansion was contributed
by the hotel, restaurant and transportation sectors. Figure 4 in the earlier discussion indicates the upward trend in these industries since FY2009, and Figure 2 also indicated the
Hotel Room Rates by Nationality
$180
$160
$140
Japan
South Korea
$120
$100
$80
Taiwan
$60
$40
$20
$0
Figure 15
Average hotel room rates by nationality
China
Economic Developments
19
strong impact of tourism expenditures and investment in hotel plant on the economy in
FY2014. However, the growth in tourism has not been even. Figure 16 indicates growth
in the recent components of the tourism industry. In the last quarter of the 2014 when the
recent boom in visitors from the PRC had reached a peak total, visitor nights spent in Palau grew by 44 percent compared with a year earlier. Expenditures on accommodation
and meals grew by 25 and 14 percent, respectively. In the dive segment of the industry
expenditures fell by 21 percent, while water based tours rose by 7 percent. Figure 16 excludes minor areas of tourist expenditures such as shopping; these “other” components
grew by 14 percent in the last quarter of 2014.
48.
From the forgoing analysis it may be concluded that for all categories expenditures per visitor night have declined. This is consistent with the earlier observation that
the growth in the use of hotel plant has been in the middle to lower end of the market.
While the shift in visitors to bulk package tours implies a reduced economic benefit per
visitor, it does not imply that there has been an absolute decline in revenues. In the dive
segment, however, there are indications that the impact has been negative. Operation of
accommodation plant at near capacity and pre-booking of rooms for packages has resulted in a lack of space for individual organized divers. This reflects the rapid uncontrolled expansion of a market inducing stress in niche components.
49.
In terms of government revenue Figure 17 indicates recent trends in the major
components: Koror State Park, hotel occupancy tax, departure fees and the Gross Receipts tax (effectively a sales tax). Revenue has been buoyant and reflects a series of factors. Koror State Park (Rock Islands and Jelly Fish Lake) is one of the main tourist attractions in Palau. Revenues have grown in line with the number of visitors but in June of
Accommodation
Food/Drinks
Diving (not Live Aboard)
Boat Tours
14.000
12.000
10.000
8.000
6.000
4.000
2.000
-
Figure 16
Static trends in Diving and Boat Tours
Tourist Expenditure by market segment ($’millions)
20
RoP Economic Review—FY2014
$4.5
$4.0
Koror State Park
S'Millions
$3.5
$3.0
$2.5
$2.0
Departure Fees
$1.5
Hotel Occupancy Tax
$1.0
$0.5
Gross Revenue Tax
$0.0
Figure 17
Public sector revenue derived from tourism
2012 the Rock Island and Jelly Fish Lake permits rose from $25 to $50 and $35 to $100,
respectively1. Similarly visitor departure fees are directly related to the number of visitors, but the fee was increased from $30 to $50 at the start of 2013. The hotel occupancy
tax was raised 10 to 12 percent in 2013 and is levied on room sales. The Gross Receipts
Tax (GRT) is levied at 4 percent of gross. Receipts from both the hotel occupancy tax
and GRT have grown as tourist expenditure has grown, but as they are ad valorem taxes,
the tax collected per visitor night has declined.
50.
Finally in this section the impact on employment of the recent expansion in tourism is indicated in Figure 18. The growth in tourist related employment has averaged 4.8
percent per annum annually since the last quarter of 2009, but below the rate of increase
in visitor nights, which has averaged 11.9 percent. This reflects greater capacity utilization and corresponding increases in productivity. Given the supply constraints in the labor market, the growth in employment almost certainly indicates growth in the use of foreign labor.
51.
The foregoing analysis has indicated a significant increase in visitor arrivals and
the recent rapid growth in visitors from the PRC. Recent additions to tourist plant and existence of unused capacity at the mid and lower grades permitted the expansion. As a result most of Palau’s tourism plant is now operating at healthy occupancy rates. However,
the rapid expansion has not occurred without disruption and market stress, particularly in
the dive market where output has declined. Both national and state government revenues
have boomed, both as a result of growth in visitor arrivals, but also due to increases in tax
1
The Jelly Fish Lake permit includes access to the Rock Islands.
Economic Developments
4,000
21
Private Sector Employment excuding tourism
3,500
3,000
Tourism Employment
2,500
2,000
1,500
1,000
500
Growth in tourist employment = 4.8%
Growth in private sector (less tourist) = 2.2%
Growth in Visitor Nights = 11.9%
-
Figure 18
Employment in tourism and other private sector activities
rates and entrance fees. Demand for labor has also grown, which has been met by additional foreign labor, given the supply constraints in the labor market.
C.
Monetary Developments and Prices
1. PRICES
52.
Figure 19 provides information on the rate of inflation and major driving forces in
the Palau CPI, including food and transportation prices (quarter on quarter of the previous
year). In the early 2000s inflation was very modest averaging 0.0 percent during the
FY2000-FY2004 period. While there was some pick up averaging 3.6 percent during
FY2005-FY2007, it was not until the FY2008 that inflation peaked at 9.9 percent. Since
that time inflation has moderated although in FY2012 prices again rose by 5.4 percent. In
FY2014 inflation recorded 4.0 percent and was above world averages.
53.
There have been two main driving forces behind the recent hikes in inflation. The
first was the impact of increases in food prices, which, due to their large influence in the
Palau CPI (25 percent), have a significant effect on measured inflation. Second, world energy prices have a direct impact on remote island economies like Palau, which have few
alternative possible responses to reduce the impact. In FY2005 fuel prices jumped, increasing not only the cost of fuel but also indirectly utility charges. The increase in prices
was mitigated to some extent by falling food prices during that period, and the overall
CPI only rose by 5 percent. However, in early FY2008, as the world economy was at the
height of its pre-recession boom, not only did fuel prices skyrocket but food prices also
were rising rapidly due to a disequilibrium in world food markets. The combination of
the two pushed the CPI up to 16.8 percent in the third quarter of 2008.
22
RoP Economic Review—FY2014
CPI
Food
Transport
30%
25%
20%
15%
10%
5%
0%
-5%
-10%
-15%
Figure 19
Change in CPI by selected commodity groups by quarter, FY2004–
FY2014
54.
The subsequent onset of the recession bought prices back down, with food and
fuel prices moderating, and inflation even turned negative in some quarters. More recently, towards the end of 2011 and start of 2012, the same process appeared to be occurring again. However, although the CPI had risen by 8.7 percent in the last quarter of
2011, the period was short-lived, and by the third quarter of 2012, inflation had moderated to 1.7 percent. During FY2014 inflation averaged 4.0 percent a relatively high rate
given the international climate with fears of deflation. However, while fuel prices were
trending downwards (with more to come in 2015), increases in tobacco taxes representing
1.7 percent of the increases, and local health charges representing 1.2 percent were the
main drivers.
2. MONEY AND BANKING
55.
With the adoption of U.S. currency in Palau, macroeconomic policy and adjustment has been limited to fiscal policy. The use of a foreign currency is practiced in many
other small island economies of the Pacific and has served Palau well. While the range of
macroeconomic policy options is limited, the use of U.S. currency has removed the potential to use inflationary monetary policy to adjust to changes and reductions in Compact
funding. Consequently, Palau has no means of adjusting to reduced levels of resource
transfers, other than the more politically painful policy of directly cutting government expenditures, reducing public sector employment and wages and increasing domestic revenues. Furthermore, the use of a foreign currency has removed exchange-rate realignment,
to encourage the export and traded goods sectors of the economy. At this stage of economic development in Palau, with many underlying structural impediments, exchangerate adjustment without accompanying supporting policies would be unlikely to have encouraged a favorable supply response in traded-goods production.
Economic Developments
23
56.
The banking system in Palau is regulated by the Financial Institutions Commission (FIC), which is governed by a board appointed by the president of Palau. The FIC is
managed by an executive commissioner and is staffed by a bank examiner and administrative staff. The bank examiner conducts off-site and on-site bank examinations, which
include but are not limited to quarterly and annual analyses of individual bank and sectorwide financial returns and financial sector statistics. There are five licensed banks in Palau, three of which are FDIC-approved (Bank Pacific, Bank of Guam and Bank of Hawaii) and two which are not (Asia Pacific Commercial Bank and the Palau Construction
Bank). While the FDIC banks provide a full range of banking services, the non-FDIC
banks are restricted to operating savings accounts only. Legislation to permit the National
Development Bank of Palau (NDBP) to take deposits has now come into force, and once
licensed will come under the regulatory inspection of the FIC. Before granting of a license the bank will be required to meet all the normal capital adequacy and regulatory requirements commercial banks are required to fulfill. In the early part of the 2000s, there
were eight banks operating, three of which have subsequently gone out of business and
operations have been shut down. After a turbulent period of restructuring, the sector has
settled down and now operates under an effective regulatory environment. Given the historical perspective, the sector requires a well-developed supervisory capability and careful monitoring. As result of the recent establishment of the FIC, the current statistical series only commenced from the last quarter of 2009, and analysis is restricted to the period
since that date.
57.
Since there is no independent monetary policy, domestic interest rates are closely
aligned with those in the United States. Deposit interest rates are broadly similar to those
throughout the U.S. In December 2009, the average three-month deposit was 0.5 percent
(see Appendix, Table 6e). It increased in subsequent quarters but had fallen to 0.2 percent
by the end of FY2013 and remained at the level in FY2014. As in many developing countries, financial intermediation is accompanied by a substantial spread between lending
and deposit rates, and lending rates are significantly higher, reflecting the additional risk
and costs of doing business in Palau. Interest rates on loans and overdrafts have been relatively stable during the period of available statistics, ranging from a high of 12.8 percent
to a low of 10.9 percent and stood at 11.3 percent at the end of FY2014. Rates for individual based loans (predominantly consumer) have fallen modestly over recent years and
stood at 11.6 percent at the end of FY2014. Rates on mortgage backed lending, which is
only a small part of the commercial banks portfolio, have been trending upwards, perhaps
due to the longer term coupled with the perceived difficulty of foreclosure, and stood at
15 percent also at the end of FY2014.
58.
Major trends in lending and deposits in the RoP banking sector since December
2009 are shown in Figure 20 (and Appendix, Table 6a). On the deposit side, the figure
shows a strongly upward trend through the period, growing by an annual average to 14
percent. On the lending side, performance is weak and far from satisfactory. The level of
outstanding credit actually fell from $31 million at the end of 2009 to $29 million by the
end of September 2014. The difference between loans and deposits indicates the large
24
RoP Economic Review—FY2014
level of liquidity in the Palau banking system and is another example of a widely observed phenomenon in the Pacific Islands region: capital is not a factor of production in
short supply. Reflecting the trends described above, the loans-to-deposit ratio fell from 33
to 17 percent. The large difference between the level of deposits and loans is invested off
shore, and, mirroring the difference in the trends in deposits and credit, the level of foreign assets rose from $69 million in December 2009 to $141 million by the end of the period.
59.
Figure 21 indicates the extension of credit to the private sector in the consumer
and commercial markets. Consumer credit reveals a declining trend between December
2009 and June 2011, falling nearly $10 million or 32 percent as banks ran off loans, presumably reflecting a lack of confidence in the economy and the impact of the recession.
However, as the economy improved and confidence returned, consumer credit grew
again, adding over $9 million to the level of outstanding credit by September 2014. The
picture for commercial credit is nearly all unfavorable. The level is exceedingly low—
averaging $3.1 million during the last two years and less than 1.6 percent of deposit liabilities. By the end of FY2014, commercial lending had fallen to just $2.8 million—an
almost non-existent level—and there has been no sign of an upturn as economic conditions have improved.
60.
Clearly, the banking culture in Palau is extremely risk-averse. Palau acts as a
source of funds, and the proceeds are invested in Guam or the U.S. mainland. Efforts are
emerging on several fronts to improve the lending environment. A secure transactions
registry was established in January 2013, but take up has been slow due to the lack of
chattels that can be effectively used as collateral. Most vehicles in Palau, for example, are
200
180
160
140
$'millions
120
100
80
60
40
20
0
Figure 20
Commercial bank loans and deposits (end of period)
Economic Developments
25
35
30
$'millions
25
20
15
10
5
0
Figure 21
Commercial bank credit by sector (end of period)
second hand imports from Japan, which are not eligible for insurance. A series of other
reforms is required, including revisions of the bankruptcy law, commercial code and
land-lease statutes. Such reforms will help establish an environment that will hopefully
encourage conservative lenders to take a more proactive role in the development of the
economy.
D.
Balance of Payments and External Debt
1. BALANCE OF PAYMENTS
61.
The current balance of payments (BoP) account is presented in abbreviated form
in Table 1 and in more detail in the statistical appendix. On the trade account exports
comprise two main items: fuel re-exports and others. Estimates of re-exports to ships and
airlines have been made on the basis of aviation gas imports and margins of resident fuel
companies. Other exports comprise small quantities of commodities, including material
for recycling. Fish transshipped in Palau is not considered an export as the commodity is
owned by non-resident long-line fishing vessels. However, the on-shore handling and
packaging is sold to the vessel owners, considered an export and is captured on the services account.
62.
Import data was until the start of 2014 collected through the PC Trade statistics
and customs administration system used in many small Pacific Island nations. At that
time Palau replaced the old system with a new system developed under grant aid from
Taiwan. Imports have generally been well-recorded, although the value of commodities
on which tax is levied on a volume-basis is less precise. Imports of food items have risen
through the period, reflecting international food prices and domestic demand, including
26
RoP Economic Review—FY2014
Table 1
Balance of payments, FY2005–FY2013 (US$ millions)
(US$ millions)
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
Current account balance
-37.9
-49.4
-35.0
-42.0
-13.7
-14.3
-21.1
-36.7
-23.5
-31.6
Goods and services balance
-57.2
-67.9
-55.1
-62.4
-36.3
-43.0
-46.3
-62.3
-47.4
-59.4
Goods balance
-97.2
-105.7
-99.0
-108.3
-85.9
-91.1
-112.2
-123.9
-132.1
-158.7
10.9
7.1
3.7
9.6
6.7
2.9
9.5
7.3
2.2
12.0
9.9
2.1
8.1
7.1
1.1
11.7
10.6
1.1
12.8
11.2
1.6
15.0
12.8
2.3
14.4
13.1
1.3
19.1
17.8
1.3
108.1
23.6
37.2
47.3
115.3
23.1
49.5
42.7
108.5
24.3
36.3
47.9
120.3
26.9
39.4
54.1
94.0
26.6
22.0
45.4
102.8
26.4
32.2
44.1
125.1
27.8
45.6
51.7
138.9
32.7
50.1
56.2
146.5
32.9
50.4
63.2
177.7
36.7
54.3
86.7
Services balance
40.0
37.8
44.0
45.9
49.6
48.1
65.9
61.6
84.8
99.3
Exports of services
Fish processing
Travel
Other
72.4
2.7
60.1
9.6
74.7
4.1
60.3
10.4
82.2
2.8
68.4
10.9
88.2
2.6
73.7
12.0
85.7
1.3
73.7
10.7
84.7
1.2
72.9
10.6
102.8
1.1
90.9
10.8
104.0
1.5
90.9
11.6
125.7
1.5
112.7
11.5
142.4
1.2
128.6
12.6
Imports of services
Transport
Travel
Other
32.4
18.2
8.0
6.2
36.9
19.8
8.1
9.0
38.2
21.7
8.4
8.0
42.3
24.8
8.1
9.4
36.2
20.9
6.4
8.8
36.6
22.7
6.0
7.9
36.8
20.2
8.3
8.4
42.4
24.0
10.2
8.1
41.0
22.4
10.2
8.4
43.2
22.7
10.7
9.7
Primary income balance
-9.8
-9.8
-10.9
-11.8
-7.9
-7.5
-10.4
-10.2
-12.1
-12.6
4.6
1.1
2.0
1.9
0.1
1.5
5.8
1.1
2.6
2.5
0.1
2.2
6.2
1.0
3.6
3.5
0.1
1.6
7.5
1.0
4.6
4.4
0.2
1.9
7.9
1.4
5.0
4.4
0.6
1.5
7.4
1.1
4.9
4.4
0.5
1.4
8.1
1.7
5.1
4.9
0.2
1.3
9.5
1.5
6.6
4.8
1.8
1.4
9.5
3.4
4.6
3.5
1.1
1.5
10.4
4.6
4.5
3.1
1.3
1.3
14.4
12.3
2.1
15.7
13.6
2.1
17.2
14.7
2.5
19.3
16.9
2.4
15.8
13.5
2.3
14.9
12.2
2.7
18.5
16.0
2.5
19.7
17.3
2.4
21.5
19.1
2.5
23.0
20.6
2.4
Exports of goods
Other
Re-exports
Imports of goods f.o.b.
Food
Fuel
Other
Primary income, inflows
Fishing licence fees
Dividends and interest
Social Security & Pension Plan
Other
Others
Primary income, outflows
Dividends related to direct investment
Interest on loans
tourism growth. Likewise, fuel imports are strongly related to international prices, given
the inelastic nature of demand. Other import items reflect inputs into the construction and
tourism industries and consumer items. In FY2014 the value of imports rose dramatically
reflecting the increased tourism activity and investment in tourism plant.
63.
The service account on the receipt side comprises fish processing, tourism revenue, and a series of other small items. As noted fish transshipped through Palau are not
considered a BoP transaction, but value is added in packaging and transfer fees. Estimated exports of tourism services are based on the sales of hotels, restaurants, dive and
tour operators and other tourist related activities. Visitor arrivals grew by 13 percent in
FY2013 while exports increased by 9 percent. Recent growth in tourism has been in
package tours at the lower end of the market and as a consequence average prices have
fallen. The Palau Visitor’s Authority recently conducted a tourist “exit” survey in the second half of 2014 and estimates for daily expenditures by nationality are available. At this
point the survey is being reconciled against the sales values, which may result in future
revisions to the statistics. Other service exports reflect a variety of small items.
Economic Developments
27
64.
Imports of services include the insurance and freight component of imports
(c.i.f.), passenger fares, overseas travel expenses and technical assistance. The level of
imported business services is not known with any degree of accuracy. Primary incomes
include compensation of non-resident workers, interest and dividends, and royalties from
fishing. Fishing royalties are not large in Palau but the Vessel Day Scheme, which is part
of the Parties to the Nauru Agreement, has resulted in significant increases in FY2013
and FY2014. The future status of these revenues is unclear should Palau proceed with the
establishment of a marine sanctuary. Interest and dividend receipts are represented by
earnings of the Social Security and Civil Servant Pension Funds, government and offshore investments of the commercial banks. On the payments side, the dominant item is
the payment of dividend earnings of foreign companies, mostly in the tourism sector.
This items is currently under revision and the estimates will take advantage of the Corporate Registry database derived from the annual business survey of the corporate sector.
65.
The major items in the secondary income account (see continuation of Table 1)
are grants and household remittances. Grant receipts consist of Compact grants, drawdowns from the COFA Trust Fund1, other U.S. grants (mainly federal programs) and
other country current grants. Receipt of remittances from Palauans living abroad is not
known with any accuracy but is understood to be small. On the payment side, significant
remittances are sent off shore from the large resident non-citizen worker community living in Palau. This is estimated in relation to the number of non-citizens living in Palau,
which fell after the completion of the large infrastructure projects, but has shown growth
with the booming tourist industry.
66.
The main and only estimated items on the capital account are capital grants. These
are received from the U.S., Japan and other countries, particularly the Republic of China
(Taiwan). A major specific capital grant was received from the U.S. to build the
Babeldaob road, known as the “Compact Road.”
67.
In regard to the financing account, the estimation of direct investment inflows is
under revision and will be based on the Corporate Registry database; indications are that
the figures will be revised downwards. The national government, Social Security and
Civil Service Pension Funds all have significant portfolio investments off shore. Overall,
the sum of net acquisitions less incurrence for this group has been in balance. Net acquisitions of “other” investments mainly reflect the changes in commercial bank foreign assets. Data for this series only became available with the new banking statistics series in
2010, but recent changes have been large. Incurrence of “other” investment liabilities reflects small changes in financial institutions (banks and insurance companies) and public
debt, both government and the SOE sector. In most periods repayment of external debt
has exceeded new loan drawdowns, although in FY2012 drawdown of the first tranche of
1
The COFA (Compact of Free Association) Trust Fund is treated as a multilateral institutional
unit derived from the relations between the U.S and Palau. As such it is non-resident.
28
RoP Economic Review—FY2014
Table 1
Balance of payments, continued, FY2005-FY2013 (US$ millions)
(US$ millions)
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
Secondary income balance
29.2
28.3
31.0
32.3
30.5
36.2
35.6
35.8
35.9
40.4
Secondary income, inflows
Government grants
US compact grants
COFA Trust Fund
US non-compact grants
Other grants
Other
46.9
40.6
12.5
5.0
9.3
13.8
6.3
46.2
39.7
12.7
5.0
9.6
12.4
6.5
48.1
41.3
12.7
5.0
9.1
14.5
6.7
48.8
42.0
13.2
5.0
9.5
14.3
6.8
45.7
39.4
13.1
5.0
8.8
12.4
6.4
51.2
43.5
13.1
5.0
10.9
14.5
7.7
51.1
42.4
13.1
5.0
10.3
13.9
8.7
52.2
42.4
13.1
5.0
10.6
13.7
9.8
53.4
42.0
13.1
5.0
9.8
14.0
11.5
57.4
44.9
13.1
5.0
10.1
16.6
12.5
Secondary income, outflows
Household remittances
Other
17.8
14.2
3.6
17.9
13.6
4.3
17.1
13.1
4.1
16.5
12.2
4.3
15.2
11.5
3.7
15.0
11.0
3.9
15.5
11.3
4.2
16.4
12.0
4.5
17.5
12.7
4.8
17.0
11.8
5.2
Capital account balance
46.9
46.3
40.2
27.0
14.5
26.1
16.8
22.9
19.5
32.6
Capital inflows
US
Compact Rd
Japan
Other
46.9
1.5
29.1
4.7
11.6
46.3
8.1
19.8
4.3
14.1
40.2
8.3
11.4
3.9
16.7
27.0
6.9
2.2
9.1
8.8
14.5
4.3
0.3
3.3
6.7
26.1
6.6
0.0
5.8
13.7
16.8
3.5
0.0
1.1
12.2
22.9
4.4
0.0
5.3
13.2
19.5
3.5
0.0
3.8
12.1
32.6
4.0
0.0
4.0
24.6
~
~
~
~
~
~
~
~
~
~
Capital outflows
Net lending/Borrowing (Curr + Cap)
9.1
-3.1
5.1
-15.0
0.8
11.8
-4.3
-13.8
-4.1
1.1
-10.8
6.4
-8.9
-0.6
1.7
0.6
5.3
12.0
-0.7
2.7
Direct investment (net lending (+) = assets - liabilities)
-16.4
Financial account balance
-15.5
-7.2
-8.3
-6.3
-5.5
-7.7
-8.0
-8.8
-15.6
Portfolio investment (net lending (+) = assets - liabilities)
-0.3
-0.1
-0.4
2.6
1.2
-3.1
-0.6
1.4
2.0
-9.9
Other investment (net lending (+) = assets - liabilities)
5.9
Assets (net acquisitions)
5.5
Liabilities (net incurrence)
-0.4
Financial institutions
0.0
Loans, Public
-0.4
22.1
20.1
-1.9
0.0
-1.9
-1.3
10.0
11.4
0.0
11.4
5.2
3.0
-2.2
0.0
-2.2
6.7
10.3
3.6
0.0
3.6
9.2
2.9
-6.2
-2.4
-3.9
13.5
9.4
-4.2
-0.4
-3.8
18.6
23.4
4.8
-1.6
6.4
6.1
2.1
-4.1
0.0
-4.1
28.2
33.7
5.6
0.0
5.6
9.5
-14.0
14.4
0.9
-11.2
9.6
25.9
3.4
1.6
Errors and omissions
-19.8
the new ADB water and sewer improvement loan of $9.9 million led to a positive net inflow. In FY2014 the second tranche of $6.2 million was received.
68.
The structure of the balance of payments has resulted in a negative balance on the
goods and services account, despite a large positive entry for tourism. The current account balance has also tended to be negative, with the large positive balance on the secondary income account being insufficient to offset the negative balance on goods and services and primary income accounts. The capital account has always been positive, reflecting the large receipt of capital grants from which Palau benefits. The balance on the finance account reflects FDI flows to support investment in tourism plant, but is offset by
large increases in the foreign asset holdings of the commercial banks. Overall, the BoP
errors and omissions have remained within 10 percent of goods and services, and indicates there is significant room for improvement. The errors and omissions have not displayed any trends either in a positive or negative direction.
Economic Developments
2. GROSS NATIONAL INCOME
29
AND GROSS NATIONAL DISPOSABLE INCOME
69.
Estimates of gross national income (GNI) and gross national disposable income
(GNDI) are derived from GDP with the addition of the primary and secondary income accounts of the Balance of Payments. In Palau both primary and secondary incomes are significant and have represented an average of 5 and 17 percent of GDP during the last three
years, respectively. While analysis of GNI and GNDI might be placed in the section on
GDP, we thought it would be more appropriate to put it in the section following the analysis of the BoP, since the data to construct the additional series comes from the BoP. In
terms of analyzing the results, it is useful to single out developments in constant price
changes in primary and secondary incomes, which are provided in Figure 22. Both the
primary and secondary incomes of the BoP have been deflated by the index of the gross
domestic expenditure (GDE) deflator. Figure 23 provides a description of the trends in
GDP, GNI and GNDI from FY2000 through FY2012.
70.
Starting the discussion from FY2005, when more confidence can be relied on the
data, primary income receipts grew from interest and dividends yield on expanding portfolio investments (see Table 1). While dividend outflows held steady in the FY2005FY2008 period, they fell sharply between FY2008 to FY2010, reflecting the erosion of
profits during the recession. In the last four periods (FY2011 through FY2014), dividend
outflows again gained momentum as the economy recovered. Combining the impact of
the large dividend outflows with the rising trend of primary inflows, the pattern of the
combined movements in Figure 22 can be analyzed. In the initial period (FY2005FY2008), growing profit remittances outpaced growth of interest earnings on investments, but in real terms generated a stable net flow. In the recession period profit remittances declined, but interest earnings maintained the upward path resulting in an increase
Primary incomes
Secondary incomes
40.0
30.0
20.0
10.0
0.0
-10.0
-20.0
Figure 22
Primary and secondary incomes, constant prices 2005 (US$ millions)
30
RoP Economic Review—FY2014
GDP
GNI
GNDI
220.0
210.0
200.0
190.0
180.0
170.0
160.0
150.0
Figure 23
GDP, GNI and GNDI, constant prices 2005 (US$ millions)
in the net flow. As the economy returned to normal the earlier stationary pattern reasserted itself.
71.
In the case of secondary incomes, the series is dominated by Compact and other
country grants on the receipt side and foreign-worker remittances on the payment side.
While current grants receipts have grown modestly, remittance outflows declined as the
number of foreign workers declined after the completion of the road project, but has subsequently trended upwards. Pulling the forces together and deflating by the GDE price index, the constant price series indicates a declining trend.
72.
We are now in a position to analyze the movements in the GNI and GNDI series
by adding the changes in real primary and secondary incomes to the real GDP price series
shown in Figure 23. First, the real GDP series lies above the real GNI series. There is a
narrowing of the gap in FY2008 and FY2009 with the recession, reflecting the upward
movement of net primary incomes in Figure 22, which then stabilizes (FY13 excepted).
Given the declining real secondary income series, it comes as no surprise that the GNDI
series is simply an upward translation of GNI with a narrowing gap. The overall result is
that while GNI is below GDP, once secondary incomes are taken into account, real GNDI
lies above the GDP series.
3. NOMINAL AND REAL EFFECTIVE EXCHANGE RATES
73.
The nominal effective exchange rate (NEER) is a trade weighted index of the exchange rates with which Palau engages in trade in goods and services. The currency composition of Palau’s trading relations has been estimated through analysis of the origin of
imports and estimation of exports of both goods and services. Given Palau’s historical re-
Economic Developments
31
lationship with the U.S., the U.S. dollar dominates and accounts for 55 percent of international trade. Considering that Palau uses the U.S. dollar as its currency of exchange, the
NEER is essentially a trade weighted index of the U.S. dollar against Palau’s trading partners. Figure 24 indicates that the NEER has depreciated during most of the period, reflecting the depreciation of the U.S. dollar. However, from the start of 2014 the NEER
and U.S. dollar started to strengthen against the currencies of Palau’s trading partners.
74.
The real effective exchange rate (REER) is a measure similar to the NEER, but
currency movements are adjusted for changes in the CPI of the respective country. It is
thus a proxy for the gains or losses of international competiveness. At the start of the period through FY2007, the REER largely mirrored the NEER, but after that point, with the
significant increase in inflation in Palau due to rising fuel and food prices, the REER
spiked in FY2008, resulting in a loss of competitiveness. The REER depreciated in
FY2009 through the end of FY2010, but it did not adjust downward to the prior level.
Since FY2010 the REER has again appreciated in part reflecting appreciation of the
NEER, but also prices rising more rapidly in Palau implying a loss of competitiveness.
Clearly, the recent rises in the real exchange rate would reduce the attractiveness of Palau
as a tourist destination, but the very significant increases in visitor arrivals suggest that
much of Palau’s tourism market is insensitive to price.
75.
In some measures of the REER, currency movements are adjusted by relative
movements in wages. As discussed above, nominal wages have displayed more modest
growth, and real wages have fallen. It is thus likely that the REER based on CPIs overstates the loss of competitiveness. However, the recent increases in the value of the U.S.
dollar and likely further strengthening in the future need to be monitored.
NEER
REER
120
115
110
105
100
95
90
85
80
Figure 24
Nominal and real effective exchange rates, 2000-2014 (2005 = 100)
32
RoP Economic Review—FY2014
4. EXTERNAL DEBT AND INTERNATIONAL INVESTMENT POSITION
i
External debt
76.
Palau has maintained a modest external debt profile with a total of ten public sector loans: three incurred by the national government, two by the National Development
Bank of Palau (NDBP), one for the Palau Public Utilities Corporation (PPUC), and four
by the Palau National Communications Corporation (see Table 2). The national government incurred two loans from the Mega International Commercial Bank (MICB) of China
for $20 million and $8 million, respectively, to construct the national Capitol and for airport upgrades. The term of the two loans is for 20 years at 3.5 percent interest. The national government has recently borrowed its first loan from the Asian Development Bank
for water sector improvement. The program includes borrowing under two facilities. The
first includes a loan of $12.6 million from the ADB’s Ordinary Capital Resources (OCR)
with a three-year grace period over a total of 15 years. The interest rate is LIBOR plus
0.15 percent. A second facility includes a loan of $3.4 million from the ADB’s Asian Development Fund (ADF), which is the bank’s concessional arm. The second loan carries a
24-year term with an interest rate of 1.5 percent after an eight-year grace period. There is
a 1 percent service charge during the grace period. The Water Sector Improvement Program (WSIP) is designed to ensure the future demand for water and sewer is achieved on
a sustainable basis. The WSIP is also intended to transform the delivery of water from the
Bureau of Public Works to an independent body on a commercial basis. The loan will assist the government in providing resources to facilitate the transfer and eliminate the current implicit subsidy.
77.
The NDBP has incurred two loans: one from the MICB and the second from the
European Investment Bank (EIB). Both loans are to support the NDBP in its role as
lender for development purposes. The MICB loan has a term of 20 years, while that of
the EIB is for a shorter term of 13 years. The MICB loan carries a 3.5 percent interest
rate, while the EIB loan is structured in two parts: one part at 3.7 percent and the other at
Table 2
External debt by loan, commitment date, original debt and outstanding principal
Lender
National Government
Construction New Capital
Mega International Commercial Bank
2003
3.5%
20,000
National Government
Palau Airport Upgrade
Mega International Commercial Bank
2005
3.5%
8,000
4,800
National Government
Water Sector Improvement
Asian Development Bank
2011 Libor & 1-1.5%
16,000
15,790
NDBP
Capital funds
Mega International Commercial Bank
2004
3.5%
5,000
2,857
NDBP
Loan and capital funds
European Investment Bank
2006
3.7% & 5.2%
5,000
2,705
PPUC
Purchase of generators
Foreign Bank
2008
3.5%
7,000
5,000
PNCC
Telecom development
Rural Utilities Services
1992
4.6%
39,143
24,258
PNCC
Telecom development
Chunghwa Telecom Company
2009
4.9%
2,563
991
PNCC
PNCC
Billing system
3G Mobile Network
National Information & Solutions Coop
Private Vendor
2012
2014
4.6%
4.8%
764
4,360
424
3,924
109,330
67,605
Note: NDBP EIB loan converted at €1 = $1.3
Interest rate
Estimated
outstanding
principal
September
2014, $'000
Purpose
Total
Year
Original debt,
$'000 (unless
stated)
Borrower
6,857
Economic Developments
33
5.2 percent. The PPUC incurred a debt of $7 million in 2006 to purchase portable generators from a foreign bank at an interest rate of 3.5 percent over 17 years. The PNCC has
incurred a significant level of debt at a relatively high interest rate of 4.6 percent to the
U.S. Rural Utilities Services. The RUS loans have supported the development of communications infrastructure in Palau. The PNCC incurred a small loan in FY2012 to finance
the replacement of its billing system, and further financing of $4.3 million in 2014 to finance the installation of a third generation network.
78.
Figure 25 shows the outstanding level of external debt as a percent of GDP and
debt servicing as a percent of national government domestic revenues. The level of outstanding debt as a percent of GDP has fallen through the period from 39 percent in
FY2000 to 28 percent in FY2014. The level of debt has risen from $58.5 million to $70.6
million indicating the rise in nominal GDP has outstripped the rise in external debt. This
is a favorable outcome and has supported financial stability. External debt fell as a percent of GDP from FY2000 through FY2006 as loans were repaid. In FY2007, there was
new borrowing both by the national government for the airport improvement and for
NDBP lending resources. The next incurrence of debt was in FY2008, with further borrowing for the NDBP from the EIB and a small loan for the PNCC. Finally, in FY2012
and FY2014 the national government drew down on the ADB loan for the WSIP.
50.0%
10.0%
40.0%
8.0%
Outstanding Debt % GDP
28.3%
30.0%
6.0%
20.0%
4.0%
10.0%
2.0%
0.0%
0.0%
Figure 25
Palau external debt and debt servicing, FY2000–FY2014
Debt Servicing % National Gov. Revenues
79.
Debt service has risen significantly as a percent of national government revenues
from 2.5 percent in FY2000 to 7.5 percent in FY2010, but has fallen back to 6.7 percent
by FY2014. While much of the debt service is maintained by the SOE sector, the national
government is ultimately responsible in case of default. In terms of values, the total cost
34
RoP Economic Review—FY2014
of debt service, including both interest and capital payments, has risen from $1.7 million
in FY2000 to $6.8 million in FY2014.
ii
International investment position
80.
The Palau international investment position (IIP) is presented in Table 3. The data
show stock positions at the end of each year corresponding to the financial account of the
BoP. The estimates of direct investment or FDI are currently under revision but are currently estimated to have risen from $108 million in FY2000 to $155 million in FY2014.
Portfolio investment consists of the Social Security, Civil Service Pension fund investments, and minor investments of the national government. Social Security funds have displayed an upward trend indicating an improving financial position, although they suffered
a downward adjustment in FY2008 reflecting the international financial crisis. In the case
of the Civil Service Pension Fund, the funds suffered the same impact of the financial crisis, but the subsequent declining balances reflect the drawdown of resources as civil servants have reached retirement age. The unfunded liability is significant, and projections indicate the fund will turn negative in the foreseeable future if remedial action is not taken.
81.
Other investments include the foreign assets of commercial banks and public sector external debt. Before FY2009 and the commencement of operations of the Financial
Institutions Commission, banking data was incomplete and the estimates have been based
on limited information. Table 3 indicates a significant rising level of commercial bank
foreign assets reflecting the large increase in deposits and lack of domestic credit creation, i.e. the banks have invested their growing liquidity offshore. The table also indicates
a small increase in external public debt, which has been discussed in the previous section.
Taken overall, the international investment position has strengthened significantly; the
growth in commercial bank foreign assets and institutional portfolio investments, has outpaced new FDI and a modest increase in external borrowing.
Table 3
Palau international investment position, FY2005-FY2013 (US$ millions)
(US$ millions)
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
TOTAL STOCKS, NET
-33.3
-18.9
-10.7
-25.1
-21.6
-15.3
-12.1
14.6
25.9
42.7
Direct investment, net
-107.5
-119.6
-123.2
-127.2
-130.2
-133.0
-136.8
-140.4
-144.3
-154.6
Portfolio investment, net
105.3
109.7
122.9
107.3
111.5
111.2
104.4
116.2
125.3
124.0
105.3
103.3
53.2
40.8
9.3
2.0
109.7
109.7
58.9
40.9
10.0
0.0
122.9
122.9
67.5
45.7
9.7
0.0
107.3
107.3
60.1
38.0
9.2
0.0
111.5
111.5
64.0
38.1
9.4
0.0
111.2
111.2
65.9
37.7
7.6
0.0
104.4
104.4
66.1
31.7
6.6
0.0
116.2
116.2
77.0
32.1
7.1
0.0
125.3
125.3
84.1
33.6
7.6
0.0
124.0
124.0
84.4
32.6
7.0
0.0
Assets
Government
Social security portfolio
Civil Service Pension Fund
Other
Other Public Entities
Other investment, net
-31.1
-9.0
-10.4
-5.2
-2.9
6.5
20.2
38.7
45.0
73.3
Assets (deposits banks)
28.5
48.6
58.6
61.6
71.9
75.0
84.5
107.9
110.0
143.9
Liabilities, loans
Other (banks)
Government
Public entities
59.6
n.a.
21.6
37.9
57.6
n.a.
20.5
37.1
69.0
n.a.
25.9
43.1
66.8
n.a.
24.8
42.0
74.7
4.4
22.7
47.7
68.5
2.0
21.1
45.4
64.3
1.6
19.5
43.2
69.1
0.0
27.7
41.4
65.0
0.0
26.1
38.9
70.6
0.0
30.4
40.2
152.5
157.0
176.4
147.1
144.0
151.1
146.5
171.8
189.6
199.2
Memo Item:
COFA Trust Fund
Economic Developments
35
82.
Table 3 indicates the balances at year end of the Compact (COFA) Trust Fund as
a special memo item. The Trust Fund is managed through an international agreement between Palau and the United States, and Palau has limited powers to withdraw funds. The
Fund although for the benefit of the people of Palau is not considered a domestic institutional unit and as such is not part of Palau’s BoP or IIP. Under the agreement Palau is entitled to draw $5 million annually from the CTF and has done so since FY2002. The outstanding balances of the CTF reflect the combination of the $5 million annual withdrawal
and the performance in financial markets. The CTF rose in the early part of the period,
but fell during the financial crisis in FY2008, and resumed an upward path during the last
three years FY2012-FY2014.
E.
Fiscal Developments
1. INSTITUTIONAL ARRANGEMENTS
i
Provisions of the Compact
83.
The Republic of Palau and the United States entered into the original Compact on
October 1, 1994, for a 50-year period, through the close of FY2044. The structure of the
Compact entailed an initial 15-year period through FY2009 with a series of economic
provisions, the major and recurring provisions being:
i.
ii.
iii.
iv.
v.
vi.
1
Annual Grants: An annual grant of $12 million for current account purposes for
10 years, plus $11 million for the remaining five. After the first five years, $5 million of this grant would be drawn from the Compact Trust Fund. Section 211(a)
Energy: An annual grant of $2 million for increased self-sufficiency in energy
production. However, this sum was converted into an upfront payment of $28 million plus an inflation adjustment of $12 million through a subsidiary agreement.1
Section 211(b)
Communications: Annual grants for communications of $150,000, Section
211(c), and $631,000 for maritime surveillance, health and post-secondary education. Section 211(d)
Compact Trust Fund: A Compact Trust Fund (CTF) with a contribution of $66
million in FY1994 and a subsequent $4 million contribution in FY1997, totaling
$70 million. Section 211(f)
Compact Road: A road system in accordance with mutually agreed specifications,
to be known as “Compact Road,” which finally cost $149 million. Section 212(a)
Capital Account: An upfront capital account provision of $36 million. Section
212(b)
The subsidiary agreement required the RoP to reimburse the U.S. $3 million due to the “economic cost” of the arrangement. The U.S. has permitted the RoP to retain the $3 million to
establish a fund for Compact Road maintenance, once the fund is established.
36
RoP Economic Review—FY2014
vii.
Education and Health Block Grant: Annual $2 million special health and education block grants. Section 221(b)
Inflation Adjustment: Annual inflation adjustment of two-thirds of the U.S. GNP
deflator, applicable to sections 211(a), (b), (c), and 212(b). Section 215
viii.
84.
The Compact also contained administrative provisions that the financial provisions would be undertaken in accordance with a national development plan, which might
be amended from time to time. An annual requirement was stipulated that Palau would
report to the president of the U.S. and Congress on the implementation of the plan and on
the use of the financial provisions. Provision was further made for a bilateral annual economic consultation process.
85.
In September 2010 the U.S. and Palau signed an agreement to extend economic
assistance under the Compact for the second 15-year period through FY2024, but with a
set of new economic provisions. These are as follows, and the major items are indicated
in Table 4:
i.
ii.
iii.
Compact Trust Fund: The U.S. will continue to contribute to the existing Trust
Fund 211(f) a total amount of $30.25 million during the period from FY2013
through FY2023.
Direct Assistance: The U.S. will provide direct assistance to support government
operations in the areas of education, health, administration of justice and public
safety (Table 4, column 3).
Trust Fund Drawdowns: Palau agrees to drawdown no more than the amounts
specified in Table 4, column 2. In total, the funds available to support government
Table 4
Major U.S. grants for operations and contributions to and drawdowns from
the Compact Trust Fund
Trust Fund
Contribution
FY2011
FY2012
FY2013
FY2014
FY2015
FY2016
FY2017
FY2018
FY2019
FY2020
FY2021
FY2022
FY2023
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
0.25
Trust Fund
Drawdown
5.00
5.00
5.00
5.25
5.50
6.75
8.00
9.00
10.00
10.50
11.00
12.00
13.00
Direct Assistance
13.00
12.75
12.50
12.00
11.50
10.00
8.50
7.25
6.00
5.00
4.00
3.00
2.00
Total Funds for
government
operations
18.00
17.75
17.50
17.25
17.00
16.75
16.50
16.25
16.00
15.50
15.00
15.00
15.00
Infrastructure
Projects
8.00
8.00
8.00
6.00
5.00
5.00
Economic Developments
iv.
v.
vi.
37
operations from both direct assistance and the CTF decline gradually, from $18
million in FY2011 to $15 million in FY2023.
Infrastructure Maintenance: The U.S. will provide $2 million annually from
FY2011 through FY2024 for the maintenance of major capital projects funded by
the U.S. Palau will contribute a total of $600,000 annually to the fund. The $3
million to be contributed to a Compact Road maintenance fund by Palau as part of
the original Compact will now be earmarked for the new infrastructure maintenance fund.
Infrastructure Projects: The U.S. will provide $40 million for mutually agreed
infrastructure projects during the FY2011-FY2016 period (see Error! Reference
source not found.).
Fiscal Consolidation Fund: The U.S. will provide $10 million in FY2014 for
fiscal consolidation and pay down of arrears.
86.
A major change in the provisions of the renewed Compact is the establishment of
an advisory group. “The purpose of the Advisory Group is to contribute to the long-term
economic sustainability of Palau by recommending economic, financial, and management
reforms.” There are to be five members in the group: two appointed by the U.S., two
from Palau and a fifth member mutually acceptable to the two parties. There will be two
meetings a year, one in Palau and the other in Honolulu. The advisory group will recommend economic, financial and management reforms and a timeline for implementation.
The advisory group will report on progress with implementation of the recommended reforms to the annual bilateral economic consultations. Examples quoted as significant reforms include:







