IMF Staff Completes 2018 Article IV Mission to Republic of Palau

Economic growth in Palau is expected to have picked up moderately to 0.4 percent in FY2018 and is projected to increase further to 2 percent in FY2019.

The team welcomes the authorities’ plan to develop a medium-term fiscal framework and to implement a tax reform as a first pillar of the fiscal adjustment strategy.

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Palau can strengthen its growth potential through a comprehensive tourism strategy focused on high value and environmental sustainability and the closing of infrastructure gaps.

An International Monetary Fund (IMF) team, led by Ms. Yuko Kinoshita, visited Koror from October 25 to November 7 to conduct the 2018 Article IV Consultation. At the conclusion of the visit, Ms. Kinoshita issued the following statement:

“Economic growth in Palau declined by 3.7 percent in FY2017 because of a continuing downturn in tourism and subdued construction activities. Growth is expected to have picked up moderately to 0.4 percent in FY2018, as construction related to infrastructure projects has resumed. Growth is projected to increase further to 2 percent in FY2019, owing to a gradual pick-up in tourism and an increase in capital investment funded by the U.S. Compact grants that were recently ratified as part of a large package of financial assistance under the Compact Review Agreement.

“Overall risks to economic activity remain tilted to the downside. Domestic risks include a delayed fiscal adjustment based on a comprehensive tax reform that could risk fiscal sustainability in the medium run. Failure to implement the comprehensive high-value and sustainable tourism strategy could limit growth opportunities. Natural disasters, including those related to climate change, could weaken fiscal and external positions. External risks include weaker-than-expected global growth, including in the U.S. and China, a sharp tightening of global financial conditions, and further US dollar appreciation. Given the absence of monetary and exchange rate policies, Palau will need to rely on fiscal and structural policies should these risks materialize.

“Against this background, the IMF team’s policy recommendations focus on three main areas: (i) developing a medium-term fiscal framework to help manage fiscal challenges and risks stemming from declining grants, civil service pension fund and public enterprises, (ii) promoting resilient and sustainable growth; and (iii) preserving financial stability and integrity.

“The team recommends that the authorities develop a medium-term fiscal framework to prepare for the future challenges. While the prudent fiscal policy stance over the past years led to an improvement in the fiscal position, this is not sufficient to address upcoming challenges. The challenges include revenue risks related to Compact Trust Fund (CTF) return volatility, domestic revenue volatility, downside risks to future grants because of the country’s high-income status, and risks from contingent liabilities from the quasi-fiscal sectors.

“The team recommends further fiscal adjustment in the medium term to make room for scaled-up public investment and to build up fiscal buffers for stabilization purposes, while protecting social spending. Palau needs the high public investment to develop adequate infrastructure to raise potential growth. Palau also needs fiscal buffers to cushion against revenue volatility, declining grants and contingent liabilities. Palau’s social spending in health and education has been adequate by international standards but about 40 percent of health and education spending has been financed