Improvements in fiscal management,
Elimination of operating deficits,
Reduction in the operating budget,
Reduction in the number of civil servants,
Reduction in the proportion of the budget allocated to salaries,
Reduction in subsidies to the utilities, and
Tax reform.
In the event that the U.S. determines that Palau has not made significant progress, the
U.S. may delay payment of the assistance.
87.
The provisions of the renewed Compact had envisaged that the new agreement
would commence in FY2011. However, no action has been taken by the U.S. Congress,
although the package remains under active consideration. While awaiting passage into
law, the U.S. has been maintaining the original Compact flows at the levels of the last
year, FY2009, of the original Compact. At the current time Palau receives $6 million plus
an inflation adjustment of $4.26 million under the current account 211(a), $2 million in a
38
RoP Economic Review—FY2014
health and education block grant 221(b), and the provisions under 211(c) and (d), in all,
totaling $13.147 million annually. Palau also continues to drawdown $5 million annually
from the CTF.
ii Fiscal procedures
88.
Fiscal policy in Palau is conducted under the constitutional requirement of a “balanced budget.” This, of course, does not guarantee that the final outcome will also be balanced: either revenue may fall short, or expenditures may exceed budget estimates. The
execution of the budget operations is performed through a series of separate funds, the
most important being the general fund. Expenditures from this fund are largely unrestricted, but there is limited flexibility or authority to use monies from the other funds.
During the initial 15 years of the Compact, a major part of the external assistance under
the current account provisions provided revenue to the general fund and thus was unrestricted. Under the renewed Compact, use of funds derived from the direct assistance provision or CTF ($15 million) must be used for education, health or administration of justice and public safety. In FY2011 the total use of funds under the ministries of Education,
Health and Justice was $28.9 million. The earmarking of the direct assistance grants and
CTF monies is thus not a binding constraint on the functional allocation of funds by the
government. The fiscal accounts and analysis in the following sections has adopted an International Monetary Fund (IMF) Government Finance Statistics (GFS) presentation. The
GFS accounts present a consolidation of the various funds presented in the annual single
audit and classified as part of the central government. The fungible or inter-changeable
nature of the various funds results in the GFS providing a clear and unambiguous statement of government operations.
89.
The government in Palau consists of: the national government, 16 state governments, a group of extra budgetary agencies, and the Social Security and Civil Service
Pension Funds, but no local governments. At present, the state governments provide services in such areas as administration, police and garbage collection. Under the RoP Constitution, powers to raise taxes rest with the national government, but state governments
may raise taxes, provided that the measures have been authorized in law by the national
government. The powers of the state governments are prescribed in the Constitution. Fiscally, the state governments are small in size, with the exception of Koror state. Koror
state revenues have grown very rapidly in recent years with the expansion in the tourism
industry, and were equivalent to 48 percent of national government domestic revenues in
FY2014.
90.
Palau has generally had a good record of timeliness in the preparation and publication of the annual single audits. Recent audits have been delayed, but have been improving. The FY2011 audit was delayed by 8 months, the FY2012 audit by 4 months, the
FY2013 by 1 month, while the FY20914 audit was produced on time. Table 9 in the statistical appendix shows fiscal performance on a consolidated basis of the central government (excluding the Compact Trust Fund, which has been treated as an international
unit), and the presentation follows the standard GFS format.
Economic Developments
39
2. RECENT FISCAL PERFORMANCE
91.
Fiscal Performance: Figure 26 indicates recent trends in the fiscal position. During the first three years (between FY2005 and FY2007), both revenues and expenditures
grew rapidly, although the growth in expenditures outstripped that of revenue. The overall fiscal position switched from one of a surplus of 1.4 percent of GDP in FY2005 to one
of a deficit of 1.9 percent in FY2007, representing a 3.3 percent deterioration. On the revenue side, tax effort actually declined, reflecting the stagnant economy during the period.
However, grant revenues were exceedingly buoyant and grew by $15 million or 37 percent. For the most part, the additional grants were used to fund capital projects in infrastructure. However, there was significant growth in payroll, use of goods and services,
and other expenses that led to the deterioration in the fiscal position.
92.
In the following two years (FY2008 to FY2009), there was a significant contraction in both revenues and expenditures. Not only did this period coincide with the onset
of the international financial crisis, but the former large increase in grant revenues came
to an end. In FY2009 grants were just $1 million above their FY2005 level. Reflecting
the financial crisis, tax revenues declined, although less than the fall in nominal GDP.
With the significant reduction in revenue, there was need for fiscal adjustment. While the
reduction in grants brought about a comparable fall in infrastructure construction, payroll
increases were modest, outlays on goods and services fell, and other expenses contracted
significantly. While the overall fiscal outturn improved compared with FY2007, the outturn for FY2009 was a small deficit of less than 1 percent of GDP.
93.
By FY2010 the economy had bottomed out, but growth was modest and the fiscal
position remained tight. During FY2011 to FY2012 the economy rebounded and tax revenues grew strongly by 24 percent, reflecting the surging increase in visitor arrivals.
120.0
110.0
100.0
90.0
$'millions
80.0
70.0
60.0
50.0
40.0
FY05 FY06 FY07 FY08 FY09 FY10
FY11
78.9
88.5
93.5
86.3
77.7
87.2
89.0
96.8
93.9 108.6
Expenditures 75.9
88.2
97.5
89.7
79.3
89.0
86.5
94.7
92.2
Revenues
Figure 26
FY12 FY13 FY14
Palau consolidated revenues and expenditures, FY2000–FY2013
99.8
40
RoP Economic Review—FY2014
However, part of this increase was due to additional tax effort and the imposition of a
sizeable tax on tourist departures. While wage growth remained modest, use of goods and
services expanded strongly by 15 percent, and other expenses also showed a significant
increase. Grant revenues declined during this period and were offset by a reduction, but
of greater magnitude, in infrastructure construction. FY2011 recorded a surplus of 1.2
percent of GDP, but this fell back slightly in FY2012 to 0.9 percent.
94.
In FY2013 the economy contracted, but tax revenues grew strongly, reflecting
strong performance in certain segments of the tourist market. However, grants declined
significantly by $7 million and overall total revenues contracted by 3.6 percent. Wage
growth remained modest at 2.7 percent, but use of goods and services and miscellaneous
expense grew by 5.3 percent, reflecting additional needs for Typhoon Bopha rehabilitation. The drop in grants was reflected in a large drop over 50 percent or $9 million reduction in capital outlays. Overall the fiscal balance improved slightly and recorded a 1.2
percent surplus relative to GDP.
95.
In FY2014 the economy returned to strong growth and domestic taxes grew by 14
percent. This was mirrored by a similar increase in the wages tax, but the Gross Receipts
Tax only grew by 6.8 percent reflecting an increase in low-end package tour visitors,
which resulted in a reduction in the average tourist spend per visitor. Import taxes grew
strongly by 24 percent reflecting the increase in tax on cigarettes. Grant revenues grew by
13 percent, and “other” revenues grew strongly. On the expenditure side payroll costs
grew by a modest 2 percent, but use of goods and services, grants to other layers of governments and other expense all grew strongly. Outlays on infrastructure also expanded
reflecting the higher level of capital grants. Overall the buoyant economy and strong
growth in revenues of 16 percent outweighed the expansion in expense, and the national
government achieved the largest surplus in recent history, a surplus of $8.8 million or 3.5
per cent of GDP.
96.
The Fiscal Structure: Table 5 provides a summary of the structure of the fiscal
account, and most items are represented in terms of GDP. Grants have shown a declining
trend as a percent of GDP in recent years, although they have shown considerable variation from year to year, depending on whether Palau has been the recipient of capital
grants for infrastructure purposes during a particular period. As a percent of total revenues, grants represent just less than half, but, again, show a declining trend with variation
depending on the nature of the grants. While Palau has developed a significant tourist
economy based on private sector development, the fiscal sector remains heavily dependent on grants from the U.S. and other donors. Tax revenues represented 16 percent of
GDP during FY2005-FY2009, but they have grown during the last five years and represented 19 percent in FY2014, mainly as a result of the discretionary tax increases. While
tax effort is similar to that in the RMI and above that in the FSM, it is below that of the
majority of other Pacific Island economies and below the rate prevailing in the U.S.
Economic Developments
Table 5
41
Comparative analysis of fiscal structure, FY2005-FY2013
FY05
FY06
FY07
FY08
FY09
FY10
FY11
FY12
FY13
FY14
Grants as % of GDP
Current grants % of GDP
Capital grants % GDP
Grants as % of Total Revenue
21.1%
14.4%
6.8%
51.8%
26.0%
14.6%
11.4%
57.3%
28.7%
16.0%
12.7%
60.1%
23.5%
15.5%
8.0%
53.8%
22.6%
15.4%
5.9%
53.9%
27.1%
16.1%
11.0%
57.1%
22.9%
15.1%
7.8%
51.6%
22.4%
14.2%
8.2%
49.9%
18.4%
13.1%
5.3%
44.8%
19.0%
13.6%
5.4%
43.6%
Tax Revenue as % of GDP
Domestic Rev. as % of GDP
16.4%
19.6%
16.0%
19.4%
15.7%
19.0%
16.6%
20.2%
15.7%
19.3%
16.9%
20.4%
17.6%
21.4%
17.9%
22.5%
18.1%
22.7%
18.9%
24.6%
Expense % GDP
Total Expenditure as % of GDP
Wages as % of GDP
Wages as % of Expenditures
Fixed assets % GDP
32.2%
39.2%
16.9%
43.0%
17.9%
34.9%
45.3%
17.3%
38.1%
22.9%
37.4%
49.9%
17.8%
35.6%
25.0%
37.9%
45.4%
18.2%
40.0%
16.7%
36.9%
42.7%
19.0%
44.5%
13.5%
37.5%
48.5%
18.8%
38.7%
22.6%
35.8%
43.1%
17.7%
41.2%
16.8%
35.8%
43.9%
16.7%
38.1%
18.4%
36.1%
40.4%
16.3%
40.4%
10.6%
35.6%
40.1%
15.3%
38.2%
11.0%
8.6%
1.5%
10.5%
0.1%
10.4%
-2.1%
5.9%
-1.7%
4.9%
-0.9%
10.0%
-1.0%
8.5%
1.3%
9.1%
1.0%
5.0%
0.7%
7.9%
3.5%
Current Balance as % of GDP
Overall Balance as % of GDP
97.
Public expenditure, including outlays on non-financial assets, has represented an
average of 44 percent of GDP since FY2005. The actual level varies from year to year,
with the variation being strongly influenced by the level of public investment, with no
clear trend. Payroll expenses as a percent of total expenditures has represented an average
of 40 percent, but as a percent of GDP rose through FY2009, but has since declined. The
overall balance as a percent of GDP has averaged 0.3 percent of GDP and attests to the
generally well-managed execution of government finances. Palau generally runs a small
surplus, but during the recent financial crisis (FY2008 to FY2010) deficits were recorded.
98.
Revenues: The tax regime in Palau is based on a tax system inherited from—and
largely unaltered since—Trust Territory days. The major source of tax revenue is the
gross receipts tax (GRT), levied at 4 percent of business turnover. While the tax is intended to be used as a proxy income tax, the incidence is comparable to that of a sales
tax. The tax suffers from the well-known cascading effect, such that each sale from one
business to another multiplies the tax yield and distorts resource allocation. Taxpayers are
entitled to a deduction for the cost of wages for local citizens. This deduction is designed
to encourage the use of local labor. The GRT has provided a buoyant form of tax that has
grown substantially in relation to GDP since FY2005—by 44 percent—compared with
nominal GDP, which grew by 29 percent. In FY2014 the GRT raised $13.1 million in tax
revenue.
99.
The second-most significant tax is customs duties, which are levied on the usual
range of “sin” goods and perfumery products. Motor vehicles are taxed at 5 percent and
$250 per unit. Fuel imports are taxed at 5 cents per gallon. There is a general rate of duty
of 3 percent, except on medical supplies and foodstuffs, which are duty-free. However,
the general rate of import tax collects a surprising low level of duty, $1.8 million in
FY2014. This reflects the low base of the tax after fuel, food imports, and special concessions have been deducted. Import taxes are levied f.o.b. and the government is exempt.
From January 1st 2014 taxes on tobacco were increased from $2.00 to $3.50 which raised
42
RoP Economic Review—FY2014
an additional $1.6 million in FY2014. This tax was increased by a further $1.50 to $5.00
the start of 2015. Import taxes have not been a buoyant form of revenue, and collections
adjusted for the increases in tobacco taxes only marginally higher in FY2014 ($9.5 million) than in FY2005 ($9.3 million).
100. The next important tax is the wages and salary tax levied on wages earned, but the
responsibility for collection resides with the employer. Wage earners pay 6 percent of income up to a threshold of $8,000, and, above that, 12 percent. The wages tax has also not
been a buoyant form of tax. It increased by only 18 percent between FY2005 and
FY2014, despite nominal GDP growth of 29 percent. Total collections in FY2014 were
$8.2 million.
101. The other significant tax is collected on departing passengers at the airport. The
rate for citizens is $20, while that for non-citizens is $50. The difference between the two
rates, $30, is referred to as the “green fee,” of which 50 percent is earmarked for the Palau Protected Areas Network, and 50 percent is set aside for waste management improvements. Collections under this item have grown significantly in recent years due to both
the growth in tourism and discretionary changes in the tax rate. In FY2005 collections
were $1.7 million, and in FY2014, they were $6.7 million. Other minor taxes include an
export tax on transshipped fish and fees for business licenses.
102. Non-tax revenues include fishing fees, sales and fees of government departments,
and interest and dividend earnings. Fishing fees are relatively minor in Palau compared to
other Pacific Island nations that are more favorably located near the main fishing
grounds. In Palau, 85 percent of fishing fee revenue collected on fish caught in Palau waters is passed on to the state governments. Palau is a member of the Partners to Nauru
Agreement (PNA) and has benefited from the sale of fishing days under the Vessel Day
Scheme (VDS). Since these revenues are collected on fish caught in international waters
they are not shared with the State governments. The level of fishing fees rose from $0.2
million in FY2005 to $3.2 million in FY2014 largely as a result of recent booming VDS
collections. Overall, non-tax fees have provided a buoyant form of revenue, growing
from $6.2 million in FY2005 to $14.1 million in FY2014, with most of the increases occurring in the last three years.
103. Expenditures: Figure 27 indicates the major elements of expenditure. Payroll
costs, representing about 40 percent of total budgetary outlays, have grown modestly during the period, by 17 percent since FY2005, or at an average annual rate of 2.2 percent.
Palau has maintained a responsible civil servant employment policy by limiting new hires
and maintaining annual wage increases within or below cost-of-living increases. This has
eased fiscal pressure during recent periods of financial stress. Use of goods and services
has displayed a stronger upward trend growing by 60 percent since FY2005 or at annual
rate of 6.5 percent. While the trend has been upward, expenditures on goods and services
have been compressed during times of fiscal pressure and buoyant on the upturn. They
Economic Developments
43
40.0
35.0
$'millions
30.0
25.0
20.0
15.0
10.0
5.0
0.0
FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14
Wages & Salaries 32.7 33.6 34.8 35.9 35.3 34.5 35.6 36.1
37.3
38.1
Goods & Services
15.6
20.1
21.3
19.6
19.8
20.9 22.7 23.3 24.9
Fixed assets
13.6
20.2 24.4 14.9
10.7
20.1
14.5
Figure 27
19.9
17.4
9.7
11.0
Expenditures on payroll, goods and services and non-financial assets,
FY2005-FY2014
have thus provided a simple means of fiscal adjustment to differing phases of the product
cycle.
104. The burden of debt service has been minor, and interest payments are close to
$0.5 million. In FY2013 the water and sewer operations of government were transferred
to the Palau Public Utilities Corporation (PPUC), and incurred an explicit subsidy of $1.8
million and of $1.7 million in FY2014. It is anticipated that an annual subsidy will be required going forward until water and sewer rates are raised to cover long-run costs. Government grants are represented by transfers to the state governments and payments to
such entities as the Palau Community College, the Community Action Agency and the
Visitors Authority. These were relatively static through FY2011, but have grown strongly
in the last two years reflecting transfers to the Protected Area Network (Pan) for use at
the state government level. Finally, “other” expenses include student grants, transfers to
non-profit groups, and other miscellaneous outlays. These have been erratic, but the
trend has been upwards recording $10.7 million in FY2014.
105. Figure 27 also indicates the level of outlays on non-financial assets or infrastructure. The graph reveals significant variations from one period to the next, reflecting the
bulky nature of infrastructure projects. In the FY2005-FY2007 period the Capitol complex was completed and was followed by some smaller projects, including the cross-insular Babeldaob road. In FY2013 and FY2014 the level of public infrastructure projects fell
to some of the lowest levels during the FY2005-FY2014 period.
106. Financing: The deficit/surplus is financed through changes in financial assets and
liabilities. The major asset classes comprise domestic currency and deposits, foreign securities and equities, domestic accounts receivable, and foreign accounts receivable
(grantor agencies). On the liabilities side, the major categories include: domestic accounts
44
RoP Economic Review—FY2014
payable, foreign loans and other foreign accounts payable (federal agencies). The items in
the balance sheet of the national government in Palau are generally small in magnitude,
and financing (the changes from one year to the next) is small in comparison with movements in revenues and expenses. Historically, government borrowing has remained modest in relation to the economy as has the accumulation of financial assets. Government
debt was just $30.4 million in FY2014, or 12.2 percent of GDP.
107. Analysis of the financing account is restricted to transactions since FY2012. In
FY2012 the government drew down $9.6 million from the ADB, which net of repayments was reflected in $8.3 million increase in foreign liabilities. The ADB loan was
used to reduce domestic accounts payable, which improved by $2.2 million and $4 million was loaned to the NDBP for on-lending to the private sector and the PNCC (domestic accounts payable). The government further drew down $2 million from the CTF (foreign accounts payable), which violated the CTF agreement with the U.S. The results of
these various transactions was that after allowing for an increase in foreign assets of $1.5
million and the operation of a $2.1 million surplus, domestic deposits rose by $4.5 million (banking statistics records an increase of $5.1 million).
108. In FY2013 the NDBP repaid $3 million to the government that was to have been
on-lent to the PNCC for the fiber optic (domestic accounts payable). The $2 million
drawdown from the CTF was also repaid (foreign accounts payable). Domestic accounts
payable were reduced by $4.3 million, while accounts receivable rose by $2.2 million.
With an overall fiscal surplus of $1.7 million domestic deposits fell by $4.9 million
(banking statistics records a reduction of $3.8 million). In the case of FY2014 the major
transaction was the second tranche drawdown under the ADB water and sewer loan of
$6.2 million. The strong fiscal position and surplus of $8.8 million enabled a further reduction of domestic accounts payable of $3.2 million, but was also used to fund a large
increase of $5.3 million in accounts receivable. Overall domestic deposits, the effective
residual, rose by $3.4 million (banking statistics records an increase of $5.7 million).
109. While the overall outturn of the fiscal account has been relatively balanced, this
masked an underlying stressed fiscal position during the FY2008-FY2010 period arising
from the financial recession, reduction in tourist numbers and negative growth in the
economy. As a result, the government accumulated a sizeable array of short-term debts to
Social Security, the Civil Service Pension Fund and the Palau National Communication
Corporation. With the support of the ADB Water and Sewer Improvement Program loan
and improved economic outlook, these have now been paid down. These trends are reflected in the unreserved fund balances, a measure of the financial resources freely available. In FY2007 unreserved fund balances stood at -$0.6 million, this deteriorated to $25.5 million in FY2009 and had attained a value of $8.7 million in FY2014, a very positive outcome. The trends indicate the low level of cash reserves in comparison to financing needs and possible shortfalls in revenue during adverse periods of the economic cycle.
III.
A.
POLICY ISSUES
Fiscal and Financial Management
1. FISCAL STRATEGY AND RESPONSIBILITY
110. The operation of financial policy in Palau is governed by the Palau National Code
Title 40 (PNC40) “Revenue and Taxation.” PNC40 regulates many aspects of fiscal management and the budget. Chapter 3 of PNC30, “Annual National Budget,” specifies that
the content and timing of the budget call for a funds availability analysis over the medium term (last year, this year and the following two years) and similar projections for
expenditures made during the same time period. The president is required to submit an
annual appropriations bill and budget documentation to the OEK by April 15 of each
year. The budget is required to be balanced, meaning that expenditures must cover revenues, which may include financing items in addition to taxes, other current revenues, and
grants. The president is required to submit a funding analysis over the medium term and
an appropriations bill at the same time. Department performance reports are also due
when the budget is submitted.
111. However, there is no law requiring a budget policy statement or that the formulation and conduct of budgetary and fiscal policy be medium-term in nature. In many jurisdictions such a perspective is legislated through a “Fiscal Responsibility Act.” The primary objective is to entrench sound fiscal policies and make it difficult for future administrations to deviate from them through two main provisions:
The first main provision involves setting fiscal objectives in a two-step process by
requiring adherence to “Principles of Responsible Fiscal Management” and
mandating preparation of an annual Budget Policy Statement by government. The
"Principles of Responsible Fiscal Management” mandate that debt, spending and
taxation be maintained at “prudent” levels. Any deviation from the principles requires explanation by the Minister of Finance as well as an explanation as to how
and when government will return to the principles. The Budget Policy Statement
requirement obligates government to make an annual statement of fiscal intentions for the next three years and their long-term fiscal objectives, as well as the
consistency of fiscal intentions and objectives with the "Principles of Responsible
Fiscal Management."1
112. In Palau, the nature of the provisions of the Compact and Compact Trust Fund
impose particular constraints on the design and conduct of fiscal policy that suggest that
the adoption of a fiscal responsibility act, fine-tuned to the RoP’s specific long-term fiscal features, would be highly desirable. In 2007, under an ADB-sponsored TA, Facility
1
See World Bank, Public Expenditure Management Handbook, Washington DC, 1998
45
46
RoP Economic Review—FY2014
for Economic and Infrastructure Management (FEIM)1, a proposal for a medium-term fiscal strategy (MTFS) was outlined2. A series of sustainability principles included the following:





Long-term fiscal sustainability such that sustainable revenues are sufficient to finance total expenditures without entailing a reduction in net economic and environmental wealth,
Domestic revenues should be sufficient to support current expenditures,
Capital expenditures should be restricted to projects financed through external
grants or have a positive rate of economic return,
No new external debt should be considered unless a project generates a positive
rate of economic return, and
The real per-capita value of the Compact Trust Fund should be sustained through
time.
113. The ADB-sponsored FEIM was prepared at a time before the current structure and
funding levels of the renewed Compact were known. At that time it was uncertain that
there would be any available future funding under the Compact. As a consequence, the
FEIM estimated that a long-term adjustment equivalent to 20 percent of GDP would be
required to replace the current grant levels to bring expenditures within the level of domestic revenues. The size of this adjustment was considered extreme, and some future
funding under the Compact was likely. A medium-term target was thus proposed for a 10
percent adjustment, 5 percent of which would be achieved through tax reform and 5 percent through expenditure adjustment.
114. The completion of the Compact Review Agreement in 2010 and revised provisions improved the long-term outlook considerably. However, as indicated in the earlier
discussion, a series of medium- and long-term fiscal challenges remain. These include:




Maintaining accounts payable and short-term debt at sustainable levels,
The need for a buffer stock of reserves to finance current expenditures during the
downturn of the economic cycle,
The declining level of nominal transfers in the provisions of the renewed Compact, and
The CTF was designed as a sinking fund and was only expected to last for the 50year duration of the original Compact.
115. Short-term Debt: At the time of the new Compact Agreement was completed Palau had accumulated a significantly adverse short-term debt and accounts payable. During
the financial crisis and recession, Palau’s fiscal position had turned negative and in order
1
2
ADB TA No. 4929, Facility for Economic and Infrastructure Management, Manila, 2007
Government of Palau, Medium-Term Fiscal Strategy for Sustainable Development, Koror,
July 2008
Policy Issues
47
to maintain operations the government ran up a series of short-term debts. At the end of
FY2011 accounts payable and debts owing to the Social Security Administration, Civil
Service Pension Scheme and PPUC totaled $17.2 million. With the revival in the economy the fiscal position improved significantly, and with additional resources from the
ADB Water Sector Improvement loan in FY2012, the government reduced accounts payable and short-term indebtedness to public entities to less than $9.0 million, and most accounts are now settled within 30 days.
116. General Fund Reserve (GFR): As part of the FY2014 budget, the government
approved the establishment of a General Fund Reserve to provide for emergencies declared as a state of national emergency, and instances when local revenues fall below 5
percent of projected revenues of the previous year. In FY2014 a sum of $821,500 was appropriated for the fund and it was specified that in future budgets 2 percent of unrestricted local revenues would be allocated to the reserve. In event, the occurrence of Typhoon Haiyan led to the use of the FY2014 allocation. In FY2015 a sum of $1 million
larger than the 2 percent target was allocated to the Reserve. The concept of General Reserve Fund is clearly in accord with the need for a buffer reserve Fund to support government operations through periods of shortfall during the economic cycle, and thus avoid
deficit funding through running up short-term debt as happened subsequent to the financial crisis.
117. This raises the issue of a suitable target for the size of the General Fund Reserve.
In countries with their own currencies and a central bank, a ratio of three months of foreign reserves is deemed a minimum. In Palau’s case, since it has no currency of its own,
the target needs adjustment. A capacity to support at least three months of non-grantfunded expenditures could be considered an alternative. In FY2014, this would be equivalent to maintaining a minimum cash reserve of $15 million. Clearly, there is a long way
to go to achieve this target.
118. Decline in real Compact transfers: Table 6 provides a picture of the declining
level of real funds available to fund government operations. Two projections are made:
(i) the renewed Compact is implemented, and (ii) the existing arrangements under U.S.
continuing appropriations remains in force through FY2024. The nominal value of both
series are given in columns (1) and (2), respectively, and include both grants and CTF
drawdowns. In columns (3) and (4) the value of funds required to maintain the FY2011
level of service is estimated in current values. In columns (5) and (6) the emerging fiscal
gap is indicated. In terms of current GDP the emerging fiscal gap rises to between 2.1 and
1.3 percent depending on when and if the renewed Compact is implemented. Since
FY2011 the government has adjusted to the decline in real transfers through holding civil
service payroll and expenditures levels constant in real terms, and raising taxes on departing visitors and increases in tobacco taxes. Going forward continuing adjustment will be
required. This issue is discussed in detail in the final chapter of this review.
48
RoP Economic Review—FY2014
Table 6
Compact funds available for operations and emerging fiscal gap
Funds
available for
government
operations
under renewed
Compact
Funds
Funds required
available for
to maintain
government
real
operations
government
under
operations
continuing
under renewed
U.S.
Compact
appropriations
(1)
FY2011
FY2012
FY2013
FY2014
FY2015
FY2016
FY2017
FY2018
FY2019
FY2020
FY2021
FY2022
FY2023
FY2024
Note:
(2)
18.00
17.75
17.50
17.25
17.00
16.75
16.50
16.25
16.00
15.50
15.00
15.00
15.00
15.00
(3)
(1) inflated1
18.15
18.15
18.15
18.15
18.15
18.15
18.15
18.15
18.15
18.15
18.15
18.15
18.15
18.15
18.00
18.29
18.55
18.84
19.22
19.60
19.99
20.39
20.80
21.22
21.64
22.07
22.51
22.96
Funds required
to maintain
Nominal
real
Nominal
Funding Gap
government
Funding Gap
under
operations
under renewed
continuing
under
Compact
U.S.
continuing
appropriations
U.S.
appropriations
(4)
(4)
(3)
(3) - (1)
(4) - (2)
(2) inflated1
18.15
18.44
18.70
18.99
19.37
19.76
20.16
20.56
20.97
21.39
21.82
22.25
22.70
23.15
0.00
-0.54
-1.05
-1.59
-2.22
-2.85
-3.49
-4.14
-4.80
-5.72
-6.64
-7.07
-7.51
-7.96
0.00
-0.29
-0.55
-0.85
-1.23
-1.61
-2.01
-2.41
-2.82
-3.24
-3.67
-4.11
-4.55
-5.00
1: US GDP Deflator used through FY2014, 2 percent assumed thereafter.
119. CTF Adequacy: The CTF was designed as a sinking fund and not as a perpetual
fund. Under the original Compact it was designed to yield $5 million in years 6 through
15 and provide $15 million thereafter over the remaining 35 years of the 50 year horizon
of the Compact. Under the provisions of the renewed Compact drawdowns from the fund
were set to rise from $5 million a year in FY2011 to $13 million in FY2024; thereafter
reversion to the original $15 million was agreed. At present Palau drawdowns $5 million
a year under the interim arrangements. As in the case of the annual Compact transfers the
value of the CTF drawdowns will decline in real value once Palau enters the post renewed Compact period after FY2024. Depending on performance, the fund may well be
fully tapped out at some future point if yields are insufficient. Chapter 3 of this Review
takes up the issue of historical CTF performance, and conducts a risk assessment of the
future sustainability of the fund. This is integrated into the long-term economic and fiscal
projections in Chapter 4.
2. TAX REFORM
120. Palau has inherited an outdated tax regime from Trust Territory days which has
many weaknesses, including: an inefficient and outmoded tax structure, distortionary
taxes such as the business gross receipts tax, an outdated institutional administration and
weak IT systems. The tax system is clearly in need of reform, enabling it to provide Palau
with a modern and efficient system suited to the structure of the tourist economy and
Policy Issues
49
providing a yield tailored to the long-term needs of the nation to raise revenue to compensate for declining Compact revenues with minimum distortion.
121. Tourism arrivals have grown rapidly in recent years, and the industry now dominates the economy. Developing a tax regime that is suited to the tourist economy without
incurring distortions is important. However, in recent years the national government and
Koror state have significantly raised taxes on the industry. A $50 departure tax ($30 of
which is considered a “green” fee) is levied as tourists leave the country. Koror state has
imposed a Rock Island fee of $50 and a Jelly Fish lake fee of $100 per tourist. The hotel
room occupancy tax now stands at 12% and collected $4.8 million in FY2014. These
taxes and fees sum to 8.5 percent of GDP, and yet much of industry is very lowly taxed.
Tourist expenditure represented 52 percent of GDP and apart from the hotel occupancy
tax is lowly taxed at the 4 percent GRT rate. There is no business or corporate income
tax, and hotels (local or foreign) escape the tax net. The adoption of a modern tax regime
would ensure the tourist economy is taxed fairly over a broad base, which would encourage enhanced revenue effort, and could enable reduction of some of the high rates recently introduced on specific items, such as the room occupancy tax.
122. Palau has at various times in the past considered tax reform, and requested the
IMF to prepare a review of the existing regime and recommend suitable reforms. Missions were fielded in 1998 and 2006 and recommended (1) eliminating import tax exemptions, (2) valuing imports on a cost, insurance, freight (c.i.f.) valuation basis, (3) replacing the distortionary gross revenue tax with a corporate income tax and (4) shifting from
taxing imports to taxing consumption. However, the proposed reforms were not implemented and Palau remained with the existing outmoded system. In early 2013 a bill to
implement a VAT was introduced into the Senate, and reignited the debate and interest
for tax reform. As a consequence the IMF was requested to return and again review the
system and propose a reform agenda. An IMF mission was fielded in August 20131 and
the following discussion is based on the review and recommendations.
i
123.
Tax Reform Principles
The following tax reform principles outlined in the review are summarized:
1.
Economic Efficiency/Neutrality. Taxes affect levels of economic activity and
for this reason tax rates need to be as low as possible, given revenue objectives. Also
taxes should (as far as possible), be raised, in a non-distorting way: economic choices
should be similar to what they would have been without the tax. For this reason tax exemptions and ‘tax holidays’ should be avoided.
2.
Simplicity and transparency. Simple taxes are good taxes, for all can understand them and they are harder to evade. A tax with simple rules, few and low rates, minimal exemptions, as well as a clear, wide and measurable base provides more revenue and
1
IMF, Fiscal Affairs Department, Republic of Palau, “Tax Policy Reform and Transition
Plan”, Margret Cotton, Lee Burns, Neil Motteram, August 2013
50
RoP Economic Review—FY2014
less opportunity for evasion. Furthermore, the tax system should be based on few such
taxes in order to avoid the proliferation of small inefficient taxes that represent heavy administrative costs and provide opportunities for corruption.
3.
Equity/Fairness. Although countries may hold widely different views on equity, it is generally suggested (1) people with similar capacity to pay should be taxed similarly (horizontal equity) and (2) people earning more income should pay more taxes
(vertical equity).
4.
High revenue generating capacity. The tax system should be able to supply the
government with the resources it needs to meet its spending obligations on a sustainable
basis. Furthermore, as tax revenues from different taxes might fluctuate, the tax system
should rely on a mix of a few taxes to lower the risk of wide annual fluctuations in overall tax revenue.
5.
Harmonization/Coordination with other systems. Tax harmonization and coordination with economic partners or geographical neighbors will help prevent opportunities for various forms of tax avoidance and/ or evasion, and avoid incentives for tax competition that could lead to revenue loss.
6.
Greater reliance on domestic taxes. Reduced reliance on trade taxes, and
greater reliance on domestic taxes such as VAT and excises which tax all goods and services irrespective of origin positions countries to obtain the benefits of free and open
trade.
7.
Feasibility. The design of taxes should be aligned with the capacity of the tax
administration to actually implement and collect tax revenue.
8.
Integration. All main taxes should be consistent, in terms of thresholds, rates
and registration in order to ensure fair treatment of all taxpayers, and minimize administrative costs.
ii Evaluation the existing tax regime (see Figure 28)
1.
Gross Receipts Tax: The GRT is a highly distortionary tax biasing economic
resource allocation, i.e. industries that are not in a countries interest to develop may be
taxed less. The GRT thus encourages an inefficient economic system. The system is simple, but fails in fairness in that industries with higher profit to output ratio pay less tax
proportionately. While the GRT raises the most of all taxes in Palau it cannot be raised to
increase yield without exacerbating inefficiencies. It thus has a low revenue generating
capacity. The tax is not harmonized with other countries tax system, but is neutral in relation to trade taxes. It is simple to administer but currently not integrated with the other
Palau taxes.
2.
Import taxes. Import taxes like the GRT are generally economically distortionary, they favor domestic production over exports and encourage an inefficient allocation
of resources. However, unlike the GRT import taxes are frequently not transparent with
many exemptions and large volumes of manuals are required for importers. They are frequently set to benefit particular interest groups and are thus not equitable. High revenue
Policy Issues
GRT
Import
taxes
Wages
tax
VAT
Net
Profits
Tax
1 Economic Efficiency/Neutrality
x
x



2 Simplicity and transparency

x


x
3 Equity/Fairness
x
x

x

4 High revenue generating capacity
x
x
x

x
Harmonization/Coordination with
other systems
x




6 Greater reliance on domestic taxes

x



7 Feasibility





8 Integration
x
x
x


5
Figure 28
51
Comparison of Palau’s tax regime with tax reform principles
yields cannot be attained without violating economic efficiency and are not compliant
with international trade arrangements such as the WTO or the Pacific trade agreements.
They are simple to administer but at this time are not integrated into the other parts of Palau’s tax regime.
3.
Wages and Salries Tax. The wage and salary does not distort resource allocation and in their current form are simple, transparent and fair. While the tax base is large
(about $100 million) and tax rates could be technically raised, this would come with a
high political cost. It is unlikely that basic rates of the wages tax can be raised significantly from their current levels. Clearly the wage and salary tax is a domestic tax and is
simple to administer, but at present is not integrated in the tax system.
iii The tax reform proposal
124. The IMF report recommended two options for tax reform. Option 1 was to remove exemptions from trade taxes, and to switch to a c.i.f. valuation of imports to align
with international standards. While higher rates of import tax on alcohol and tobacco
would be retained, excises should be levied where domestic production competes with
imports as with beer and bottled water. A Net Profit Tax (NPT) of 20 percent should be
levied on commercial banks, and an upper band on the wage and salary tax introduced to
make the system more progressive.
125. While option 1 was intended to propose a few modest changes to the system that
would improve tax efficiency and equity the main proposal was outlined under option 2.
This is summarized as follows:
52
RoP Economic Review—FY2014







VAT replaces the existing general import tax on imported goods at the c.i.f. level
and applies also to domestic production and distribution of goods.
The VAT extends to tax consumption of services and replaces the GRT. The hotel
room tax which also taxes services would be retained to support the VAT tax
base. Likewise the departure tax is retained.
Only the largest businesses above a certain threshold would be liable to register
for VAT.
A NPT would be introduced for all registered businesses.
Some income tax to apply to businesses not registered, based on a percentage of
turnover, while ‘micro’ businesses would not be subject to income tax.
Special rates of import taxes on alcohol and tobacco to remain, and domestic excises levied at similar rates on competing industries.
Introduction of a higher band on wages and salaries for equity purposes.
4.
The Value Added Tax. Referring back to Figure 28 it can be seen that the assessment of the tax reform proposal has many of the desired features of a wellstructured tax regime. The VAT scores highly on all fronts with the exception of
fairness, where the well-known “regressive” nature of the tax disadvantages low
income households. It is thus usually proposed that some relief is given to vulnerable groups to compensate for the additional tax burden. The VAT is economically efficient in that its impact is neutral on the economic system; on the
basis that a “clean” VAT is introduced with no exemptions. The system is simple and transparent once the public is made aware of how the system works.
The tax base is large, $301 million in Palau representing 121 percent of GDP,
comprising households, tourism and government. In comparison the wage and
salary tax base is $123 million (51 percent of GDP) and the NPT base of $52
million (21 percent of GDP). The VAT thus has a high revenue generating ability, and the more so in tourist economy such as Palau. Finally, the VAT is a domestic tax, administratively simple, and compliant with international trade
agreements.
5.
Net Profit Tax: Regarding the NPT the main issue is that there are currently no
income taxes on businesses in Palau. Without inclusion of the NPT in the system the tax regime would be inequitable. Revenue yield would be significant
and similar to the wage and salary tax although not as great as the VAT. Administratively the NPT would be the most complex, which is why introduction
would follow the VAT.
iv The current status of the reforms
126. Following the IMF mission the existing Senate VAT bill was revised to confirm
to modern standards and a series of public awareness meetings were held. There was
strong support from the Ways and Means Committee of the Senate, and the President endorse the tax reform proposal in his 2014 State of the Republic address. Meetings were
Policy Issues
53
held with the Chamber of Commerce and Belau Tourism Association. Considerable analytical work was undertaken on constructing an overall package that would be both revenue neutral and addressed the potentially regressive impact of the VAT. However, there
were insufficient supporting members in the Senate to bring the proposal to the floor. At
the current time the tax reform proposal is thus effectively shelved. At the present time
the renewed Compact remains stalled in the U.S. Congress awaiting passage. However,
once the outcome is finally decided focus will no doubt shift once again onto long-term
fiscal sustainability, and a re-ignition of the tax reform agenda.
3. EXTERNAL DEBT SUSTAINABILITY
127. The analysis presented in Chapter 1 indicated that Palau had a very favorable external debt profile. However, the two new large ADB loans, the effective Koror Airai
Sanitation Project (KASP) ($28 million), and the submarine cable project to provide access to the internet backbone under consideration ($25 million is programmed although a
current proposal indicates a possible cost of $14.4 million), suggest that Palau’s debt profile should be examined carefully for long-term sustainability. Figure 29 indicates Palau’s
projected debt profile through FY2035 on the basis of existing debt repayment schedules
and incorporating the two new loans, which have a 25 year term, 5 year grace and 20
years of capital repayments. It has been assumed the KASP loan is drawn down over a
three year period, and that Cable project is drawdown in one lump sum in FY2017. It is
further assumed that no further borrowing takes place.
128. The projected debt to GDP ratio rises in the near term, and especially in FY2017
with the drawdown of the cable loan, from 28 percent to 31 percent of GDP. From this
point forward the debt to GDP ratio declines. This reflects both the repayment of loans
and the projected growth in nominal GDP (using the projections discussed in the last part
50%
10%
40%
28.2%
30.7%
8%
30%
6%
20%
4%
10%
2%
0%
0%
Figure 29
External debt and debt service projections, FY2014-FY2035
Debt Servicing % National
Gov. Revenues
Outstanding Debt % GDP
New debt service for KASP & Fiber loan
54
RoP Economic Review—FY2014
of this Review). Clearly, external debt remains sustainable and there remains scope for
additional borrowing should this be required. In terms of debt service this rises from 7
percent to 7.3 percent of national government projected revenues in FY2020. It is assumed that both loans will be serviced by the respective SOEs, the PPUC and the proposed Belau Submarine Cable Company. However, there remains a risk that both entities
may require subsidies depending on the pricing policy adopted by Government although
both entities are intended to operate on a full cost recovery basis.
4. SOCIAL SECURITY AND THE CIVIL SERVICE PENSION SCHEME
129. Based on the actuarial evaluation1 completed in October of 2014 relating to
FY2013, Table 7 indicates the status of the Social Security fund. The accrued liability,
with respect to active workers, retirees and other beneficiaries and inactive workers, was
$202 million. The value of the assets of the fund were valued at $100 million indicating
an unfunded liability of $102 million. The fund ratio of assets to liabilities represented 50
percent. Compared with other Social Security Funds in the region this is a favorable position.
130. Effective October 1st 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
OEK. Taxable earnings currently $5,000 are scheduled to rise to $6,000 per quarter effective October 2015, and to $8,000 effective October 2017, and from October 2020 all
earnings will be taxable at the current rate of 6 percent for both employees and employers. The current retirement age of 60 was raised to 62 in October 2015, and will be raised
to 63 from October 2020. Other significant financial changes include an increase in the
basic benefit from $98 per quarter to $148. The basic benefit of 21.5 percent of the first
$11,000 of total remuneration on which benefits were paid was raised to 27 percent.
131. A projection of a likely growth of the contributions, benefits, and fund status is
shown in Figure 30. The estimates for benefits adopts the projections in the actuarial report, while the value of contributions uses the projections of compensation of employees
Table 7
Social Security valuation during 2013 (US$ millions)
2013
Active Workers Earning Benefits
Retirees, Spouses, Children, and Disabled Workers Receiving Benefits
Fully or Service Insured Inactive Workers Entitled to a Future Benefit
Total Accrued Actuarial Liability
Market Value of Assets
Unfunded Actuarial Accrued Liability
Funded Percent
1
106.1
74.8
20.6
201.5
-100.0
101.5
50%
Wilshire Associates, Inc., Actuarial Valuation as of October 1, 2013, Santa Monica, CA
Policy Issues
$250
$30
Contributions
$200
$25
$20
$150
Benefits
Fund Assets
$15
$100
$10
$50
$0
Figure 30
$'s Millions
$'s millions
55
$5
$0
Social Security fund balance, contributions and benefits, FY2013-FY2025
indicated in the long-term projection section of this Review. The annual change in wages
is estimated at 4.9 percent which is close to the actuarial assumption of 5 percent. A market rate of return of 6.5 percent was adopted compared with 7.5 percent used in the actuarial report. This is closely aligned with projected return on the COFA Trust Fund simulations in Chapter 3; it is also close to the actual Social Security performance of 6.52 percent. As Table 7 indicates projected contributions are above benefits and the Fund corpus
grows at a health rate. These projections are of course subject to market risk, which may
result in a less favorable outcome.
132. The financial position of the Civil Service Pension Fund has been less favorable.
The unfunded liability stood at $104 million at the end of FY2011 and the funded ratio
was 26 percent, indicating a more precarious situation. As in the case of Social Security,
both employees and the national government contribute 6 percent of earnings to the fund.
Changes in law during 2013 eliminated mandatory retirement after 30 years of service,
allowing employees to extend their career, increase contributions and delay benefits.
Other changes in law have also improved the viability of the fund. Perhaps less desirable
was the inclusion in the changes to law for the provision of a 4 percent tax on remittance
transfers to be earmarked for the fund. This tax is not applicable to commercial bank
transfers, acts as a tax on money transfer agencies, and is effectively a distortionary tax
on low income foreign workers.
56
RoP Economic Review—FY2014
B.
Public Financial Management
1. THE PALAU PLANNING AND BUDGET FRAMEWORK
133. As part of the ADB Facility for Economic and Infrastructure Management
(FEIM), a medium-term development strategy (MTDS) was prepared. The MTDS set out
key strategies and actions to help achieve economic, social, environmental and cultural
goals over the five-year period from 2009 to 2014. This document, in essence a five-year
development plan, provided the basis for economic policy and budget formulation during
the period. However, while the MTDS was a comprehensive document covering the major development issues, there was little focus on implementing the plan after the change
in administration in 2009. In 2013, with a further change in administration—a return of
the one that commissioned the plan—the MTDS again became the centerpiece of the
planning effort. Upon attaining office, the returning administration prepared a management action plan (MAP) to serve as the road map for the administration. The MAP indicates the government’s intention to implement the medium-term fiscal strategy (MTFS)
discussed above in the context of the MTDS (see Figure 31 for a diagrammatic representation of Palau’s planning and budget system).
134. In 2010 under a further ADB TA1, an effort was made to develop and institutionalize a medium-term budget framework (MTBF). The objective was to incorporate the
two strategic documents (MTDS and MTFS) into a medium-term budgetary framework.
The MTFS would guide the formulation of a medium-term fiscal framework (MTFF): the
projection of the fiscal envelope and identification of fiscal risks and pressures. The
MTDS would provide the direction for line ministry and departmental expenditures on
activities and outputs through another document: the medium-term expenditure framework (MTEF).
Figure 31
1
The Palau planning and budget system
ADB TA #7421: Implementing a Medium-Term Budget Framework
Policy Issues
57
135. The TA initiated a series of efforts to improve public financial management
(PFM). These included the development of the MTFF, and implementation of a new performance reporting and results-based framework (RBF) at the line ministry level to assist
in the development of the MTEF. The TA proposed the adoption of a MTBF document,
bringing together the economic and fiscal projections, line ministry expenditure ceilings,
and performance data—all to be presented at the time of the budget, in essence, fulfilling
part of the fiscal responsibility act discussed above.
136. However, the implementation of the MTBF cannot be said to have been a success;
the program was commissioned by one administration but implemented under another.
The TA final report indicates a series of weaknesses: while the minister of finance supported the reforms, other parts of government did not. There was a lack of resource availability in the ministry, availability of accurate financial data was problematic, the forecasting committee had not been convened throughout the TA, and the RBF was not approved by either the administration or the OEK.
137. The overall approach to planning and budgeting in Palau is appropriate: the
MTDS and MTFS provide a sound framework for subsequent policy implementation. At
this point, the original five year framework of the MTDS would have been completed,
and a follow-on second five year period initiated. A complete re-write of the full document is not necessary, but an update and re-issue of the basic strategies and key policies
would be desirable. With the recent uncontrolled expansion in the tourism industry and
ad hoc policy environment Palau needs a guiding framework to direct the nation. The
long-term structural fiscal deficit inherent in the Compact also requires addressing if public resources are to be efficiently managed.
2. PUBLIC EXPENDITURE AND FINANCIAL ACCOUNTABILITY
138. In March of 2013, Palau invited the Pacific Financial Technical Assistance Center
(PFTAC) to assist the nation in the preparation of a Public Expenditure and Financial Accountability (PEFA) self-assessment. The PEFA is aframework for the assessment of
public financial management (PFM) developed by the World Bank and a group of international donors in 2005, which has subsequently been updated1. It has been implemented
in many countries in the world and provides an objective yardstick by which countries
can assess and improve their PFM performance. The framework has six broad categories:
i.
ii.
iii.
1
Credibility of the budget—the budget is realistic and implemented as intended;
Comprehensiveness and transparency—the budget and fiscal risk oversight are
comprehensive, and fiscal and budget information is accessible to the public;
Policy-based budgeting—the budget is prepared with due regard to government
policy;
Public Expenditure and Financial Accountability (PEFA), PEFA Secretariat, Washington
D.C., 2011 revised
58
RoP Economic Review—FY2014
iv.
v.
vi.
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;
Accounting, recording and reporting—adequate records and information are produced, maintained and disseminated to meet decision-making control, management and reporting purposes; and
External scrutiny and audit—arrangements are made for the scrutiny of public finances and follow-up by the executive agents.
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 next stage in the PEFA process—once Palau has decided to participate—is to request a formal or external assessment. With the external assessment complete, Palau will be eligible to request that PFTAC assist in the preparation
of a road map to improve the PEFA score. The road map will identify areas in PFM that
are in need of improvement and reform and focus efforts on the more critical components. It can be seen that many of the areas addressed in the policy section of this review
are covered in the PEFA framework. The PEFA provides a very desirable method to assess reform effort over time. However, at this point further progress beyond the initial
self-assessment has been disappointing and adoption and implementation of a PEFA program has been accorded low priority.
C.
State Owned Enterprises and Public Infrastructure
139. State owned enterprises (SOEs) are not large in number in comparison to other
Micronesian economies, and Palau has avoided the pitfalls experienced in the FSM and
RMI, in particular. There are two major SOEs: the Palau National Communications Corporation (PNCC) and the Palau Public Utilities Corporation (PPUC). Until recently the
provision of water and sewer services had been provided by government, but these functions have now been merged with the PPUC. The provision of airport operations remains,
however, a government department. There is no overarching government policy on SOEs
or regulatory framework. It is understood that the government sought ADB technical assistance to support the development of an SOE policy and legislation to cover the regulation and operation of the sector, but as yet no action has been taken.
1. TELECOM
140. The telecom sector in Palau consists of one main provider, the Palau National
Communications Corporation and two WiFi service providers Palau Telecom and Palau
WiFi. The PNCC, is a state owned enterprise, while the latter two are private entities. The
PNCC provides GSM mobile, fixed line, Internet, and digital TV services. During the
2007-2014 period, the cell phone market grew strongly, from 9,424 customers to 19,114,
an annual rate of growth of 11 percent. This represents a coverage of 108 percent of the
estimated population in 2013—a very high percentage—but may include a significant
number of visitors. The rate of penetration would suggest the market is largely saturated.
Policy Issues
59
Fixed line business has fallen from 7,474 subscribers in 2007 to 7,149 over the same period. Digital TV has remained a relatively constant share of the PNCC’s business, while
Internet coverage has grown from 1,194 to 2,252, an annual average growth rate of 9 percent—with a significant 74 percent increase over the last three years, due to the introduction of the HomeNet service in 2011. DSL customers numbered 553 in 2014, while the
dialup service has declined to 649, and HomeNet has 835 customers.
141. Figure 32 indicates the net operating profit and net income of the PNCC. In recent
years the SOE has achieved a positive net operating profit, but net income, after allowing
for interest payments on debt and other costs, until FY2014 has been negative. As an
SOE, the PNCC serves the public interest of Palau and is not required to operate at full
cost-recovery. The PNCC carries a large external debt to the U.S. Rural Utilities Service
(RUS), which stood at $24.3 million at the end of 2014. Once allowance for interest payments is made, it can be seen that the PNCC has a negative income (until FY2014), and
does not cover principal repayment on loans. In essence, the PNCC has been repaying its
debt obligations through depreciation of its fixed capital base to remain operational. It
thus operates significantly below full-cost recovery level.
142. While general telecom services in Palau are satisfactory, Internet services are one
of the most costly and poorest in the Pacific region, and are well below that other of nations of a comparable income level. The recent tourist exit survey conducted by the Palau
Visitor’s Authority indicated that the main dissatisfaction of Palau’s visitors was overwhelmingly poor internet connectivity.
4.0
$'s millions
2.0
Net Operating Income
-2.0
Net Income
-4.0
-6.0
-8.0
Figure 32
PNCC, net operating profit and net income
60
RoP Economic Review—FY2014
143. A 128 kb line costs $370 a month, and internet transactions frequently “time out”
due to the high latency in the system. During 2014 the PNCC improved the service with
connection to O3B (Other 3 Billion) at a cost of about $0.5 million. This has reduced
costs from the $2,400 per month megabit connection of the original geosynchronous satellite, to $600 under the new low orbit system, although the PNCC currently maintains
the original satellite connection for strategic purposes. The latency in the system (the time
delay required to communicate with satellites in orbit) has been reduced, but the general
improvement of the service has been marginal.
144. The World Bank has played a significant role in facilitating IT reform in the region, and is providing TA ($0.6 million) to Palau to assist implementation. The government issued an RFP for the implementation of telecommunication sector reform and a
contractor is currently implementing the TA. The objectives include: policy reform, legislative and regulatory reform, investment in a submarine fiber-optic cable, and issuance of
licenses for new operators and services. The TA contains three major areas:
i.
ii.
iii.
Policy and Legislative reforms: Advise on an appropriate regulatory environment
for a completive ICT market. Prepare a new law and regulations to give effect to
the proposed reforms. Assess possible sharing of regulatory functions across Micronesia
Transactional advice regarding Cable System: Advise on the technical, legal and
transactional aspects of the proposed cable system, including the structure and nature of the Government’s financing of the entity responsible for the delivery of the
cable system to Palau; the ownership and management structure of that entity; and
the nature and structure of the local operating company expected to participate in
the cable project.
Capacity building for the Ministry off Public Infrastructure, Industries & Commerce: (i) Provide the Ministry with an implementation plan of a dedicated unit
that will be responsible for sector policy development, monitoring, and liaison between the Government and the Office of the Regulator, (ii) Develop an action
plan for the establishment of the Office of the Regulator and transfer of functions
from the Ministry to the office, (iii) Advice the Ministry on spectrum recovery.
145. The TA contractor has drafted legislation for the creation of a public corporation:
the Belau Submarine Cable Corporation, which has been passed by the House of the
OEK and is actively under consideration by the Senate. The new company will own and
operate the cable on behalf of the Government on a commercial “full cost recovery” basis. It is tasked to ensure open access for all ICT service providers so that the benefits of
the open fiber optic cable accrue to the benefit of the consumer. For the first 10 years the
company will be publicly owned and there is no provision of sale of stock to the private
sector. In order to achieve the objectives of a competitively priced IT sector this provision seems appropriate. Private ownership in a monopolistic situation has not provided
competitively priced services elsewhere in the region. However, competition amongst IT
Policy Issues
61
providers purchasing bandwidth from the BSCC should ensure fair and efficiently priced
services.
146. The TA contractor is also drafting legislation and regulations for the creation of a
competitive ICT market and establishment of an independent regulator. It is understood
this legislation is nearing completion and will be available for legislative action in the
near future. The two pieces of legislation lay the ground work for the new IT environment. Lastly, the TA makes provision to build capacity in the Ministry of Public Infrastructure, Industries & Commerce, but this component is yet to be initiated.
147. The financing of the new cable will through a joint initiative with the FSM and
jointly serve both Palau and Yap State. The Yap portion will be financed out of a grant
from the WB of up to $22.5 million, which is part of a larger initiative ($47.5 million) to
provide a series of IT initiatives in the FSM. In the case of Palau the ADB has agreed in
principle to provide a loan of up to $25 million to finance Palau’s share of the project.
Cable costs are to be shared, but each country will be responsible for its own onshore
components. In the case of Palau the nation needs to pass the BSCC legislation before the
ADB loan is considered by the Bank’s Board. Similarly in the case of the FSM the government is required to implement the recent enacted Telecommunications Act of 2014
and to operationalize a sister FSM Cable Company, although it is understood this may
now remain within FSM Telecom.
148. Both Palau and the FSM are examining alternative cable suppliers, although at
this time the SEA-US (South East Asia - United States) submarine cable is the preferred
choice. The SEA-US cable system provides a unique opportunity for Palau to connect to
the internet backbone at low cost ($15-$20 million), in a timely manner (early 2017), and
with effective cable maintenance due to the international nature of the cable partners. At
the time of writing, funding of the proposal is under consideration by the OEK, but there
is strong opposition to the proposal reflecting partisan politics. Hopefully, Palau’s leadership will rise above internal disagreements, and act positively to provide a critical component of Palau’s infrastructure and IT environment that supports the provision of vastly
improved services in education and health, the business community, households and the
tourism sector.
2. PALAU PUBLIC UTILITIES CORPORATION
149. The Palau Public Utilities Corporation (PPUC) is the sole provider of electricity
in Palau. In a recent re-structuring of the utilities sector, the PPUC now provides water
and sewer services, which were formerly (until June 2013) provided through a government department. The discussion in this section relates to power generation and the following deals with water and sewer. The PPUC has provided a mixed level of service,
with disruptions at times due to lack of maintenance of generating capacity. At the end of
2011, the utility suffered a fire at one of its two major plants, effectively decommissioning four major generators. However, services were quickly restored. The erratic level of
62
RoP Economic Review—FY2014
service has resulted in private businesses installing their own generating equipment, placing a significant burden on the private sector. New generators have recently been commissioned with two larger 5MW generators to replace those destroyed by the fire at the
Aimeliik plant financed through grant aid from Japan.
150. Figure 33 provides a picture of the financial operation of the utility. The PPUC
recorded a negative net operating income in many years, but its financial position has
clearly been improving since a disastrous year in FY2008 when fuel prices peeked. On a
net income basis (excluding capital grants) the utility has made a loss in many years, but
turned positive in FY2014. Figure 33 also indicates the level of current subsidies received
from the national government and other donors.
151. The weak financial performance of the PPUC is attributed to a variety of interrelated factors. Most important, the utility has not been allowed to operate at full-cost recovery. Political considerations have resulted in the establishment of a sub-optimal tariff
structure, which has constrained setting aside a reserve for plant replacement. This, in
turn, has led to increased costs for more frequent maintenance. In FY2008, with the spike
in fuel prices, very significant losses were recorded. At the end of 2012, a new tariff
structure was introduced, which has placed the utility in a better financial position. Improvements in efficiency have also been achieved which has helped reduce cost with the
introduction of more efficient generators. However, the despite these improvements the
utility remains below full-cost recovery. At the end of FY2014, the utility had $7.5 million in outstanding loans, with debt services payments (interest and principal) of $0.9
million. The ratio of cash to current liabilities (quick ratio) was 52 percent indicating a
less than satisfactory position, but better than many other regional power providers. As
discussed in the case of the PNCC, the utility is able to maintain a positive cash flow by
funding operations through the erosion of the capital base.
4.0
Subsidies
$'s millions
2.0
-2.0
-4.0
Net Operating Income
Net Income
-6.0
-8.0
Figure 33
PPUC, net operating profit and net income
Policy Issues
63
3. THE ADB WATER SECTOR IMPROVEMENT PROGRAM (WSIP)
152. The provision of water and sewer services was, until the merger with PPUC in
June 2013, provided by the public works department of the Ministry of Infrastructure, Industry and Commerce. Figure 34 indicates the financial performance of the provision of
services. Up to the merger in FY2013 the cost of the provision of water and sewer operations, while under government control was above revenues, and the figure indicates a significant level of implicit subsidy. In FY2014 after the merger was complete and the full
cost of services is fully recorded the true financial position of operations is revealed. Despite the increase in charges for sewerage as required under the WSIP (see below), the
cost of operation is very significantly above revenues, and indicates the level of subsidy
required to maintain operations.
153. To support the government in reforming the sector, the ADB initiated a Water
Sector Improvement Program (WSIP) loan. A loan of $16 million was agreed upon, with
a $9.873 million first tranche and a second tranche of $6.2 million. As a program loan,
the funds were not earmarked for specific purposes but were provided to assist the government with the transition, subject to a set of conditions, The conditions for 1st tranche
release were:



A law creating a power, water and sewer company to run water and sewer operations. It was later agreed that the PPUC would be split into two divisions: one for
electricity generation and the second for water and sewer.
The initiation of tariff increases for water supplied toward full-cost recovery, and
regulations issued for metered sewerage charges.
A detailed transition plan.
8.0
7.0
$'s million
6.0
5.0
4.0
Water and Sewer Operations
3.0
2.0
1.0
Figure 34
Water Utility Chrages
Water and sewer operations
64
RoP Economic Review—FY2014


A stipulation that the government would allocate a specific subsidy in the budget.
Prepare, approve, and implement a Community Consultation Plan
154. In FY2012, the loan became effective and the first tranche was released. It included: $1 million in capital for the NDBP, $2 million for Typhoon Bopha relief, $3.2
million for a reduction in accounts payable at the PPUC, $1 million for PPUC repairs,
and the remainder $2.7 million to support establishment of the new SOE. At the start of
FY2014 the second tranche of $6.2 million was released, which included a further set of
conditions:







Approval of a national water resource management plan.
A Bill to mandate the regulation of water abstraction.
A further increase in tariffs for both water and sewerage.
Commencement of operations of water and sewer under the reformed institutional
structure, which would control assets, staff and billing.
Implementation of a user pay policy such that illegal connections are disconnected, non-metered connections are identified and connected.
An additional subsidy allocation of $1.5 million, and financing agreement between the government and PPUC for future subsidies and loans to support water
operation.
Further community and health awareness consultation.
155. A review of progress on attainment of the loan covenants was undertaken and sufficient progress was achieved for the ADB to release the second tranche. Water and
sewer operations commenced at the PPUC in June 2013, which took over all operational
aspects of the enterprise. It is known that water tariffs were increased plus a new tariff for
sewer services introduced prior to the transfer of these functions to the PPUC. A further
50 percent increase in tariffs has been schedule for FY2015. To fully cover operational
costs and service the KASP loan repayments, tariffs will need to further double and treble, respectively. Operating subsidies of $1.8 and $1.7 million were transferred in
FY2013 and FY2014, respectively.
156. There is no doubt that if the Water Sector Improvement Program is fully implemented in compliance with the conditions, then it will provide a reformed efficient SOE
that operates at full-cost recovery. The WSIP will encourage moderation in water usage.
In addition, the ADB estimates enable expansion in the tourism industry without the need
for additional investment before the end of 2020. However, the president expressed concerns to the OEK that the bill creating the independent water and sewer entity lacks clarity in the definition of several key components, especially full-cost recovery. The original
intention was that the new law would require not only the provision of water and sewer to
be subject to full-cost recovery but also the sale of electricity. As it currently stands, water is subject to the condition (albeit, with some ambiguity), but electricity is not. This
Policy Issues
65
was a golden opportunity to place the new combined SOE on a sound financial footing to
encourage efficient use of both water and electricity.
4. THE ADB KOROR–AIRAI SANITATION PROJECT
157. Koror’s centralized sewerage system and sewage treatment plant (STP) is over 30
year’s old and badly in need of refurbishment, renovation and extension if it is to continue to serve the needs of the nation. Available sewer treatment capacity effectively
places a constraint on future growth of Koror and the tourism industry1.
The sewerage network comprises 40 kilometers of gravity mains, 13 kilometers of
force (pumped) mains, 48 pump stations, and a sewage treatment plant (STP) located on the island of Malakal. For the most part, the commercial sector of the
city is located at the crest of the ridge and the residential hamlets stretch down to
the coast. Sewage is pumped up to the ridge and flows to the STP. Two other islands, connected by causeways, are part of the network. While the STP and some
pump stations have been refurbished in the last 10 years, these have not been
maintained or operated as designed.
The current sewerage flow exceeds the design capacity of the network and the
STP. This causes overflows at the low-lying pump stations and subsequent discharge of effluent to the natural and built-up environment, including through people’s homes, taro patches, and into the lagoon. There are an increasing number of
overflows as the network deteriorates. The problem is exacerbated by: (i) poor
maintenance, (ii) inadequate emergency response capability, (iii) groundwater infiltration, and (iv) illegal storm-water connections.
158. The loan document goes on to describe a series of environmental and health issues, and potential impact on the economy of adverse consequences of system degradation and failure. Two major outputs are identified:
1
1
Effective, efficient, and sustainable sewage collection systems in Koror and
Airai. The sewerage network in Koror will be rehabilitated and augmented to (i)
minimize the frequency and severity of uncontrolled sewage overflows; (ii) reduce
the energy requirement to operate the network; (iii) improve the operation of the
network through real-time system monitoring; and (iv) enable rapid response to
disruptions in sewerage services resulting from system failures. A sewerage network will be constructed at Kesebelau (Airai) connecting the residential and commercial dwellings to an STP.
2
Sewage treatment and disposal meets Palau’s environmental standards. Sewage
collected in the Koror and Airai sewerage networks will be treated at new STPs to
be constructed at Koror and Airai. Effluent from the new STPs will meet Palau’s
See ADB, Proposed Loan Republic of Palau: Koror-Airai Sanitation Project, Project Number
42439, October 2013
66
RoP Economic Review—FY2014
environmental discharge quality standards. The STP in Koror will be consolidated on a much smaller footprint further from the coast than the existing STP,
protecting the infrastructure from future storm surge damage and releasing land
for tourism development.
159. A program of $30 million of which $28.8 million would be provided through
ADB loan resources is proposed to remedy the situation. The majority of the ADB financed proportion, $26.9 million would be provided under the banks Ordinary Capital
Resources (OCR) conditions, with a 5 year grace period, repayable over 20 years with interest at prevailing LIBOR rates. The majority, 97 percent, of the disbursements will take
place over a 4 year timeframe. Given the improved institutional environment generated
by the sister ADB Water Sector Improvement Program, it is hoped that this much needed
project will provide a secure an efficient system for waste disposal in the long-term and
enable the economy to continue its upward path.
D.
The Renewed Compact Oversight Mechanism
160. The renewed Compact, as specified in the Compact Review Agreement, and still
awaiting approval by the U.S. Congress, calls for the establishment of an advisory group
“to contribute to the long-term economic sustainability of Palau by recommending economic, financial and management reforms.” The agreement offers several examples of
relevant reform issues, including:
“meaningful improvements of fiscal management, including the elimination and
prevention of operating deficits; a meaningful reduction in the national operating
budget from the previous fiscal year; a meaningful reduction in the number of
government employees from the level of the previous fiscal year; a meaningful reduction in the annual amount the national operating budget dedicated to government salaries from the previous fiscal year; demonstrable reduction of government subsidization of utilities, and meaningful tax reform.”
161. As described in the policy section of this review, there are many potential reform
issues in addition to the items listed in the renewed Compact. In fact, the Compact list is
very limited and may not be entirely appropriate. No doubt the advisory group will want
to reconsider and broaden the list, once it becomes functional. Clearly, the PEFA provides a useful checklist of PFM performance. However, the PEFA focuses on systems rather than reforms, and the advisory group would likely wish to monitor the implementation of such areas as fiscal strategy, tax reform and performance of state owned enterprises. Furthermore, the Compact fails to mention reforms to encourage private sector development or monitoring mechanisms such as the World Bank’s “Ease of Doing Business” survey, which is discussed at the end of this chapter. It would be desirable for Palau
to take a proactive approach in preparing a template reform monitoring matrix for consideration by the advisory group before it meets.
Policy Issues
67
162. However, as the renewed Compact specifically mentions a number of public sector issues, several of these are discussed below. Comments on others, such as tax and
SOE reform, have already been noted. The following discussion will focus on recent
trends, and important issues will be raised.
1. DEFICIT/SURPLUS TARGETING
163. In the earlier section on recent fiscal performance, it was noted that Palau has pursued a generally conservative fiscal position. The ratio of surplus/deficit ratio to GDP has
fluctuated between a low of -1.9 percent in FY2005 to a surplus of 3.5 percent in
FY2014, depending on the point in the cycle. By today’s standards in most developed
countries, this performance is considered favorable. However, the level of overall deficit/surplus Palau has achieved may be less than desirable. Palau does not have a central
bank or capital markets to fund short-term liquidity needs. During the recent financial recession, as tourism numbers declined, Palau suffered a period of liquidity shortfall. Consequently, the nation accumulated a significant level of accounts payable, in effect, forcibly borrowing from other government entities and the private sector.
164. In the first section of this chapter of the review it was indicated that a buffer reserve of approximately 3 months of domestic revenues would form a comfortable buffer
to operate behind; this is equivalent to about $15 million. The initial section of this chapter also indicated that the due to declining Compact funding and anticipated COFA trust
fund shortfalls, additional resources would be needed. This might be resolved through
implementation of the tax reform initiative or alternative the large emerging fiscal surplus
would provide a source of funds.
2. SIZE OF GOVERNMENT
165. Table 5 illustrated the size of the national government expressed as a percent of
GDP. A ratio of 40.1 percent was recorded in FY2014, with a reducing trend since
FY2007. By international standards, this ranks Palau 130th out of a total of 185 major
economies (ranking from lowest expenditures to GDP ratio)1. This is lower than the
Scandinavian, German and U.K. economies and close to the U.S., which is ranked 136th
with a ratio of 42 percent. Perhaps more meaningful, by Pacific Island standards2, Palau
ranks 5th lowest out of 12 nations. Palau ranks below the FSM and RMI, which have ratios of 60 and 57 percent, respectively, but above Fiji (30 percent), Papua New Guinea
(38 percent), and Tonga (25 percent). Clearly, it is difficult to define a desirable level of
government; this is a choice for individual countries to make. Neither is there a clear association with economic growth. The Scandinavian countries have performed well despite having large public sectors above 50 of GDP in some cases.
1
2
Wikipedia, based on 2014 Index of Economic Freedom. Note: differences in definitions and
which levels of government are included makes strict comparison problematic.
ADB, Basic Statistics, Manila, April 2014
68
RoP Economic Review—FY2014
166. The above discussion indicates that there is no a priori indicator of an optimum
size of government: the size of government in different countries is diverse reflecting historical patterns and political priorities. There is thus no reason to suppose the level of
government in Palau is either too high or too low. Only a careful review and audit of the
functions of government, and whether they were being delivered efficiently or not, would
indicate whether Palau could deliver the existing services at lower cost. But this is outside the scope of this review. The discussion at the beginning of this Chapter of the review indicated that Palau has a significant fiscal gap, and one of the ways to reduce the
gap is through tax reform. However, the position could equally well be taken that Palau
could eliminate the gap through expenditure compression. For example, the IMF recommended a mix of revenue reforms and expenditure reduction in a recent Article IV mission.1 The current failure of the tax reform initiative suggest that Palau has a revealed
preference to cut expenditures rather than the more politically difficult road to raise taxes.
3. PUBLIC SECTOR PAYROLL
167. Recent trends in government payroll, hourly rates and equivalent man-years are
indicated in Figure 35 (sourced from the government payroll system). Equivalent manyears2 worked have fallen from 2,016 in FY2005 to 1,889 in FY2015; this is a reduction
of 0.8 percent per annum between the two end points. Figure 35 clearly shows the downward trend in public sector employment. On the other hand, hourly rates of pay (including benefits) have risen from a level of $8.76 per hour to $11.17 an average annual
growth rate of 2.7 percent. Taken as a whole, the cost of payroll has risen by an annual
average rate of 1.9 percent. Finally, as indicated in the discussion on fiscal developments,
payroll costs have remained largely unchanged in terms of total expenditures, but have
fallen in relation to GDP since FY2007.
168. Given recent economic and fiscal developments, Palau’s performance on the payroll question would appear satisfactory. Palau has avoided pressure to increase the size of
the civil service, unlike many other small developing nations with limited economic opportunities. Employment in government has actually fallen, and annual wage drift has
been moderate. In fact, taking into account the cost of living as measured by the CPI, real
government wages have fallen by an annual average rate of 1.6 percent since FY2005.
1
2
See IMF, Palau Article IV, April 2014.
Man-years are based on the number of hours worked divided by the number of hours in the
working week and assuming a 50-week year.
Policy Issues
$12.00
69
2,200
Hourly Rate
$11.00
Equivalent Man-Years
2,100
$10.00
2,000
$9.00
1,900
$8.00
1,800
$7.00
1,700
$6.00
1,600
Figure 35
E.
Public sector payroll: hourly rates (US$) and equivalent man-years,
FY2005-FY2015
Private Sector Development
1. TOURISM SECTOR POLICY
169. The rapid increase in visitor arrivals from the PRC discussed in Chapter 1 at the
end of 2014 and during the beginning of 2015 engendered concern from many quarters in
Palau that tourism was developing too quickly, that demand was outstripping supply, and
that the market was not operating efficiently by displacing visitors from traditional markets. Despite the increase in overall visitors, demand in some segments of the market was
falling. There was also concern that pressure was being placed on the environment and
especially on the aging water and sewer system in Koror. As a result of these concerns
the President implemented a policy to halve the number of charter flights which enabled
the new surge in visitors, effective mid-April. The majority of Palau’s traditional tourism
market is based on regularly scheduled flights.
170. The rapid increase in visitor arrivals largely caught the nation by surprise. Despite
the operation of major resorts at full capacity in recent years, most of Palau’s middle and
low end tourism plant has operated at low occupancy rates. This excess capacity and recent additions to the hotel stock enabled visitor numbers to increase rapidly. Further, the
lack of a clear tourism policy and a weak regulatory and legislative environment enabled
rapid growth to the holding level of the installed plant. With a further 200 rooms in the
pipeline nearing completion, this growth could continue further.
171. In response to the emerging problem the government requested support from the
ADB to: (i) consider the adoption of the “Pristine Paradise. Palau” branding and marketing concept, (ii) review the present aviation policy and formulate criteria for licensing,
70
RoP Economic Review—FY2014
and (iii) consider a suspension of tourism projects given the environmental, social, cultural and economic pressures on the country. The ADB fielded a TA in February 2015 to
assist with support for the tourism issues confronting the nation1. The TA provides a
sound set of recommendations in response to the terms of reference:
172. Tourism Strategy: It is generally recognized that Palau wishes to pursue a high
value tourism policy, and this has been adopted by the Palau Visitor’s Authority. However, recent developments have been precisely in the mass package low end of the market; the opposite of Palau’s declared policy. The policy in and of itself makes good sense
for a small nation with limited human and capital resources, but recent developments outline the consequence of having no policies in place to guide development towards a desired result. The ADB TA indicated it will take at minimum five years to develop and implement the specific actions needed achieve this objective.
173. Limitations of Charters: While the reaction to reduce the number of charters to
limit the rapid increase in visitors was understandable, the TA recommends that this
should be seen only as a temporary policy until a tourism strategic/action plan can be developed. Many investors have made decisions to develop the tourist plant on the basis of
market indications and the existing regulatory environment for the private sector. The decision to limit charter flights has consequences for existing operators as well as those in
the pipeline, and there has been a strong response from the affected parties. The justification for the action has been made on the grounds of the impact of pressures on specific
parts of the system, and the issue of licenses should be designed to alleviate that pressure.
174. As events have materialized the targeted reduction in charters has failed to be
fully implemented. In May, the first full month since the implementation of the restrictions, the number of arrivals from the PRC fell by 2.4 percent. The number of charter
flights fell from 46 in March to 40 in May, although there was an increase in the size of
the equipment used. The failure to implement the stated policy underscores concerns that
Palau operates a weak regulatory environment.
175. Moratorium on new Tourism Development: Since the current water and sewer
systems are unable to accommodate the existing levels—let alone future tourism developments in Koror, there are strong grounds to place a temporary hold on new projects. The
current ADB KASP loan will rectify and improve waste management, but the project will
take more than three years to complete. This will allow for the development of regulatory
and planning processes to catch up with tourism activity. However, the imposition of
placing a moratorium on tourist development should not restrict development outside the
Koror area or inhibit projects that place no burden on the existing waste infrastructure or
threaten the environment.
1
Walter Jamieson, An Assessment of Selected Policy Options for Tourism Development in Palau, ADB TA 8565-REG, April 2015, Manila.
Policy Issues
71
176. Apart from providing a response to the immediate tourism issues on hand, the
ADB report outlines key components of a tourism management action plan. There is a
large list of activities, many of which are common to development and private sector issues in general. The most important of these include:




the need for a land-use policy to provide a framework for resort development to
fit the tourism strategy,
the need for manpower policies to reduce the reliance on foreign labor and raise
the quality of Palauan skills,
development of an infrastructure strategy, and
assessment of visitor carrying capacity by destination and attractions.
177. One area not highlighted in the ADB TA is tax policy. As already discussed in
this chapter, Palau has inherited an inefficient and outdated tax regime that is particularly
poorly tailored to its tourist economy. Given the resource constraints in Palau of limited
domestic labor and limited capital to invest in the industry, the main benefit of the tourism economy is to provide a source of revenue to government. Development of a high
value tourism strategy should coincide with tax reform in order to maximize government
yield without distortion to the local economy.
2. THE ANNUAL ECONOMIC SYMPOSIUM
178. In November of 2013 Palau convened its first economic symposium with two major objectives: to formalize public-private sector dialogue, and attain consensus on specific actions (derived from the Medium-Term Development Strategy-MTDS) to be implemented over the following year. The Symposium agreed that similar meetings would be
held annually to facilitate dialogue between the private and public sectors.
179.
Several initiatives were proposed for consideration based on the MTDS:
1.
Creation of an Economic Advisory Group
2.
Adoption of State-Owned Enterprise policy
3.
Routine publishing of the current Statistical Yearbook
4.
Adoption of a Value Added Tax
5.
Establishment of comprehensive National Investment Policy
6.
Adoption of Fiscal Sustainability Policy
7.
Adoption of Micro Small and Medium Enterprise (MSME) Policy
8.
Establishment of comprehensive National Labor Policy
9.
Actions to lower Palau’s ranking in the Doing Business Index measured by the
World Bank
72
RoP Economic Review—FY2014
10.
Consideration of “One-Stop Shop” policy to improve service delivery in the Republic
The initiatives received were endorsed by both the Public and Private Sector representatives and consensus was reached to action these items over the next year. The Palau
Chamber of Commerce and the Republic of Palau now has entered into a memorandum
of understanding establishing the Economic Advisory Group. After a period of absence
the Statistical Yearbook series is being released and routine publication is set for future
years. As discussed in this review considerable attention has been paid to the implementation of the VAT, but at this point has the tax reform agenda has gone on the back
burner. On the remainder of the list no action has been taken.
180. In November 2014 a second Economic Symposium was convened and supported
by the Palau Chamber of Commerce, entitled “Bridging the Gaps between Government
and the Private Sector”. Three discussion areas were addressed: (i) Macroeconomic Review - New Directions, (ii) Tourism Development – Pristine Palau, and (iii) Agriculture
and Aquaculture - Supplying the Tourism Industry. Speakers were invited from prominent business people, and from the international agencies dealing with Palau. At the close
of the Symposium it was decided to continue with the emphasis of the items identified
but not addressed at the first meeting, namely items 2, and 4-8, with the last two items being dropped.
181.
Additional items that emerge from the 2nd symposium included:
1.
Physical planning improvements including: the requirement for a land use and
zoning law and associated regulations.
2.
Formalization of an agriculture and aquaculture policy.
3.
Formalize a Tourism Policy, finalizing the definition of “High-End Tourism”,
updating the Tourism Action Plan and developing a Tourism Strategic Plan.
4.
Strengthen Policy Planning.
Items 1 and 3 are much interrelated, especially given the rapid recent growth in the development of tourism in Palau. These are much needed if Palau is to develop a rational approach to tourism development and avoid the pitfalls that been experienced with an uncoordinated ad hoc policy that has been effective to date. Overall while the Symposium has
not resulted in any dramatic change in policy or new reforms, it has highlighted many of
the critical areas that need to be addressed, and provided a venue for an open dialogue.
3. THE WORLD BANK DOING BUSINESS SURVEY
182. As indicated in the Symposium’s list of initiatives reducing Palau’s ranking in the
World Bank’s Doing Business Survey was an important objective. Table 8 indicates Palau’s ranking for each of the 10 major categories, which has changed little over the last 3
years. Overall, Palau currently scores 113 out of a total of 189 countries, about 2/3rds
down the list, suggesting that there is much room for improvement. Palau fairs better than
Policy Issues
Table 8
73
Palau: Ease of doing business, World Bank ranking
2012
2013
2014
Ease of doing business overall rank
116
111
113
Starting a business
Dealing with construction permits
Getting electricity
Registering property
Getting credit
Protecting investors
Paying taxes
Trading across borders
Enforcing contracts
Resolving insolvency
124
39
80
20
182
174
97
124
144
61
130
44
78
17
185
177
83
108
146
71
111
66
98
21
71
183
132
105
127
167
the FSM and RMI which are ranked 145th and 139th, respectively, but is substantially below most of the South Pacific nations. Papua New Guinea is ranked 133th below Palau,
but Fiji 81th, Vanuatu 76th, Tonga 69th and Samoa 67th are above.
183. Overall, Palau’s scores are generally weak. Protection for investors is particularly
poor, but it is interesting to note that the ranking for getting credit has improved from 182
and 71. The improvement probably reflects the establishment of the secure transactions
registry in January 2013, although the level of outstanding credit to the private sector fell
in FY2014 to $2.8 million. This is less than 1 percent of GDP, and indicates while the
conditions for lending to the private sector may have improved the commercial bank sector remains incredibly risk adverse. Ease of paying taxes has slipped back from 83 to 132
despite there being no changes in the tax regime or regulations; implying that other countries must have improved their score significantly in this area. Also resolving insolvency
has deteriorated without any apparent changes in Palau. While the World Bank “Doing
Business” survey is a useful metric and overall country scores accord with intuition, individual rankings of the particular categories would appear subject to a wide margin of variation from year to year for no apparent reason.
F.
Conclusion
184. Table 9 provides a selected summary of various components of Palau’s policy and
institutional structure comprising a reform agenda. A brief summary is included in the table with a color-coded indication of the success of the reforms.
185. Fiscal Policy: During the international recession Palau experienced a period of
cyclical downturn and fiscal deficits. This has gradually improved and Palau recorded a
3.5 percent of GDP surplus in FY2014 (coded green). Public sector employment has
gradually fallen since FY2004, but has been offset by increases and annual wage increases averaging 2.7 percent (coded green). Palau has adopted a favorable external debt
74
RoP Economic Review—FY2014
Table 9
Summary of Palau Policy Reforms
Achievement
Fiscal policy
Fiscal balance
Public sector payroll
External debt
Long-term fiscal adjustment
Social security
Civil service pension fund
Macroeconomic Monitoring
Monitoring Activities
Public Financial Management
Public Expenditure & Financial
Accountability (PEFA)
Financial accountability
Strategic Development Plan
Medium-Term Fiscal Framework
Performance management
Information Systems
Fragile, balance achieved since FY2010; large surplus in FY2014
Size of public service has been reduced since FY2005 -0.8% per annum, wage rates
+2.7% pa
Sound external debt position
No policies for adjustment to declining real value of Compact grants or restructuing of
the Cofa Trust Fund to maintain a permanent fund
Reforms enacted and unfunded liability reducing
CSPS projected to collapse within 10 years without reform
Full set of Statistics available for economic performance assessment
External assessment completed; no implmentation road map executed
Audits currently "unqualified"
In FY2008 the RoP completed a strategic development framework: Facility for Economic
and Infrastructure Management. This requires some updating
Not currently adopted in the RoP
Weak and no monitoring of outputs or outcomes
Captures financial information only
State Owned Enterprises
Subsidies
Divestment
Full cost recovery
SOE policy
less than 1% of GDP
World Bank reforms in IT sector underway.
Utilties operate on cash-flow basis without setting aside funds for depreciation
No RoP SOE policy framework, although support from ADB requested
Tax Reform
Tax Reform Progress
No progress on the FY14 reform inititive: blocked in the OEK
Regulatory Environment
FDI
Tourism
Environment for private sector
Doing business Survey
Score
RoP operates a non transparent foreign investment board
No well developed policy or planning framework: policy to limit charters not observed,
policy to encourage high value tourism not effective
Recent changes to secture transactions law
World Bank survey places RoP 113th out of 189
+
+
-
strategy, reflected in a low debt to GDP ratio and poses no significant risk (coded green).
Palau has not developed a long-term fiscal strategy to adjust to the reduction in real grant
transfers under the Compact. Further, Palau has not developed a policy to switch the
COFA Trust Fund to a permanent fund or achieve intergenerational equity (coded red).
The Social Security system has been modified to reduce the unfunded liability through
legislative change with adjustments to tax rates, thresholds and retirement provisions
(coded green). Finally, the Civil Service Pension Scheme without legislative change is
projected to collapse with 10 years (coded flashing red).
186. Macroeconomic Monitoring: At the end of FY2011 Palau’s economic statistics
were in a seriously depleted state and required improvement for macroeconomic monitor-
Policy Issues
75
ing before implementation of the renewed Compact. Since that time, with technical assistance from the U.S. Department of the Interior’s Office of Insular Affairs, Palau has developed a full set of the major economic statistics: GDP, employment, wage data, CPI,
banking statistics, balance of payments, international investment position, external debt,
and government fiscal statistics. Local capacity is improving, and capacity building is
supported by both the Graduate School USA and international donors (coded green).
187. Public Financial Management: Palau 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 initial internal assessment was made, no further progress has been achieved (coded yellow). In the area of financial accountability
and control, audits are no longer qualified and the national government finance office is
adequately staffed (code yellow-plus) As part of a large scale ADB TA in 2008 Palau
prepared a series of medium term planning documents referred to as the Facility for Economic and Infrastructure Management (FEIM). In essence the FEIM fulfills the role of a
medium to long term planning framework. At this point the FEIM remains relevant but
parts of the framework, especially those related to long-term fiscal management, need updating (coded yellow). While the FEIM included a standard approach to medium-term
budgeting and planning, this has not been implemented. As a result there is no effective
performance management. The medium-term fiscal framework is coded yellow while the
performance management item is are coded red-plus, indicating some recent attention to
addressing weaknesses. Financial management information systems provide adequate accounting and audit data, but they do not provide a sound basis for measuring output delivery, fiscal statistics or budgeting (coded yellow).
188. State Owned Enterprises: The level of SOE subsidy in Palau is less than 1 percent of GDP and the nation has avoided the financial pitfall experienced in many countries. However, the recent establishment of water and sewer operations at the PPUC will
require subsidy for some time until cost recovery is established (coded yellow). The main
state owned enterprises in Palau include the PPUC and PNCC. Recent reform initiatives
sponsored by the World Bank require establishment of an open access internet provider
and liberalization of the market. Legislation is currently pending in the OEK (coded yellow). All utility operations operate at less-than-full cost recovery, although both electricity and telecom operate on a positive cash flow basis (coded yellow). Palau has requested
ADB support for preparation of an SOE policy framework.
189. Tax Reform: Palau initiated tax reforms in the late 1990s and more recently in
2014. After much TA support from PFTAC and the IMF, the reform initiative has stalled
in the OEK (coded red).
190. Private Sector Regulatory Environment: Palau operates an old style Foreign Investment Board, which operates in a less than transparent manner. However, despite this
impediment the nation has managed to attract significant foreign investment (coded yellow-minus); although there is growing pressure to address issues through legislative and
76
RoP Economic Review—FY2014
institutional improvements. No coherent and well-articulated tourism policy or planning
framework exists. The nation recently adopted a high value tourism policy, and imposed
a 50 percent reduction on charter flights, although recent trends indicate this has not been
effectively implemented. While the policy is of questionable validity, no attempt has been
made to restrict new tourism plant development to comply with a high value tourism policy (coded yellow-minus). New laws have been enacted to develop a secure transactions
environment, but further efforts are needed to improve the regulatory environment for
private sector development (coded yellow). Finally, the World Bank’s “Doing Business
Survey” ranks Palau 113th out of 189 countries, which is weak performance (scored yellow.)
IV.
THE COFA TRUST FUND PERFORMANCE AND SUSTAINABILITY
A.
Compact Trust Fund Performance (Analysis based on data
through April 2015)
1. BACKGROUND
191. In comparison to its sister Freely Associated States, the Republic of Palau negotiated a significantly different economic assistance component under its Compact of Free
Association. An important feature was the Compact Trust Fund (CTF), which had the
mutually agreed objective of providing $5 million annually from FY1999-FY2009 and
then $15 million annually for Palau’s government operations through FY2044 (the end of
the 50-year period of the Compact). For reasons that are difficult to discern, the assumed
rate of return for the CTF was 12.5 percent annually. This assumption was surely influenced by the high interest rates prevailing at the time of the original negotiations; however, by the time the CTF was actually invested in February 1995, such a sustained rate
of return over an extended period was clearly going to be difficult to achieve. As it turns
out, and as described below, the CTF has performed satisfactorily relative to U.S. market
benchmarks for stock and bond returns during the period from February 1995 through
both the end of FY2009 and through April 30, 2015.
192. This review will not comment extensively on the governance of the CTF. However, it should be noted that the management of the fund has clearly been consistent with
the Compact and subsidiary agreement requirements, with the possible exception that
oversight and reporting to the U.S. government has been less robust than was anticipated.
For most of its life, the CTF has been managed by a board of trustees, under ROP statutory authority, that set the initial investment policy and enacted modifications of that policy on three subsequent occasions, as detailed below. For the seven years through midFY2014, the management was more or less by a committee made up of the minister of finance and the chairs of the relevant committees in the House and Senate of the OEK.
Since mid-FY2014 the CTF has once again come under a statutory committee governance mechanism. This seems appropriate when considering the following two factors: the
relative importance of the CTF to Palau’s future fiscal stability; and concern about the
lack of transparency of certain withdrawals made in FY2011 and FY2012. Those withdrawals exceeded the Compact-restricted level ($5 million annually) by $2 million in
each year. While Palau had restored the excess withdrawals as of the second quarter of
FY2013, there was clearly a need for greater transparency and improved control mechanisms in the day-to-day management and broader investment policy oversight of the
CTF.
193. Starting in January of 2014 the CTF “Advisory Committee” revised the Investment Policy Statement and this was further revised and officially confirmed by the then
77
78
RoP Economic Review—FY2014
official mandated CTF Committee in April 2014. The four separate strategic asset allocations that have been in place from the outset are detailed in Table 10. It should be noted
that the transition to the new investment strategy, including a shift from the investment
advisory/custody arrangements that prevailed from the outset through early 2014 is
deemed for the purposes of this review to have started on April 1, 2014. In fact, the transition began as early as February 2014 and was not fully implemented until June 1, 2014.
2. CTF PERFORMANCE
194. Switching to a review of CTF performance, Figure 36 shows the projected values
using the originally projected investment rate of return of 12.5 percent, juxtaposed with
the actual results through both FY2009 and April 310, 2015. Over the 20.5-year period,
the actual final value through the first seven months of FY2015 reflects a growth rate of
7.93 percent annually.
195. As of the end of the initial 15-year period (the end of FY2009), the Trust Fund
value of $143.98 million reflected an average rate of growth of 7.42 percent from investments made in February 1995. However, that value was far below the original CompactTable 10
COFA Trust Fund Investment Strategic Asset Allocation Strategies Levels, FY1995present
Benchmark Index
US Public Equities
Large Cap
Large Cap Value
Large Cap Core
Large Cap Growth
Small Cap
S & P 500
Russell 1000 Value
S & P 500
Russell 1000 Growth
Russell 2000
Non-US Equities
Developed Markets
Emerging Markets
MSCI EAFE
Morningstar/MSCI Emerging Mkts
Fixed Income/Cash
ML Master/Core Bonds
US Core
US Intermediate
US High Yield
Global
Barclays US Aggregate Bond
Barclays US Aggregate Bond
Barclays US Govt/Credit Intmdt
Barclays US Corp High Yield
Citi WBIG NonUS Denominated
Alternative
Commodities
UBS Bloomberg CM Commodity
Master Ltd PartnershipsAlerian MLP
Real Estate
NCREIF Property
Private Equity
MSCI World Gross
Total
Notes:
02/01/95 01/31/00
02/01/00 05/31/203
06/01/03 3/31/14
04/01/14 present
60.0%
60.0%
65.0%
65.0%
65.0%
50.0%
38.0%
15.0%
8.0%
8.0%
8.0%
14.0%
0.0%
0.0%
0.0%
25.0%
18.0%
7.0%
40.0%
40.0%
35.0%
35.0%
35.0%
35.0%
19.0%
6.5%
6.5%
3.0%
3.0%
0.0%
0.0%
0.0%
100.0%
100.0%
100.0%
18.0%
3.0%
3.0%
6.0%
6.0%
100.0%
Estimates derived from Government of Palau Investment Policy Statements: 1995, 2000, 2003, 2014
All allocations assumed to be re-balanced when funds are deposited/distributed and quarterly.
The Medium Term Economic Outlook
$470
us $millions
$420
79
$419m
PROJECTED AT 12.5%
$370
$320
$204m
$270
CURRENT VALUE
$220
$170
$120
Figure 36
Original projected CTF values –vs– actual, FY2001-FY2015 (4/30/15)
assumed value of $285.32 million. It should be noted that Palau prudently chose not to
withdraw Compact-allowed amounts of $5 million annually for the four years from
FY1999 through FY2002. Without Palau’s admirable forbearance, the shortfall of the
CTF in comparison to assumptions would have been much greater.
196. The peak value of the CTF at the end of any fiscal year during the initial 15-year
period was $177.09 million (at the end of FY2007), and at that time investment returns
had averaged 9.45 percent annually. As noted above, the assumed rate of growth of 12.5
percent annually was simply too high.
3. BENCHMARKING THE PERFORMANCE OF THE CTF
197. The analysis that follows is not intended to replace or refute any of the ongoing
investment monitoring performed by the CTF’s investment manager (either through
early-FY2014 or subsequently under new arrangements) or the responsible parties within
the government of Palau. Instead, it is intended to be an overview based on the designed
structure and anticipated flows under the Compact. Assumptions, which undoubtedly
vary from the actual day-to-day management of the CTF, include: (1) it is assumed that
the two contributions from the U.S. government into the CTF were deposited into the investment strategy precisely on February 1, 1995, and again on October 1, 1997; (2) in
years in which the ROP government used monies from the Trust Fund, it was assumed
that such withdrawals were made on the first day of the fiscal year; and (3) Palau’s investment strategy is broken into four distinct time periods, precisely as noted below and
in Table 10.
198. From February 1, 1995, through January 31, 2000, the prevailing investment strategy had only two asset classes: 60 percent in large capitalization U.S. equities, and 40
percent in U.S. fixed income. In this analysis the benchmark index for the former is the
80
RoP Economic Review—FY2014
S&P 500, while the benchmark for the latter is the Barclays Aggregate U.S. bond index.
It should be noted that the Trust Fund’s investment manager benchmarked the fixed income category against its own proprietary index, the Merrill Lynch Domestic Master
Fixed Income Index through the initial two time periods and then against their similar
Merrill Lynch US Corporate & Government Master Index during the period since June 1,
2003. The author had access to the Barclays (formerly Lehman) index values which has
a nearly identical performance history over the several periods in which comparisons
could be made.
199. From February 1, 2000, through May 31, 2003, the same benchmark indices are
used, with the weighting changed to reflect Palau’s added risk allocation to 65 percent in
large capitalization U.S. equities and 35 percent in U.S. fixed income.
200. From June 1, 2004, through the present, the strategy reflected allocations of 50
percent in large capitalization U.S. equities and 35 percent in U.S. fixed income, with the
remaining 15 percent allocated to U.S. small capitalization equities. The latter, newly introduced asset class is benchmarked using the Russell 2000, which tracks the smallest
2,000 companies within the Russell 3000. The Russell 3000 is a nearly total U.S. equity
market index, reported to track more than 98 percent of the total U.S. stock market based
on market capitalization. The Russell 2000, on the other hand, as an index of small companies, has a total value equal to approximately 7 percent of the U.S. stock market.
Hence, the introduction of the “small cap” asset allocation to the CTF strategy resulted in
an increase in both expected returns and expected volatility.
201. Finally, just as the CTF has come under a revised statutory committee mechanism, the CTF also replaced the one-and-only investment advisor that had served through
early-FY2014 with a new investment advisor. This analysis covers a period matching
roughly 13 months under the new arrangements. Of significant importance, the CTF
Committee has used the recent change to greatly increase the number of asset classes utilized, including the introduction of non-U.S. holdings. Based on modern portfolio theory
and experience of a broad range of institutional investors, this should enable the CTF to
perform better with similar levels of risk, or perform similar to what previous narrower
asset allocations would have produced with reduced long-term volatility. With just over a
year under the new arrangements it is clearly too early to make judgements; however, the
Committee is to be commended for choosing a more rigorous and modern approach to its
adopted asset allocation strategy.
202. Figure 37 shows the end-of-period values of both the CTF and the blended benchmark index from FY2001 through April 30, 2015. The blended benchmark index, of
course, reflects the prevailing strategy and the related indices over the four periods of
varying investment strategy target allocations. It should be noted that the benchmark indices are used for comparative analysis only, and there is no way to invest directly in such
indices. Furthermore, the benchmarking methodology assumed re-balancing to the precise target allocations both at the time of contributions/distributions and on a quarterly
81
The Medium Term Economic Outlook
$220
$211m
$210
blended benchmark
us $millions
$200
$190
$204m
$180
actual value
$170
$160
$150
$140
$130
$120
Figure 37
Comparison of CTF values with benchmark, FY2001-FY2015 (4/30/15)
basis. It is likely that the investment manager, in consultation with the responsible officials, would have set variance thresholds and/or made tactical recommendations that
would have caused the CTF to vary at times from its precise asset allocation target levels.
Finally, the actual values of the CTF at the end of each fiscal year reflect returns net of all
investment costs, which include custodial fees, money manager fees, and other costs necessarily associated with investment management of institutional funds.
203. As shown, the performance of the CTF has tracked quite closely in relation to its
blended benchmark. In fact, the investment rate of return of the CTF of 7.93 percent is
just a fraction below that of the (unmanaged/cost-free) benchmark index of 8.07 percent.
If the primary objective of the government of Palau and, more specifically, of the actual
responsible officials was to utilize professional investment management, including the selection of active money managers in each asset category, as a way to significantly exceed
the performance of the blended benchmark, then the results shown would be somewhat
disappointing.
204. On the other hand, if the cost of ensuring that a high standard of fiduciary care is
always maintained, then it will always be necessary to have some costs of investing.
Such costs among midsized institutional investors could rarely be kept below 0.3 percent
per annum, and on average would quite commonly exceed 0.5 percent per annum. The
reported expenses of the Palau CTF during the final three fiscal years under the previous
investment advisory arrangements averaged 0.65 percent per annum. Under the new,
much more diversified arrangements, total fees are reported at 0.64 percent per annum.
Notably, the similar costs have been achieved despite the introduction of numerous asset
classes with substantially higher costs. The new arrangements reflect the competition and
82
RoP Economic Review—FY2014
negotiations managed by the responsible officials and compare rather favorably with the
costs of the larger sums invested under the CTF’s of Palau’s sister Freely-Associated
States. With a total of $621 million under management between the two CTFs at the end
of FY2014, the “total investment management fee” for the RMI’s portion ($240.1 million) was reported at 0.65 percent per annum in the FY2014 RMI CTF Annual Report;
while the “total investment management fee” for the FSM’s portion ($380.9 million) was
reported at 0.78 percent per annum in the FY2014 FSM CTF Annual Report.
205. The investment rate of return the CTF has achieved also compares favorably with
those achieved by the RMI and FSM CTFs over the more recent common period of audited end of fiscal year values. For the period FY2006 – FY2014, Palau achieved an 8.0
percent return against a benchmark for the same period of 8.07 percent. The same results
for the FSM are 6.74 percent return against its benchmark of 7.00 percent; and for the
RMI they achieved 6.49 percent against its benchmark of 7.05 percent.
206. In summary, since it appears that the investment strategy as deployed by Palau
during the period since 1995 has lagged only slightly behind the performance of its
benchmark by 0.14 percent annually, it can be deduced that the combined efforts of Palau’s investment advisors and money managers made up for most but not quite all of the
costs associated with investment and custodial care. Conversely, if Palau had decided to
implement a completely passive investment strategy during the same period, the costs of
investing and custodial care would have likely reduced returns by more than the 0.14 percent by which actual performance lagged the benchmark.
207. While past performance is not an indicator of future results, going forward, the responsible parties for the CTF should continue their due diligence in considering their investment strategy and in considering the extent to which they may be able to use a
blended approach to possibly utilize a passive (index-based) strategy for a portion of their
asset allocation. More importantly, other institutional investors with assets in the size
range of the CTF tend to utilize more asset classes than were used through early-FY2014,
including, but generally not limited to: non-U.S. equities, non-U.S. bonds, and alternative
or niche assets. It is thus commendable that the responsible officials—now the CTF Committee—have sensibly expanded the range of asset classes to which CTF funds are allocated to achieve greater diversification. The introduction of truly non-U.S. assets classes
which required notification (and no objections) from the U.S. government appears to now
be fully accepted, especially since non-U.S. asset classes feature in the allocation strategies of the CTFs for both the FSM and the RMI.
4. LOOKING FORWARD—THE IMPORTANCE OF THE COMPACT REVIEW
AGREEMENT
208. The CTF featured prominently in the Compact Review undertaken by the U.S.
and Palau following the end of the 15th year of the Compact. Specifically, Compact Section 432 calls for reviews at the end of the 15th, 30th and 40th anniversaries. The first review was concluded with the signing of an agreement in September 2010 to renew the
The Medium Term Economic Outlook
83
economic assistance terms of the Compact for the 15-year period from FY2010 through
FY2024. In recognition of the perceived likelihood that the CTF would not assuredly
achieve its objective of providing $15 million of annual funding to the government of Palau through FY2044 (the 50th year), substantial changes were built into the Agreement for
both the supplemental funding of the CTF and for reducing the pace of withdrawals that
would otherwise have been taken from the CTF.
209. Figure 38 shows the nature of the projections that were reviewed after FY2009
with respect to the CTF. If the end-of-FY2009 balance of $143.98 million had been
drawn upon as originally anticipated at $15 million annually starting in FY2010, without
any sort of accommodation resulting from the Section 432 review, then the results were
projected to be dismal. As shown, if the Trust Fund had delivered returns of 5.5 percent
annually, failure would have occurred just prior to FY2022, long before the mutually
agreed goal of funding through FY2044. Even if the Trust Fund had delivered its average
returns through FY2009 of 7.42 percent annually, it would have failed during FY2024,
coincidentally timed for just before the second required Compact Section 432 Review as
called for at the end of the 30th year under the Compact.
210. Together with other results agreed upon through the Section 432 Compact Review
process, there was an agreement to “shore up” the CTF so that it would have a much
stronger chance of performing, as agreed in the original Compact, through FY2044. With
respect to strengthening the Trust Fund, an important methodological agreement was
reached between the U.S. government and RoP officials. It was agreed that the earlier
mistake of choosing an assumed investment rate of return that was inordinately high
would be avoided. Specifically, it was agreed to use a 5.5 percent (net) investment rate of
return for all projections guiding the review. As shown in Figure 38 that alone would not
have been sufficient. So, in addition, it was agreed that a portion of new (annual) funding
$160
TF Value
$140
END OF 15th YEAR
us $millions
$120
Projected Failure
$100
FY25 FUND FAILURE
AT 7.42% ANNUAL GROWTH
$80
$60
$40
Projected Failure
$20
FY22 FUND FAILURE
AT 5.5% ANNUAL GROWTH
$0
Figure 38
CTF projections completed at end of 15th year, FY2009-FY2025
84
RoP Economic Review—FY2014
would be dedicated to the CTF. Furthermore, a substantial, though declining, flow of annual economic assistance was agreed to be provided, thereby enabling Palau to reduce its
annual withdrawal rate from the Trust Fund. These factors combined to allow for both
more reliable and more successful forward projections of the likely ability of the CTF to
achieve the agreed-upon objectives through FY2044.
211. Figure 39 shows two scenarios that indicate the importance of the approval of the
Compact Section 432 Review. In the current policy scenario—in the absence of approval
of the agreement as re-submitted by the U.S. executive to the U.S. Congress in 2015—the
projected results are not promising. Still, the recent strong market performance, reflecting
recovery after the nadir of the Trust Fund at the end of FY2009, allows for the Trust Fund
to likely survive longer at a 5.5 percent growth rate than had previously been projected.
By the end of FY2024, in advance of the second Compact Section 432 review, the Trust
Fund balance would have shrunk to a projected $156.5 million and would be on pace to
fail in FY2039.
212. More optimistically, Figure 39 also projects the value of the CTF under the assumption that the agreement is approved and implemented at the outset of FY2016. At
the agreed projection rate of 5.5 percent, this scenario allows for fully achieving the objective of funding to Palau for specified government operations through FY2044. With a
projected balance at that date of just over $200 million, but declining, the CTF would not
be projected to fail for several decades beyond the end of the 50-year Compact period.
While there are other measures of importance awaiting approval of the Agreement, such
as funding for infrastructure projects and maintenance, the successful “shoring up” of the
Trust Fund is surely the most important outcome to support Palau’s fiscal stability and
economic security going forward.
$235m
$300
WITH AGREEMENT IN FY16
(END 50th YEAR AT 5.5% GROWTH)
us $millions
$250
$200
$150
$100
$50
Projected Failure
WITHOUT AGREEMENT
FY39 AT 5.5% ANNUAL GROWTH
$0
Figure 39
CTF projections with and without approved review agreement, FY2015-FY2044 (year 50
of COFA)
The Medium Term Economic Outlook
85
213. In the section of this review that follows a more sophisticated, risk-inclusive form
of analysis is used 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.
B.
Simulating the CTF through FY2044 subject to Market Risk
214. The analysis in this section switches to examining the sustainability of the CTF
over the long-term and its ability to provide a secure yield to support the operation of fiscal policy. The CTF was designed as a sinking fund to provide a fixed nominal yield of
$15 million until the fund is exhausted. It firstly, implies an annual fiscal adjustment
since the drawdowns are not adjusted for inflation. Secondly, at some point in the future
the CTF is designed to fail and at that point an adjustment equivalent to the $15 million
will be required. The nature of the design of the existing arrangements is to pass on the
entire fiscal adjustment of the $15 million loss onto future generations of Palauans. The
following analysis is thus concerned, bearing inter-general equity in mind, with the policies and adjustments required to maintain a steady real flow of future resources equivalent to the $15 million in FY2024 (the final year of the renewed Compact) and forever
thereafter.
215. The analysis is further concerned with subjecting the projections to market risk.
International financial markets are subject to a high degree of risk and in the design of the
CTF and distributions on which fiscal policy relies, it is critical to ensure market volatility is accounted for. The method deployed follows an approach widely adopted in analyzing market risk, and utilizes Monte Carlo simulation to estimate the impact of market risk
based on the characteristics of the investment portfolio adopted.
1. MARKET RISK
216. Before examining the impact of the implementation of the CTF arrangements, it is
beneficial to inspect the degree of risk investments are exposed to in financial markets.
Figure 40 indicates the annual total return of investments in the S&P 500, U.S. Government T-Bills and 10 year Bonds. The S&P 500 index displays large annual fluctuations
during the period 1925-2014. US 10-year Bonds display less volatility or risk while TBills are more stable, but of course with much lower returns. On average the S&P 500 returned 11.9 percent during this period while the yield on the 10-year bonds averaged 5.6
percent. While the average or mean return on the S&P 500 index looks favorable, the
standard deviation, a measure of dispersion, was 20.1 percent. This implies that 2/3rds of
the time one could expect a return ranging from between -8.2 to 32 percent, a very large
range of possible outcomes.
217. It is further important to note that the measure of the simple mean rate of return
overstates the geometric or compound mean rate of return. The geometric rate takes that
value of the S&P 500 in 2014 compared with 1925 and calculates the rate of return required to attain the 2014 value. The geometric mean on the S&P 500 during this period
was 9.9 percent some 2 percent less than the simple mean. One further needs to account
86
RoP Economic Review—FY2014
S&P 500
T-Bill
10 Year Gov Bonds
60%
40%
20%
0%
-20%
-40%
-60%
Figure 40
Return on Investment in U.S. Stocks and Bonds, 1925-2014
for inflation, which during this period averaged 2.8 percent implying that real returns on
the S&P 500 were 7.1 percent. After allowing for investment management fees (50 basis
points have been assumed in the present analysis), it can say that an average investor
could anticipate a long-run geometric mean rate of return of 6.6 percent. In the case of the
RoP CTF the resources are invested in a balanced portfolio designed to reduce risk and
the portfolio geometric mean rate of return will be different to that of the S&P 500 on its
own.
2. TRUST FUND PRINCIPLES
218. It is important at the outset of the analysis to define a set of broad principles the
CTF should be designed to maintain:
1. The real, inflation-adjusted value of the CTF should be protected,
2. The CTF should provide a secure and stable source of real revenues to the national government of the RoP on an annual basis, and
3. Annual distributions should entail minimal volatility from period to period and
when unavoidable be of known magnitude to limit disruption to the operations of
fiscal policy.
219. The first objective is specified to ensure that future generations of Palauans will
benefit from the CTF. The principle is designed to ensure intergenerational equity. The
current embodiment of the Trust Fund in the Compact Agreement is not designed to pro-
The Medium Term Economic Outlook
87
tect this principal, but in this review redesign of the CTF to achieve this objective is investigated. The second principle indicates that the each year the CTF should provide a
constant real level of resources for distribution. Thus both current and future generations
can enjoy an identical level of benefit. The current arrangements do ensure an equivalent
nominal drawdown each year, but at some point the future generation will be left without
benefit. Finally, the third principle indicates that while the CTF will be subject to market
risk, the annual distributions should avoid volatility to the extent possible, and when necessary be of a known quantum.
220. Sadly, there is no way in theory or in practice to achieve these three core principles. Rather, the approach adopted in this Review is that the performance of alternative
arrangements can be evaluated against the principles outlined. Thus policy makers can
adopt a CTF framework that scores the highest ranking against the objectives.
3. BENCHMARKS AND PERFORMANCE MEASURES
221. In this section some useful benchmarks and performance measures to aid the analysis are defined:
1. Target Distribution: This is defined as the inflation adjusted (U.S. GDP deflator)
level of the annual $15 million permissible under the Compact. Switching to an
inflation adjusted level is likely to require U.S. concurrence. Should the RoP contribute to the CTF it is possible that withdrawals greater than the annual $15 million may be possible without dipping into the U.S. funded portion of the corpus.
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 estimated 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 benchmark.
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 and defined below.
222. Performance of the CTF is assessed against a series of benchmarks related to the
three CTF principles outlines above. The simulations in the following sections are conducted over the remaining renewed Compact period: FY2015-FY2024 and over the remaining 20 years of the original agreement through FY2044. Each of the core principles
has two elements a value in FY2044 and an average over the drawdown period FY2025FY2044. The focus is on both averages over the period and long-run state values in
FY2044. The benchmarks are designed to achieve intergenerational equity.
1. Protecting the Corpus:
88
RoP Economic Review—FY2014
2.
3.
4.
5.
a. Probability of attaining the primary target in FY2044.
b. Probability that the FY2044 real value of the CTF is above the FY2024
value.
Protecting Distributions:
a. Average distribution as a percent of the target in FY2044.
b. Average distribution through FY2025-FY2044 as a percent of the target
distribution.
Protecting against Volatility:
a. Probability of a zero distribution in the FY2024-FY2044 period.
b. Average variation in real drawdown between FY2043 and FY2044.
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.
Sustainability: The outcome of any set of simulations, which attains a 95 percent
performance level is considered sustainable.
4. TRUST FUND SIMULATIONS
223. The analysis undertaken in this Chapter follows that in two other recent studies of
the amended Compact Trust Funds in the FSM and RMI.1 Both studies deploy Monte
Carlo simulation analysis to investigate the likely performance of the two Trust Funds
and capacity to meet their objectives. The analysis followed 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. Bonds (15 percent), U.S. Corporate Bonds (10 percent) and World Government Bonds (10 percent). All
indices are total return indices including reinvestment of interest and dividends. Data covers the historical period 1925-2014.2 Since the inflationary environment projected over
the FY2015-FY2044 is expected 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 is provided in Appendix 1.
1
2
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 D.D.; 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, 2015, Manila.
Global Financial Data.
The Medium Term Economic Outlook
89
224. The simulations start in FY2015 based on the value of the CTF at the end of
FY2014. The simulations are split into two periods: the shoring-up phase of the renewed
Compact between FY2015 and FY2024, and the drawdown phase thereafter.
5. PROJECTED VALUE OF THE CTF AND DISTRIBUTIONS UNDER THE COFA
RULES
225. Under this set of simulations three variants are examined: (i) the renewed Compact is implemented in FY2016, (ii) the current continuing U.S. appropriations are maintained through FY2024, and (iii) under the renewed Compact it is assumed the drawdowns are adjusted for inflation after FY2024. In the first case and recalling the data in
Table 4, it is assumed the RoP receives a back payment of $9 million as the contribution
to the CTF, due to the failure of the U.S. to implement the renewed Compact, and that
going forward both contributions and drawdowns will be as indicated in the table. After
FY2024 the RoP will drawdown the nominal $15 million as per agreement. Based on
these information the simulations were run.
226. Figure 41 provides a depiction of the simulated CTF value at the end of the renewed Compact period FY2024. It indicates that from a current value in FY2014 of $199
million the fund is likely to attain a value of $330 million in FY2024 (the median simulated value). However, the probability of the CTF attaining the level of the Primary Tar-
7.0%
Primary
Target
= $279
million,
65 percent
chance of
attainment
6.0%
5.0%
4.0%
3.0%
Median
Value =
$330
million
2.0%
1.0%
0.0%
0
Figure 41
200
400
600
Probability Distribution of FSM Compact Trust Fund in FY2023
800
1,000
90
RoP Economic Review—FY2014
get is 65 percent. Further it must be born in mind that the Primary Target is only a benchmark and is based on a risk free assumption. Figure 41 thus indicates that the likely level
of the CTF in FY2024 may well be below a level required to provide a sustainable yield
to support government operations in the RoP thereafter.
227. Table 11 provides statistics based on the performance criteria defined above for
the set of simulations undertaken in this Review during the FY2024-FY2044 period. Focusing on the results for the “COFA” simulations and the column for the renewed Compact, the measure for the protecting the corpus, the probability of maintaining the real
value of the corpus between FY2024 and FY2044 is 61 percent. The chance of the CTF
being above the Primary Target value in FY2044 is 69 percent, but an improvement over
the probability of attaining the Primary Target in FY2024 of 65 percent. All of these
measures are in relatively proximity indicating the sustainability of the Corpus remains
little changed through the period. Figure 42 provides a projection of the real value of the
corpus at different levels of probability. At the 25 percentile the real value of the CTF is
projected to remain unchanged. In 75 percent of cases the real value of the CTF is projected to grow, in 25 percent of cases to fall, and in some cases to collapse.
228. The second section of Table 11 further indicates the nature of the annual distributions that can be anticipated post FY2024. In terms of attaining the target drawdown
level, defined as the inflation adjusted equivalent of the $15 million, the average drawdown over the period is 80 percent, and in FY2044 the average level is 63 percent. In
terms of volatility, there is a 6 percent chance that the CTF will be exhausted during the
Table 11
RoP Compact Trust Fund Simulated Results and Performance
S imulations
C ofa R ules
R ule S ets
C ompac t T rus t F und v alue res ults
R enewed
C ompac t
C ontinuing
Appropriatns
S us tainability
R ule
S afer R ule
P 1.1 % c as es where real C T F in F Y 44 is above F Y 25 s im
value
R eal
D rawdown =
$15m F Y 25
pric es
61.1%
63.1%
51.9%
76.1%
73.4%
P 1.2 % c as es where C T F value is above the P rimary
T arget in F Y 44
68.9%
71.5%
61.8%
82.2%
80.3%
P 2.1 Average dis tribution through F Y 25-F Y 44 perc ent target
80.4%
80.9%
96.7%
70.1%
78.0%
P 2.2 Average dis tribution in F Y 44 perc ent target
63.0%
64.4%
88.6%
70.0%
85.4%
6.0%
4.1%
10.8%
0.0%
0.0%
1.8%
4.8%
1.2%
0.1%
1.1%
77.6%
78.5%
81.2%
83.1%
86.0%
D is tribution res ults
Volatility res ults
P 3.1 P erc ent of c as es with z ero dis tribution in F Y 2025F Y 2044
P 3.2 Volatility in F Y 44 D is tirbution c ompared to previous
year % target
O v erall P erformanc e R ating
The Medium Term Economic Outlook
5%
25%
50%
75%
91
95%
2,000.0
1,800.0
1,600.0
1,400.0
1,200.0
1,000.0
800.0
600.0
400.0
200.0
0.0
Figure 42
CTF Projected Real Values at Selected Percentiles, FY2015 prices, FY2025FY2044
period and a 2 percent chance of exhaustion in FY2044. Finally, the overall performance
rating of the CTF under the renewed Compact framework is 77 percent. On its own this
benchmark has little value without comparison to the alternative simulations, which are
discussed below.
229. Table 11 under the COFA rule segment also indicates the results assuming the
Compact is not renewed and the RoP continues to receive $13.147 million over the
FY2024 period to support government operations and only draws $5 million from the
CTF each year until FY2025 when drawdowns increase to $15 million. The table also indicates the results if the RoP is allowed to drawdown the $15 million inflation adjusted
from FY2024 (assuming the renewed Compact is implemented). In the first case of continuing appropriations the results are similar but slightly improved, indicating that the net
impact under the current interim arrangements with the U.S. are slightly more favorable
to CTF accumulation than if the renewed Compact was implemented.
230.
In the case of the RoP drawing out an inflation adjusted distribution, and thus
avoiding the need for fiscal adjustment, the results indicate an improved result. While the
CTF corpus falls relative to both the renewed Compact case and continuing appropriations, the average distributions are improved significantly. However, this is offset by an
increased chance of fund collapse to 11 percent over the 20 year drawdown period. Overall, the combined performance indicator rises to 81 percent. However, this result is obtained through limiting the horizon to FY2044. As the horizon is extended, the probability of fund collapse increases and the overall performance indicator declines.
92
RoP Economic Review—FY2014
6. DEFINING SUSTAINABLE CTF LEVELS AND RULES
231. From the foregoing analysis it is clear that the results are far from perfect: there is
a significant probability of fund collapse, and the highest score of performance indicator
of 81 percent falls a long way short of the defined sustainability target of 95 percent. In
this section we consider what size of Fund is likely to achieve sustainability and generate
a score of over 95 percent on the performance indicator. This problem is also viewed
from the perspective of what level of drawdown can be sustainably achieved without
jeopardizing the CTF. In the process two alternatives to the COFA rules are defined, the
Sustainability and SAFER rules.
i
Defining Sustainable CTF Levels
232. To define a sustainable CTF level the Primary Target indicator is used as the
benchmark. Simulations are run from FY2024 assuming the CTF is funded at the Primary
Target level in FY2024. It is recalled that the Primary Target is derived through dividing
the target distribution by the real portfolio geometric rate of return. Under these assumptions Primary Target is estimated to be $279 million in FY2024. Simulations were run assuming CTF levels ranging from 10 to 200 percent of the primary target in FY2024 in increments of 10 percent.
233. Figure 43 provides the results of the simulations. Clearly, as the level of CTF
funding increases the score of the performance indicator improves. However, as the funding level increases above about 50 percent of the primary target, decreasing returns to additional funding sets in and the benefit of additional funding declines. While the choice of
a target level of performance is subjective, a 95 percent level is considered desirable. This
100.0%
90.0%
80.0%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
Figure 43
Overall CTF Performance at different levels of funding relative to the Primary Target
The Medium Term Economic Outlook
93
translates approximately into a funding level of the CTF, which is 2/3rds (the sustainability adjustor) above the Primary Target. At this level, the CTF corpus and annual distributions are maintained at healthy levels and volatility is reduced to a minimum. At the 95
percent level a strong level of confidence can be assured that the CTF will be sustainable
in the long-run.
ii Defining a Sustainability Rule
234. The Sustainability rule is based on the assumption that the realized CTF in
FY2024 is actually 67 percent above a newly defined primary target. Drawdowns based
on multiplication of the real geometric yield by the new primary target will be consistent
with the sustainability target defined above. The drawdown under the sustainability rule
is thus 1/(1+sustainability adjustor) of the real geometric rate of return times the realized
CTF value.
235. Under the Sustainability rule the median drawdown in FY2025 is $10.6 million or
69 percent of the target rate of $15.3 million ($15 million plus inflation adjustment), and
would imply a fiscal adjustment of $4.7 million. However, the overall results as shown in
Table 11 indicate a much higher level of CTF performance than under either of the two
COFA rules assuming the renewed Compact. The projected probability of attainment of
the Primary Target level of the CTF in FY2044 is 76 percent compared with 52 and 61
percent under the renewed COFA with and without inflation adjustment. The average distribution throughout the drawdown period falls to 70 percent compared with 97 percent
and 81 percent under the two COFA rules, respectively. However, while the probability
of attaining the target distribution in FY2044 under the sustainability rule is below
COFA, it is above the COFA rules in terms of reducing volatility. The sustainability rule
virtually eliminates fund collapse and zero distributions. Overall, the CTF performance
index increases to 83 percent.
236. The probability of achieving given levels of annual drawdowns as a percent of the
target under the Sustainability rule is indicated in Figure 44. In FY2025 the probability of
a shortfall of less than 5 percent (the bottom band in the figure) is 22 percent. The probability of shortfall lying between 5 and 33 percent (the next band up in the figure) is 31
percent, and between 33 and 67 percent is 41 percent, and so on. These probabilities remain little changed through the 20 year period projected. The adoption of the Sustainability rule, which implies drawing out less than the long-run geometric average would permit, protects the corpus of the fund and ensures drawdowns are sustainable, albeit at a
lower level.
iii The Sustainability Adjustment For Enhanced Reliability Rule (SAFER)
237. Building on the Sustainability rule just developed, it is extended to protect against
fund collapse on the downside and to allow increased drawdowns on the up side once the
corpus has grown above a certain level. A moving adjustment is incorporated into the
framework. On the downside a downward adjustment or decrement of 5 percent of the
94
RoP Economic Review—FY2014
less than 5%
greater than 33% less than 67%
greater than 95% less than 100%
greater than 5% less than 33%
greater than 67% less than 95%
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Figure 44
Probability of Reduction in Distribution Compared with Target under the Sustainability
Rule
previous year’s distribution is made if a five year moving average of the CTF value falls
below the redefined Primary Target specified for the Sustainability rule1. Downward adjustment continues until the reduction in distribution exceeds the CTF shortfall (the ratio
of the actual CTF value to the redefined Primary Target). At this point an upward adjustment or increment of 2 percent is made. Adjustment is thus asymmetric: on the downside
adjustment is more rapid and on the upswing adjustment is slower to allow the CTF to return more rapidly to the redefined Primary Target. On the upside when the CTF value
exceeds twice the redefined Primary Target, distributions are allowed to rise by 5 percent
per annum until the inflation adjusted drawdown target of $15 million is achieved. The
addition of the moving adjustment to the Sustainability rule thus makes provisions to protect the corpus on the downside and allow distributions to rise on the upside.
238. Referring back to Table 11, the basic metrics for the SAFER simulations are provided. The starting position is the same as under the COFA case and the Sustainability
rule with the corpus attaining a median value of $330 million. In terms of sustaining the
CTF corpus, the SAFER rule exceeds COFA, but is not as strong as the Sustainability
rule alone. Through allowing drawdowns to rise on the upside the final value of the CTF
declines over the period. However, drawdowns are an improvement over the Sustainability rule, but are not as good as those under COFA, which make no adjustment to avoid
1
See annex to this Chapter for full specification of the moving adjustment rule.
The Medium Term Economic Outlook
less than 5%
greater than 33% less than 67%
greater than 95% less than 100%
95
greater than 5% less than 33%
greater than 67% less than 95%
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
Figure 45
Probability of Reduction in Distribution Compared with Target under the SAFER Rule
fund collapse. In terms of protecting against volatility and fund collapse SAFER performs on par with Sustainability, and considerably better than COFA. Overall SAFER
logs the highest performance to date of 86 percent.
239. Figure 45 indicates the probability of a reduction in distribution compared with
the inflation adjusted target. The starting position is similar to the Sustainability rule
alone without incorporating the moving adjustment. However, as time progresses and the
corpus accumulates (since the drawdown rate is below the long-term geometric average),
enhanced distributions are allowed. By FY2044 the probability of a reduction in drawdown compared with the inflated target of less than 5 percent has increase from 22 to 59
percent. Conversely the probability of reduced distributions decline.
240. The adoption of the SAFER rule thus indicates that an improved result can be
achieved over time through the adoption of well-designed rules and without additional
funding. Clearly, the SAFER rule favors future generations in terms of protecting the
CTF corpus, and avoids fund collapse. This is achieved, however, through a reduction in
annual drawdowns. While SAFER gives the best result so far, distributions are less than
target, and overall the performance score is less than the objective of 95 percent.
96
RoP Economic Review—FY2014
V.
THE MEDIUM-TERM OUTLOOK AND LONG-TERM PROSPECTS
241. In this Chapter of the review a medium and long-term economic framework is
presented, which provides an outlook of the Palau economy over the FY2015-FY2040
period. In the FY2013 Review a medium-term framework was presented. This has been
extended to provide a long-term framework to review the impact of continued tourism
growth and fiscal sustainability. The framework provides a framework to review the impact of the renewed Compact over the long-term as funding switches to drawdowns from
the COFA Trust Fund and the emergence of a fiscal gap. Long-term risk of collapse of
the civil service pension fund and issues of moving towards full cost recovery of the
newly created Water and Sewer division in the PPUC are investigated.
242. A baseline scenario is developed based on current policies as revealed in the
FY2016 budget submitted to the OEK by the President. A reform scenario is developed
to redress the long-run fiscal weaknesses of the current policy regime. The tax reform initiative that has currently gone on the backburner is considered as part of the reforms. The
baseline scenario assumes a long-run tourism growth of 2.5 percent. However, this is
conservative compared with growth of 4.2 percent since FY2004, and long-run projections of tourism demand in the Asia Pacific region of 4.9 percent. A high growth tourism
scenario is examined as a third scenario.
243. The modeling structure presented in the FY2013 Review has not only been extended through the long-term (FY2040), but also has been further developed to improve
the modelling of the economic relationships in Palau. The generation of income from production has been extended to include the estimation of compensating of employees and
operating surplus. The household sector account is now modeled in some detail capturing
the generation of income and including primary and secondary incomes. This is channeled back into household final consumption. An external debt model has been included
and accounts for Social Security, Civil Service Pension Fund, Water and Sewer Operations of PPUC, and the creation of new Company to operate a fiber optic connection to
the internet backbone have been included. Lastly, the COFA Trust Fund is now included
in the model. The resulting model has been named the Palau Macroeconomic and Fiscal
Forecasting Framework (MFFF). A write-up of the MFFF is provided in Appendix 2. A
set of projection tables, and the spreadsheet model can be downloaded from
www.econmap.org.
A.
Baseline Projection
1. ASSUMPTIONS
244. The baseline is projected on the basis of the current policy regime and the initiatives revealed in the FY2016 budget. Where the policy stance has not been explicitly
stated, the baseline assumes a position consistent with the current policy environment.
The Medium Term Economic Outlook
97
245. Tourism Growth: It has been assumed that the current hotel plant under construction (329 rooms) is completed and that the tourism industry continues to grow at a rate of
2.5 percent thereafter. On these assumptions the number of visitor arrivals will reach
close to 300,000 by FY2030, an annual rate of increase of 3.5 Percent, and 380,000 by
FY2040. By FY2030 this is an increase of 121,000 visitors compared with the 130,000
over the period FY2000-FY2015. The annual number of additional rooms constructed
once those in the pipeline is completed is just over 50 and well below the current level of
activity. The baseline tourism projection is thus conservative especially when compared
with the projected growth of tourism demand in the Asia Pacific region. The current policy to restrict the number of charters has not been effective and there are no land or zoning requirements to ensure hotel development is line with the “high” value tourism objective. While the baseline projection may well be exceeded, it is consistent with environmental concerns and the potential “holding” capacity of Palau tourism.
246. Marine Sanctuary: It has been assumed that the marine sanctuary is implement
despite the uncertainty that the OEK will pass this into law. Under the Vessel Day
Scheme of the Parties to Nauru Agreement, countries are allocated days according to the
level of fish stock and catch, although it is understood that catch is used as a proxy for
fish stocks. A seven year moving average is used for fish catch. It is assumed on a 50:50
basis that Palau will continue to receive days on the basis of fish stocks, but that it will
lose days on the fish catch part of the formula. This implies that the government will lose
half of the current $6 million in revenues over a seven year period, and also the fish export tax of $0.5 million, and the local long-line industry will no longer be based in Palau.
It has not been assumed that any additional revenues will offset the implementation of the
Marine Sanctuary.
247. Renewed Compact: The implementation of the renewed Compact has been subject to passage in the U.S. Congress since 2010. The baseline assumes that the new regime will be implemented in FY2016. While this remains unclear there is currently a proposed bill in Congress, and although passage is uncertain, it remains the assumption that
at some point during the next few years the renewed Compact will become part of U.S.
law. In nominal terms the renewed Compact will entail a reduction in resources to Palau
from the current $18.1 million to $15 million by FY2024. The level of grants will decline
while withdrawals from the trust fund will increase. By FY2024 all resources will entail
withdrawals from the CTF. Not only does this imply a reduction in annual funding, but as
described in Chapter 2 there is a loss in real resources to maintain government operations.
There is the potential that CTF might become exhausted during the 25 year horizon, although at the assumed 5.4 percent real rate of return on investments this is not projected
(under the assumption of no risk).
248. Subsidy: Under current policy water and sewer rates remain about one third of total costs after the incorporation of water and sewer operations with the PPUC. This excludes servicing of the Koror Airai Sanitation Project (KASP) ADB loan. Under the base
98
RoP Economic Review—FY2014
scenario it is assumed that rates are not increased to achieve full costs recovery as required under the ADB loan program and government will be required to pay PPUC a subsidy rising from $1.9 million in FY2016 to $4.3 million in FY2020 to maintain operations
and the KASP debt service. This excludes any contribution to provide funds for depreciation and maintenance of assets in the longer-term.
249. It has been assumed that some allocation of subsidy is required to support the establishment of the Belau Submarine Cable Company, which will be responsible for managing the new fiber optic, although it looks as though the OEK will not pass the authorizing legislation. A reducing subsidy is projected from $0.5 million in FY2021, when
amortization payments commence under the loan. An allowance for subsidy is included
although these payments are unlikely as revenues from expanding demand for internet
services are likely to exceed cost.
250. Civil Service Pension Fund: Our projections indicate the CSPF will collapse in
FY2023 and from the point forward government will be required to make up the short
fall: difference between benefits and contributions. This is projected to be $7 million in
FY2024 and rising thereafter. There is no allowance for support to the CSPF in the
FY2016 budget and there is currently a lack of awareness of the fiscal time bomb on the
horizon.
251. External Debt: The MFFF assumes the government will maintain an external debt
to GDP ratio of 10 percent, the historical average and that new borrowing will be used to
support infrastructure projects. The IMF Debt Sustainability Assessment (DSA) projects
external debt as the accumulation of fiscal deficits over time. This is unreasonable in a
country such as Palau which has no access to markets to finance a deficit. In the MFFF
deficits are financed out of government’s cash deposits. Once drawdowns are exhausted
the government would be require to make adjustment.
2. ECONOMIC ACTIVITY
252. The baseline projected growth in the economy and in the tourism sector is shown
in Figure 47. The trajectory indicates a lot of activity in the early years but then converging to the steady state rate of 1.8 percent. The strong association between visitor growth
and GDP is also indicted although this does not hold in all years, reflecting the impact of
changes in construction activity. In FY2015 a growth rate of 6.7 percent is projected reflecting the rate increase in visitors in that year projected to rise to 167,000 based on the
first 9 months data. The tourism activity index grows by 9.1 percent in the year and is
lower than the increase in tourism numbers due to the dominance of low end package
tour visitors. The economy continues to grow in the subsequent years peaking again in
FY2017 and slowly declining as the period of rapid tourism growth stabilizes at the longrun projected rate.
The Medium Term Economic Outlook
Gdp Growth
99
Tourism Activity
12.0%
10.0%
8.0%
6.0%
Steady state growth =
1.8 percent per annum
4.0%
2.0%
0.0%
-2.0%
Figure 47
Baseline projection GDP and tourism growth
253. Figure 46 provides further information on the sources of growth over the 15 year
horizon. It can be seen that while tourism growth clearly plays a very significant role investment growth is more important during the FY2016-FY2018 period. While growth in
tourism plant is strong during this period there are two other major sources of construction activity. The first is the Koror Airai Sanitation Project (KASP) with an investment of
$28 million in infrastructure with most occurring during the period FY2016-FY2019
(construction activity taken from the project documents). The baseline scenario also assumes that the renewed Compact is implemented and the $40 million for infrastructure is
utilized through FY2017-FY2022. While the projects that Palau might select are not
Government Consumption
Capital Formation
20.0%
15.0%
10.0%
5.0%
0.0%
-5.0%
-10.0%
Figure 46
Sources of growth
Household Consumption
Exports
100
RoP Economic Review—FY2014
known at this time it has been assumed that 50 percent will be spent on construction. In
FY2019 and FY2021-FY2023 investment activity declines reflecting both lower levels of
construction activity in hotel plant and the major public sector projects coming to a close.
254. Figure 46 also indicates that both government and private final expenditures have
a lesser impact on GDP growth. There is a boost to household consumption in the early
period through FY2020 and in the steady state it plays a significant role. Government
consumption while included in the Figure is barely visible and reflects the current policy
position to hold the real level of government constant in real terms. The MFFF indicates
that government will decline as a share of GDP from 38 percent in FY2015 to 31 percent
in FY2030.
255. The impact of the growth in the economy and tourism industry on the distribution
of income is indicated in Figure 48. The share of wages in the economy declines by
nearly 5 percent during the period and reflects the same trends discussed in Chapter 1.
With much of the benefits of the growth in visitors accruing to the owners of tourism activities, the returns to labor are constrained and reflect the model assumption of productivity growth equivalent to the historical average for the private sector of 0.9 percent. As
the share of wages declines, the MFFF suggests that real wages are likely to remain unchanged during the period. These results have important implications. While the owners
of capital will do well out of the bourgeoning tourism industry, the majority of Palauans
do not benefit in this growth and one can expect the trends in migration to continue.
256. The baseline projection for the economy is shown in Figure 31, with growth rates
of visitor arrivals and overall GDP. After strong growth between FY2010 and FY2012,
the rate of growth is anticipated to slow over the medium term. While FY2013 was a
poor year for Palau, the economy is expected to return to positive growth in FY2014 of
Share of wages in GDP
Real wage
55%
11,000
53%
51%
FY15
50.4%
Average 0.1 percent
projected increase in real
wages per annum
47%
Figure 48
10,600
FY30
10,327
49%
45%
10,800
FY15
10,194
FY30
46.6%
10,400
10,200
10,000
Distribution of Income: share of wages in DGP and real wages growth
The Medium Term Economic Outlook
101
2.3 percent and experience strong growth in FY2015 of 5.1 percent. The outlook for the
two outer years FY2016 and FY2017 remains favorable. While the dominant force in the
baseline scenario is the anticipated rate of tourism growth, construction activity is also an
important driver.
3. FISCAL PROJECTIONS
257. Figure 49 indicate the major trends in the fiscal position over the 15 year projected period. Both revenues and expenditures (expense plus non-financial assets) decline. In FY2015 the government is projected to operate a 4.5 percent surplus. This follows on from the large surplus of 3.4 percent achieved in FY2014. Large increase in visitors generate a favorable revenue response. However, following from this position revenues as a share of GDP declines, reflecting an out dated tax and inefficient tax system
and the receipt of large share of revenues which are fixed in nominal terms, namely Compact grants and drawdowns from the Compact Trust Fund. Expenditures are also expected to decline as a share of GDP, reflecting the current policy position of government,
but not as rapidly as revenues. Outlays on wages and goods and services are projected to
be held constant in real terms (declining as a share of GDP) but subsidies and transfers
are set to increase. The need to subsidize water and sewer operations holds up the decline
in expenditures in in the near term and the collapse of the civil service pension scheme in
FY2024 requires large government transfers thereafter.
258. Revenues: On the revenue side, each major tax is projected according to an estimate of the tax base. Personal taxes (wage and salary tax) are projected based on a projection of the total compensation of employees for the economy plus an adjustment for
tax buoyancy of 1.25, although buoyancy in relation to GDP is only 0.58 reflecting the
declining share of wages in relation to GDP. The GRT projection is based on current
Expenditures
Revenues
45%
Fiscal surplus in FY 15 = 4.5% GDP
40%
35%
30%
25%
Fiscal Deficit in FY 30 = 1.6% GDP
20%
Figure 49
Revenues and expenditures percent GDP
102
RoP Economic Review—FY2014
price GDP projections for private sector activities plus a buoyancy ratio of 1.38. While
the GRT is a highly distortionary tax it is a buoyant tax. Similar customs taxes are projected in relation to import demand from the GDP(E) projections. Imports are highly inelastic with a buoyancy ratio of only 0.46. Export taxes are assumed to disappear with the
commencement of the marine sanctuary in FY2016. The other major tax is the departure
tax, including green fee, which is projected in relation to visitor arrivals and GDP growth
(for nationals). Taxes revenues decline as a share of GDP from 19.5 percent in FY2015 to
18.2 percent in FY2030 reflecting the outmoded regime
259. Government grants are composed of current and capital, Compact related and
third-country grants. It has been assumed that the renewed Compact comes into force in
FY2016 and that current grants follow the agreed schedule. For Compact capital grants it
is assumed the grants will be dispersed over time generate a smooth impact on the economy rather than being released all at once. Other non-Compact grants including Federal
programs are assume fixed in nominal terms. Grants decline rapidly from 16.5 to 7.8 percent of GDP, reflecting that they are projected to decline in nominal terms. Other non-tax
domestic revenues include fishing royalties, which are inflation adjusted. However, in the
base scenario it is assumed fishing royalties decline with the establishment of the marine
sanctuary to half the projected level. Other domestic revenues are projected to decline
from 6.6 to 3.3 percent of GDP. Overall as Figure 49 indicates revenues decline significantly as a share of GDP reflecting the lack of buoyancy in the tax system and decline
feature of grants.
260. Expenditures: On the expense side of the equation, compensation of government
employees is projected as an estimate of the change in employment and trend in wage increases. Employment in government is projected to remain unchanged despite the 1.4
percent decline in recent years. Wage rates are projected to rise by an average of 3.2 percent reflecting an annual wage drift of 1.9 percent and gifting of periodic COLA. The result is the government’s total wage bill is projected to decline from 11.4 percent of GDP
to 8.7 percent over the period. Use of goods and services has been projected by component. Most items are forecasted as moving averages, reflecting the static nature of the
component. Several items have shown more rapid growth, and these have been projected
on trend. Use of goods and service is projected to decline in relation of GDP from 9.4 to
7.1 percent.
261. Subsidies to public enterprises include a rising level to PPUC assuming that water
and sewer rates are not raised to full cost recovery level. It has not been assumed the government pays the FY2016 proposed subsidy to PPUC on account of electricity bills of
low income earners. Transfers to the state government are projected on trend while transfer to government agencies are projected as moving averages and thus assumed to be constant in nominal terms. As indicated it is assumed the Civil Service Pension Scheme investments are depleted by FY2024 and thereafter government is required to make up the
shortfall. Other transfers to households and NGOs are projected on trend. Unlike other
The Medium Term Economic Outlook
103
components of expense subsidies, transfers and other expense is projected to holds it’s
share of GDP.
262. Outlays on non-financial assets (gross fixed capital formation) are set equal to the
total level of capital grants. An allowance for investment in the KASP infrastructure project is included as per project documents. The government is assume to maintain a constant debt to GDP ratio of 10 percent and that new funds are used for infrastructure projects. Given the declining level of capital grants outlays on infrastructure are projected to
decline as a share of GDP over time.
263. Financing: On the financing side, drawdowns of the KASP loan have been built
in, together with scheduled debt repayment, and new borrowing to maintain the 10 percent external debt to GDP ratio. The government is assumed to set aside 2 percent of domestic revenues as per budgeted allocation to establish a revenue reserve fund to help
smooth irregularities in cash flow, unforeseen needs and to support cyclical downturns.
The residual on the fiscal account is assumed to be drawdown of domestic deposits. In reality perpetual running of chronic deficits such as in the base scenario are not possible the
government would be forced into fiscal adjustment.
264. The overall balance is shown as a declining trend in relations to GDP in Figure
50. The result indicates the fiscal challenges facing Palau based on the current policy scenario. Tax revenues are weak and lack buoyancy, and grants are fixed in nominal terms.
While fiscal policy is conservative and assumed to maintain the real level of outlays (declining as a percent of GDP), this is insufficient to offset the weak revenue position. The
projected increases in subsidies and transfers to SOEs and the Pension Fund have as
strong impact on the overall outcome. Clearly the result begs the need for policy reform.
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
-1.0%
-2.0%
Figure 50
Overall fiscal deficit percent GDP
104
RoP Economic Review—FY2014
265. Before departing this section a projection is provided of the COFA Trust Fund in
Figure 51 on the assumption of no market risk and that a market real rate of return of 5.4
percent is achieved. The COFA fund increases through the renewed Compact and attains
a value of $256 million in FY2024 compared with a projected value of $205 million at
the end of FY2015. Once the drawdown phase in FY2024 has commenced the fund is
projected to grow slowly in real terms attaining a value of $267 million by the end
FY2030. While this suggests the fund may support a perpetual fund yielding a fixed nominal drawdown, it also suggests that this outcome is fragile should the market perform
less than the historical average. Table 11 indicates the level of risk while Figure 42 indicates that at the 75 percent percentile the CTF can be expected to maintain its real value.
This suggests that a prudential distribution policy would withdraw less than the agreed
rate of $15 million per annum so as not to pass on the risk of fund depletion to future
generations.
4. BALANCE OF PAYMENTS
266. The balance of payments is a less critical component of the economic system in
Palau than in economies with their own currency. Using the U.S. dollar insulates the
economy from the need to take balance of payments protective action. Adopting somebody else’s currency removes monetary policy as a tool of adjustment and focuses adjustment strategy squarely on fiscal policy. While the GDP, household and fiscal accounts
have been modeled with care and attempt to capture the underlying transactions, the
transactions in the BoP are subject to a higher degree of error and require further investigation. With that said the MFFF has included the balance of payments and monetary accounts not only for completeness, but also as several important variables are derived from
these accounts.
CTF Value (FY15 Prices)
$300
$250
FY24
$256
$200
$150
FY15
$205
$100
$50
$0
Figure 51
Projected value of the CTF in constant prices, FY15
FY30
$267
The Medium Term Economic Outlook
105
267. Figure 52 indicates trends in the current account balances of the balance of payments. The goods and services account is projected to improve and reflects that the
growth in tourism outweighs the growth in imports. The demand for imports is projected
into three major categories: food, fuel and general imports. Food imports are linked to
household incomes with a low income elasticity. Similarly fuel imports are considered
inelastic although more elastic than food, but are linked to GDP growth. General imports
are more elastic and also linked to GDP. The MFFF indicates that imports decline as a
proportion of GDP over time. The assumptions relating to the elasticities require further
investigation although the values are consistent with overall balance in the GDP and BoP
accounts.
268. The two major items on the primary income account are foreign investment dividend out flows and earnings on social security investments. The former grow strongly
with the expansion of foreign investment in the tourism industry. The social security fund
is projected on an improving trend, but is insufficient to outperform the foreign investment outflows and the primary income account deteriorates. For secondary incomes the
major items are grants, tourist departure taxes, and foreign labor remittances. The three
items offset each other and net secondary incomes decline modestly.
269. The capital account (comprised of overseas grants) remains largely unchanged
through the cycle, although there is an upturn as the renewed Compact capital grants are
drawn upon for a short period. On the finance account the major items include FDI, portfolio investments of the social security funds, and external assets of the commercial
banks. Net borrowing of the public sector is relatively minor. Despite the growth in FDI
there is significant buildup in external assets of the banks and SS and overall there is
trend outflow on the finance account.
150.0
Secondary incomes
100.0
50.0
Primary incomes
0.0
-50.0
Goods and Services
-100.0
Figure 52
Balance on goods and service, primary and secondary incomes
106
RoP Economic Review—FY2014
270. Overall the error and omissions on the balance of payments remains within tolerable limits of less than 5 percent of total goods and services. In the initial period through
FY2020 when there is considerable investment activity the errors and omissions trends in
a positive direction. However, from that point forward the trend turns negative. The overall results indicate the BoP projections require further elaboration during different phases
on the cycle, but also indicate the inherent weaknesses in framework which does not include internal macro consistency.
5. THE BANKING SURVEY
271. The projected banking survey relies on a few basic assumptions. Deposit growth
is dependent on current GDP growth, and is projected to grow during the period as the
economy expands. Lending on the other hand while linked to household incomes for consumer credit and GDP for commercial credit expands only slowly and reflects the reluctance of the banking sector to lend in Palau with many structural impediments. The result
is continuing growth in liquidity, which the banks use as a source of funds for offshore
lending. The result is rising trend in foreign assets largely mirroring the growth in the deposit base.
800
700
600
Deposits
500
Foreign Assets
400
300
200
100
Lending
0
Figure 53
Monetary projections, FY2015-FY2030
The Medium Term Economic Outlook
B.
272.




107
A Reform Scenario
The reform scenario is based on the following set of policies:
A transfer equivalent to $5 million is transferred annual to Civil Service Pension
Fund.
All subsidies are removed on water and sewer charges. PPUC operates at full
cost recovery.
In FY2025 the drawdown from the COFA Trust Fund is reduced to establish a
perpetual fund yielding a real sustainable yield.
The tax reform proposal is implemented.
273. For water and sewer charges of the PPUC, it is assumed the full cost recover is
charged to users including depreciation. Clearly, this has an unambiguously positive impact on the fiscus (see Table 12 below).
274. In order to avoid collapse of the CSPF an annual payment equivalent to $5 million, inflation adjusted thereafter, is transferred to the Fund. The projections show that the
Fund Status steadily improves thereafter. However, the fund collapses by FY2040 if the
transfer is reduced to $4 million. In reality it is possible that adjustment measures can be
implemented to share the burden more equitably between pensioners and tax payers. Table 12 indicates that while there is a charge to the fiscus through FY2023, thereafter the
result shifts to a positive gain. The transfer of funds to the CSPS avoids fund collapse and
the need for government to fully fund pensions after FY2024.
275. In the case of the COFA Trust Fund, it is assumed that the drawdown is reduced
in FY2025 to a rate that allows for the establishment of a perpetual fund that will provide
fully inflated distributions thereafter. Based on the simulations conducted in Chapter 3,
the rate of drawdown is reduced from $15 million to $10.4 million. Table 12 indicates
that the cost of moving from a fixed nominal drawdown to a fully indexed rate falls by
FY2030. Projecting out further reveals that this cost has been totally eliminated by
FY2040 (not shown in Table 12). The policy to reduce the rate of drawdown in FY2025
in effect shares the burden of adjustment more equitably between current and future generations.
Table 12
Comparison of baseline with alterative scenarios on the fiscal balance
S's millions
Water & sewer subsidy
Civil service pension fund
COFA Trust Fund
Tax Reform (rev neutral)
Tax Reform (VAT + 2%)
Reform Scenario
FY17
0.8
-5.0
0.0
0.0
0.0
-4.2
FY18
1.6
-5.1
0.0
0.0
0.0
-3.5
FY19
2.6
-5.2
0.0
0.0
0.0
-2.6
FY20
4.1
-5.4
0.0
0.0
0.0
-1.3
FY21
4.4
-5.5
0.0
0.2
0.2
-0.9
FY22
4.4
-5.6
0.0
0.5
0.5
-0.7
FY23
4.5
-5.8
0.0
0.8
0.8
-0.5
FY24
4.5
0.9
0.0
1.0
1.0
6.4
FY25
4.6
1.5
-4.5
1.1
4.6
6.2
FY30
4.8
3.5
-3.2
2.7
7.2
12.4
108
RoP Economic Review—FY2014
276. The tax reform scenario entails a series of reforms that were considered by the
OEK while the program was active. The major elements were:







Elimination of the GRT
Replacement with a revenue neutral VAT
Implementation of a net profits tax of 12 percent (equal to the marginal rate of
personal taxation)
Business below the VAT threshold to continue to pay the GRT
Implementation of a tax free allowance for the first $4,000 for Palauans, to offset
the regressive impact of the VAT
Provision of an allowance for pensioners
Various other minor adjustments.
277. The implementation of the tax reforms is assumed to take place in FY2019 two
years after the next election and designed to be revenue neutral with no impact on the
fiscus. However, given the more efficient nature and buoyancy of the tax reforms there is
a positive impact in the following years. In the second tax reform row in Table 12 the rate
of VAT is raised by 1 percent in FY2025 to compensate for the loss in revenue from the
reduction in COFA Trust Fund drawdowns.
278. Figure 54 indicates the combined impact of the reforms on the fiscal deficit both
overall and compared with the baseline. The projected fiscal position falls from the high
expected in FY2015 of 4.5 percent to a balanced position in FY2025. From this point on
the fiscal outturn improves and rises to over 1 percent of GDP by FY2030. The Figure
also indicates the impact of the reforms compared with the baseline. The reforms incur an
5.0%
4.0%
3.0%
2.0%
1.0%
Fiscal Surplus
Impact of reforms
0.0%
-1.0%
-2.0%
Figure 54
Impact of the reform scenario on the fiscus, percent GDP
The Medium Term Economic Outlook
109
additional cost in the near-term as it is necessary to shore up the CSPF. However, in the
early years with the recent booming tourism industry there is more scope for the fiscus to
bear the cost. As time progresses the impact of the reforms becomes stronger and enables
the deficit projected in Figure 50 to turn positive. The cost of the reforms is born more on
the current generations with the benefits falling into the future as the COFA Trust Fund is
turned into a perpetual fund and rewards from the tax reforms are realized.
C.
The Tourism Scenario
279. Palau has benefited from strong tourism growth during the last 15 years. The recent explosive growth in tourists from China and similar experiences in other tourist host
nations suggest the potential for future developments is unbounded. Recent analysis1 has
suggested that future growth of 4.9 percent could be expected in the Asian region. In the
tourism scenario the impact of this rate of growth is explored. A total of 500,000 visitors
could be expected by FY2030, 3 times the current level and one visitor for every resident.
A total tourist plant of 4,500 rooms could be anticipated (present stock is 1,500). Figure
55 indicates both the growth in visitors and GDP. From a baseline steady state rate of
GDP growth of 1.8 percent, the tourism scenario suggests GDP growth would reach 3.4
percent in the long-term. On the fiscal side on current policy, a surplus of 4 percent of
GDP could be expected in the long-term. While Palau’s long-term structural deficit disappears, it is likely that the tourism holding capacity will be way surpassed with adverse
environmental degradation. While this scenario is not presented as a probable outcome, it
begs the need for development of a well-articulated tourism policy, regulations and land
development policy.
12.0%
600,000
10.0%
500,000
8.0%
GDP growth
Tourist arrivals
400,000
6.0%
300,000
4.0%
200,000
2.0%
100,000
0.0%
0
Figure 55
Tourism scenario: visitor arrivals and GDP growth
1 Lakshman Ratnapala, Asia to Drive Strong Growth in Global Tourism, Inter Press Service, 7/30/2015
APPENDIX 1 TECHNICAL NOTES TO THE CTF SIMULATIONS
MARKET FINANCIAL DATA AND SIMULATIONS
280. The simulations under taken in this Review are based on statistical estimates derived
from historical financial data. The data used was downloaded from the Global Financial Date
Corp on-line database. The following series have been utilized:
4.
5.
6.
7.
8.
9.
S&P 500 Total Return Index (w/GFD extension)
GFD World x/USA Return Index
GFD Emerging Markets Return Index
USA 10-year Government Bond Total Return Index
Dow Jones Corporate Bond Return Index
GFD World x/USA USD TR Government Bond Index
35%
25%
5%
15%
10%
10%
281. The data series covers the period 1926-2014 and approximates the portfolio used in the
RoP. The weights in the portfolio of the respective series are indicated on the right. It was not
considered appropriate to attempt to exactly replicate the current portfolio as the investment
strategy deployed varies over time. The simulations undertaken are designed to incorporate the
risk inherent in the adoption of a Trust Fund approach to funding Compact distributions relying
on international financial markets as the investment vehicle. As indicated in the CTF Chapter
there is considerable variation in outturn and while the intent is to provide the most realistic projections possible, they remain indicative and designed to guide policy rather than to provide any
kind of definitive forecast.
282. The simulations were programmed using Oracle Crystal Ball software that is designed to
enable Monte Carlo simulations in an Excel spreadsheet environment. The software is easy to
use and coupled with Excel provides an excellent environment for the type of exercise conducted
here. For each time series a log-normal distribution has been fitted to derive estimates of the
mean, standard deviation and co-variances. Estimates of auto-correlations were also made. But
Table A1
Financial Data Statistical Estimates of Means, Standard Deviations, and Correlations
S&P 500
Total
Return
Index
(w/GFD
extension)
Mean
1.091
Standard deviation
0.199
Correlation Matrix
S&P 500 Total Return Index (w/GFD extension)
1.0000
GFD World x/USA Return Index
0.4442
GFD Emerging Markets Return Index
0.3040
USA 10-year Government Bond Total Return Index -0.1023
Dow Jones Corporate Bond Return Index
0.2821
GFD World x/USA USD TR Government Bond Index 0.1205
GFD World
x/USA
Return
Index
GFD
Emerging
Markets
Return
Index
USA 10-year
Government
Bond Total
Return Index
Dow Jones
Corporate
Bond
Return
Index
GFD World
x/USA USD TR
Government
Bond Index
1.074
0.215
1.090
0.237
1.029
0.086
1.044
0.087
1.029
0.116
1.0000
0.6205
-0.1761
0.1311
0.3784
1.0000
-0.0910
0.2380
0.2711
1.0000
0.6617
0.3923
1.0000
0.5599
1.0000
110
Appendix 1: Technical Notes to the CTF Simulations
111
accept in the case of the Dow Jones bond index and GFD World bond index was not found to be
significantly auto-correlated. Table A1 provides a list of the statistical estimates that were used.
SPECIFICATION OF THE MOVING ADJUSTMENT AND SAFER RULES
a
Definitions
Actual CTF value in period (t).
CTF moving average
Primary Target fund estimate
Sustainability adjusted primary target fund estimate
Ratio of CTF_MA(t) (t) to PTS(t)
Long-run historical real geometric yield on portfolio
Target distribution in period (t)
Sustainability target adjusted distribution
Distribution in period (t)
Ratio of D(t) to DS(t)
Percent change in U.S. GDP deflator
The sustainability adjustor
Annual Decrement
Annual increment
Venting increment
CTF(t)
CTF_MA(t)
PT(t)
PTS(t)
RC(t)
Y
TarD(t)
DS(t)
D(t)
RD(t)
GDP_Df(t)
sus
dec
inc
Vent
5 year MA adopted
sim value 0.67
sim value 0.05
sim value 0.02
sim value 0.05
Starting the specification with establishing a few important benchmarks; the target drawdown is
defined to be the inflation adjusted Compact agreed drawdown level in FY2025 of $15 million.
This is adjusted for inflation in subsequent periods:
TarD(FY25) =
TarD(t)
=
15
TarD(t-1) * (1 + GDP_Df(t-1)) for t > FY25
(1)
(2)
The Primary Target is defined as the target drawdown divided by the long-run real geometric investment yield:
PT(t)
=
TarD(t) / Y
(3)
b The Sustainability Rule
In the case of the Sustainability rule, the target sustainable adjusted drawdown in FY2025 is defined as the CTF corpus value in FY2024 times the long-run real geometric investment yield,
discounted by the sustainability adjustor to guard against market risk. The sustainability adjustor
is estimated from simulations to provide an acceptable degree of market risk. In Chapter 3 this
was estimated at 67 percent.
DS(FY25)
=
CTF(FY24) * Y * 1/(1+sus)
(4)
Over time the target sustainability adjusted distribution is inflation adjusted by the U.S. GDP deflator.
DS(t)
=
DS(t-1) * (1 + GDP_Df(t-1))
(5)
112
RoP Economic Review—FY2014
The sustainability adjusted primary target is defined as:
PTS(t)
=
DS(t) / Y
(6)
Under the sustainability rule the actual drawdown is set equal to the target sustainable adjusted
drawdown.
D(t)
=
c
DS(t)
(7)
The Moving Adjustment Rule
In year FY25 the drawdown is equal to the target sustainable adjusted drawdown
D(FY25)
=
DS(FY25)
(8)
Downside adjustment: a decrement of the previous year’s distribution is made if a five year
moving average of the CTF value falls below the sustainability adjusted Primary Target. Decrement continues until the reduction in distribution exceeds the shortfall (the ratio of the actual
moving average CTF value to the sustainability adjusted Primary Target). At this point an increment can be made. Adjustment is thus asymmetric: on the downside adjustment is more rapid
and on the upswing adjustment is slower to allow the CTF to return more rapidly to the sustainability adjusted Primary Target. On the upside when the CTF value exceeds the sustainability adjusted Primary Target adjustment halts (unless the five year moving average of the CTF value is
more than twice the sustainability adjusted Primary Target—see below). These adjustment mechanisms are specified as follows:
Indicator of Fund performance RC(t) is given by:
RC(t)
=
CTF_MA(t) / PTS(t)
(9)
Drawdown as a proportion of the sustainable drawdown is given by
RD(t)
=
D(t) / DS(t)
(10)
Drawdown in years greater than FY2025 is given by:
When RC(t) < RD(t-1)
D(t)
=
D(t-1) * (1-dec)
(11)
D(t-1)
(12)
When RC(t) = RD(t-1)
D(t)
=
When RC(t) > RD(t-1) and provided RD(t-1) * (1+inc) < 1
D(t)
=
D(t-1) * (1+inc)
When RC(t) > RD(t-1) and RD(t-1) * (1+inc) >= 1
(13)
Appendix 1: Technical Notes to the CTF Simulations
D(t)
=
DS(t)
113
(14)
Upside adjustment: a increment of the previous year’s distribution is allowed if a five year moving average of the CTF value rises above twice the sustainability adjusted Primary Target, and
provided the distribution does not exceed the inflation adjusted COFA level of $15 million.
D(t)
=
D(t-1) * (1 + Vent)
(15)
APPENDIX 2 THE MACROECONOMIC FISCAL FORECASTING
FRAMEWORK PROJECTION METHODOLOGY
1.
This appendix provides a description of the projection methodology of the MFFF to enhance understanding of the MFFF 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 are related to
each other, and rely on simple projection techniques that can be modeled in spreadsheets. 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 important 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 include:




trend, either linear, exponential or growth factor,
constant or moving average,
exogenous, based on policy variables or known factors such as project implementation,
investment intentions, etc., and
endogenous, linked to other economic variables in the system.
1. PRODUCTION AND GDP
283. 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.
ii.
iii.
Production for home consumption: Subsistence or household non-marketed production
including ownership of dwellings are projected in relation 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.
Non-traded 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, IT, financial intermediation, commercial real estate, administrative support services, and other private services.
Tourism: tourism services are estimated on a sub-model related to the plant installed and
different market segments. Total hotel rooms are projected based on the current stock
plus known construction projects in the pipeline and an estimated 2.5 percent long-run
growth projection. Actual growth in visitors has been over 4 percent since FY2004.
While the 2.5 percent projection is conservative, a more active tourism policy is described in one to the scenarios. This assume tourism grows at 4.9 percent basd on projections of the Asian tourism market. Palau’s traditional markets, Japan, Korea, U.S.A., and
Europe have been projected on long-run trends. The residual is assumed to be taken up by
114
Appendix 2: The Macroeconomic Fiscal Forecasting Framework Projection Methodology
115
the PRC. In recent times tourism growth has been dominated by PRC visitors filling up
all available space. Given the lack of an effective regulatory environment this trend is
seen as likely to continue despite Palau’s policy to adopt a “high” value marketing strategy.
iv.
v.
vi.
vii.
In the GDP projections tourism is comprised of the hotel and restaurant sector, diving and
water based tours, airport operations, travel agents, airline operations, and the rock island
state park. Based on the visitor arrival projections and average spending patterns derived
from a recent tourism exit survey, projections are made for the various sub-sectors of the
tourism industry. This allows for the impact of changes in country composition (and the
recent switch to the lower end package tour market) to flow though into the projections.
Construction: Current price forecasts are made for government projects (linked to the
GFS projections), hotel projects (linked to the tourism sub-model), the ADB Koror and
Airai Sanitation Project, and renewed Compact infrastructure grants. These are deflated
by an index of construction costs. Residual private sector construction is estimated
through a 3 year lagged accelerator principle.
Government services: Government non-marketed production is considered a policy variable and projected exogenously. While the trend has been for a reduction in payroll numbers, the projections have been based on a policy to maintain the real level of government
services. There is thus an in-built assumption for government expenditures to decline as a
proportion of GDP. Current price projections for government services utilize the wage
projections in the MFFF (see below).
NPISH: Non-profit institutions serving households, and various other minor activities
has been projected as moving averages.
Taxes less subsidies on imports and products: taxes on products have been projected in
relation to the tax base: import taxes are estimated in relation to aggregate 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 (SOE)s
have received only minor subsidies in Palau which have been projected in relation to the
growth in the utilities sector.
2. PRICE AND WAGE PROJECTIONS
284. Model prices are projected exogenously on the basis of the “small country assumption”.
While this is a simplifying assumptions and non-traded goods prices would be domestically determined, it is not unrealistic to endogenize prices given the very small size of Palau. Consumer
prices are taken from the CBO (Congressional Budget Office) long-term forecasts of the US CPI
as a proxy for Palau’s CPI. Projections of the US GDP deflator are taken from World Bank projections. In the case of commodity prices the World Bank provides a very handy set of projections for the major commodities effecting Palau: food, fuel, and coconut oil. Fish prices are decomposed into long-line Sashimi grade fish, and Purse Seine Skip Jack prices. Projections are
made based on long-term trends which have been rising over the last 10 years.
285. 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. For government wages an “add-
116
RoP Economic Review—FY2014
factor” is included as a policy variable depending whether government issues a “COLA”. In
FY2016 (an election year) a COLA of 3.9 percent is incorporated equivalent to an additional $25
for each employee per pay period. In other years an average of 1 percent has been included. In a
more comprehensive 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 to indicate likely trends.
3. GDP AT CURRENT PRICES AND THE GENERATION OF INCOME ACCOUNT
286. The projection of GDP at current prices is a relatively straight forward affair with the
change in GDP at constant prices being indexed to the respective price or wage indicator. In general the constant price traded goods industries of the economy are inflated by the appropriate
world price. For private sector non-traded goods the CPI (US) is used. In the case of general government the constant price series are 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 account. The total of all industrial production and taxes less
subsidies on imports and products provides the estimate of GDP at purchaser’s values.
287. The generation of income account is the allocation of value added between compensation
of employees, operating surplus, and taxes less subsidies on imports and products. An estimate
of compensation of employees is made by industry through multiplication of the prior period
compensation estimate by the increase in industry constant price GDP and the respective wage
index. An economy wide estimate of productivity is applied equally to all private sector activities. The model thus implicitly assumes fixed factor proportions and allows for no factor substitution. Estimates of operating 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 accuracy, and may be ignored for practical modeling purposes.
4. THE HOUSEHOLD SECTOR ACCOUNT
288. We are now in a position to bring together the various components of the household sector account and move towards estimating household disposable income. Household income is
generated from a series of value added components: compensation of employees from domestic
production, plus a small amount of compensation accrued to workers at foreign missions, 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. Compensation of workers at foreign missions is projected in line with current price GDP. Withdrawals
from quasi corporate enterprises is estimated from the operating surplus derived in the generation
of income account. A deduction is made for the returns due to foreign ownership by industry and
deprecation.
289. Turning to primary incomes, households receive interest on savings and time deposits,
and make payments on loans. They also receive rent from foreign owners of capital in proportion
to ownership. Rent payments are also made to Koror state. On the secondary distribution of income account there are major receipts and payments to the social security administration. Social
security payments are projected to grow in line with the growth in compensation of employees.
Appendix 2: The Macroeconomic Fiscal Forecasting Framework Projection Methodology
117
Social security benefits are based on the actuarial report provided to the SS Administration. Similarly contributions to Civil Service Pension Scheme are based on growth in government compensation of employees, while benefits are projected on the trend growth. These projections indicate that the CSPS will collapse in FY2024 at which time benefits are linked to the annual contributions. 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 are received from
Pell grants and are projected as a moving average. Households receive certain remittances from
the rest of the world which are derived from the BoP. Significant outward remittances are transferred by foreign labor working in the economy; again estimated in the BoP.
290. Adding up all the transaction enables an estimate of total household disposable income,
which is either saved in fixed proportion to income (based on historical behavior) 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
291. The GDE account is built from a mixture of current and constant prices and then either
deflated or inflation to derive the corresponding series. Government final consumption expenditure is derived from the fiscal accounts and is the sum of compensation of employees, use of
goods and services less sales. Each item has a direct counterpart in the fiscal account. Compensation is deflated by government wage increases, use of goods and services by a cost index of the
CPI plus World Bank manufacturing unit value index. Sales are deflated by the CPI. General
government is comprised of the national government, state governments and agencies. The fiscal
account relates to the national government alone and is used as the driver for the GDE estimates.
While the national government is responsible for 67 percent of general government final consumption expenditures, the simplification in the MFFF could be improved through including an
account for Koror state, which is becoming increasingly important with growth in the tourism
industry.
292. Household final consumption expenditure is composed of three elements: household 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. Estimates for ownership of dwellings and other items produced for own consumption are indexed to population growth. The current price series are derived through inflation by the respective elements of the CPI. The estimation of consumption of
Non Profit Institutions Serving Households (NPISH) is driven by the growth in the NPISH sector
GDP growth in current and constant prices.
293. Gross Fixed Capital Formation (GFCF) is decomposed into construction and other
(mainly equipment). The construction component is indexed to the GDP current and constant
price series. The constant price equipment series is also driven by the growth in construction activity, while the current price series is inflated by a cost 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 projected.
294. Current price estimates of imports and exports are linked to the BoP estimates (see below) and grouped into major categories. Exports are grouped into re-exports (mainly fuel),
118
RoP Economic Review—FY2014
goods, services, tourism and foreign missions. Imports are grouped into food, fuel, other manufactures and services. The constant price series are deflated by the appropriate price index.
295. The estimates of GDP(E) are now possible though adding up all the components of the
account. Aggregate demand is considered to be the sum of final consumption plus gross capital
formation plus exports.
6. THE FISCAL ACCOUNT AND EXTERNAL DEBT
296. The fiscal projections are based on two different sets of assumptions: (i) revenues are
driven by developments in the economy plus known levels of Compact receipts, and (ii) expenditures are projected on the basis of the current policy position. Taxes are projected based on rates
of growth of the respective tax base, plus estimates of the buoyancy of each tax. Income taxes
(wages tax) are projected in line with the total change in compensation of employees and a tax
buoyancy ratio of 1.26 percent. The gross receipts tax is projected in line with selected elements
of GDE on which the GRT is levied and a buoyancy ratio of 1.38 percent. The MFFF does not
model the gross output of industries directly so a proxy is used to project the tax base. Import
taxes are indexed to the cash components of GDP and buoyancy ratio of 0.46. The hotel occupancy tax is related to the growth in current price GDP estimates of hotels. Fish export taxes are
related to the projected activity of the fish support service industry; the tax is collected on a
quantity basis. Other taxes (airport departure taxes) are pegged to the projected number of visitor
arrivals.
297. The MFFF allows for the implementation of the tax reform proposal that was under consideration by the OEK in FY2014, but is now off the agenda. The proposal allows for the introduction of a VAT, a net profit tax, removal of the GRT on large businesses, and the import tax
on general merchandise. The reforms also allowed for an offset to the regressive nature of the
VAT with a reduction in the wages tax for low income households, and an increase in pensions.
298. Receipt of Compact funds can be based on either of two assumptions depending on
whether the renewed Compact is implemented. On a continuing appropriations basis Palau receives $13.147 million per annum and this nominal level is projected through FY2024 and withdrawals of $5 million per annum from the COFA Trust Fund. If and when the Compact is renewed the MFFF reflects the terms of the new arrangements. In the base case this is assumed to
occur in FY2016, although on recent performance this is unlikely. Federal programs and all other
country grants are projected as moving averages.
299. Nontax revenues comprise: fishing royalties, airport landing fees, administrative fees and
various minor items. Palau is expected to continue to benefit from the Parties to the Nauru
Agreement despite the possible implementation of the Marine sanctuary and royalties are assumed to increase from $6,000 to $8,000 a day in FY2015 and thereafter with inflation. The
MFFF allows for switching out this assumption to one where Palau is no longer a member of the
PNA. Airport landing fees are projected in line with visitor arrivals. Administrative fees are indexed to inflation and other minor revenues are projected as moving averages.
300. On the expenditure side, under the base scenario it is assumed that payroll numbers for
public administration, education and health remain unchanged. Wage rates are forecast to grow
Appendix 2: The Macroeconomic Fiscal Forecasting Framework Projection Methodology
119
on trend, at approximately 1.9 percent for the national government. An allowance is made for periodic award of a COLA, which is 3.9 percent in FY2015 and projected at 1 percent thereafter.
For goods and services, fiscal discipline has been assumed to be maintained with the majority of
components projected as constant in real terms but with an allowance for inflation in current
prices. In certain cases where there has been more rapid increases, medical supplies, communications and contractual services, items have been projected on trend.
301. Interest payments are derived from the external debt module. Subsidies to the SOE sector
are projected according to differing assumptions relating to recent corporatization of water and
sewer operations previously operated by government. It can be assumed that the new venture
will operate according to full cost recovery, or be subsidized by government. Transfers to extra
budgetary units are projected as a 5 year moving average, while transfers to state governments
are projected on trend. Other expense includes transfers to NGOs, households, students, and miscellaneous expense. Transfers to the NGOs and students are projected on trend, while other
transfers and expense are adjusted for inflation.
302. Capital expenditures are linked to capital grant disbursements, plus new projects funded
through external borrowing. On the financing account the major item is debt transactions which
are derived from the debt module. Domestic other accounts payable has been treated as the residual on the fiscal account.
303. Existing external debt service has been projected based on loan repayment schedules. The
national government is assumed to maintain a fixed external debt to GDP ratio to fund new projects: set at the historical average of 10 percent. After repaying existing debt obligations the national government is assumed to contract new borrowing to maintain the ratio. While there is no
indicator of government future needs for project financing, the historical rate provides an anchor
for future commitments. All new loans are assumed to be contracted on concessionary terms
such as the ADB. Unlike the IMFs external debt sustainability analysis, it is assumed Palau has
no recourse to international finance markets, and cannot fund a deficit through borrowing. Budgetary shortfalls must be adjusted to through fiscal re-alignment.
7. THE BALANCE OF PAYMENTS
304. Palau has a very limited range of exports of goods with fuel re-exports to airplanes being
the major item. This is linked to the growth in visitor arrivals and price of fuel. Other exports are
small and projected as moving averages. In the case of imports there are 3 major categories:
food, fuel and other manufactures. Food imports are projected in relation to household real incomes times a world price index of food, and allowance for a low income elasticity of 0.5. Fuel
imports are projected in relation to real expenditures times the projected fuel price and an income
elasticity of 0.65. Other imports are similarly projected with an income elasticity of 0.8. In the
case of exports of services, tourism is the major item and is projected based on the tourism module and the CPI. All other service exports are projected as moving averages. Imports of services
are projected on a variety of bases depending on the item. Personal travel and passenger services
are the two major components and are projected in relation to the cash component of real GDP
plus an allowance for inflation.
305. In the case of primary income flows most inflows are minor with the exception of fishing
royalties which is based on changes in the Vessel Day Scheme price plus allowance in the longer
120
RoP Economic Review—FY2014
term of inflation. Interest receipts of the Social Security Fund are derived from projections of the
Fund, while the civil service fund is projected to collapse. In the case of primary income payments the major item is dividend outflows, which is related to the operating surplus of foreign
companies estimated in the generation of income account.
306. Secondary income flows are dominated by grants and are consistent with the fiscal account. Drawdowns from the COFA Trust Fund are treated as part of secondary income as the
COFA Fund is treated as a non-resident international unit. Revenues from the $50 departure tax
are included as part of secondary incomes in the BoP and linked to the projection of visitor arrivals. Household and NPISH receipts are minor, but household remittances outward are significant and reflect the large number of foreign workers in Palau. This is linked to household disposable income, but would preferably be derived from a labor market projection.
307. Capital account inflows are dominated by grants and linked to the fiscal account. Japanese grants in-kind are projected as a moving average. Turning to the finance account, FDI is
dominated by investment in the tourism industry and linked to new hotel construction. Net acquisitions of financial assets is comprised of changes in funds held by the Social Security Administration and Civil Servant Pension Scheme. The annual flows are derived from the finance submodule. Changes in commercial banks foreign assets are consistent with the banking survey
forecasts, and draw downs and repayments of the external debt are consistent with the external
debt projections.
8. THE BANKING SURVEY
308. Starting with the liability side, bank deposits by category (demand, savings, and time)
have been subdivided by institutional category. The major categories of demand deposits are
non-financial corporations and individuals. Both of these are projected in relation to nominal
GDP. In the case of savings accounts the same two sectors together with government are the major depositors. Again private sector accounts are projected in relation to nominal GDP while government savings deposits reflect the fiscal account balance. Time deposits are a minor category
in the banking survey in Palau, but again projected in relation to nominal GDP. The capital account has been projected as a constant ratio of demand deposits. On the asset side consumer
lending, the major category, is assumed to grow in line with increases in compensation of government employees, while commercial credit (one of lowest in the world) is projected in line
with nominal GDP. Foreign assets are treated as a residual.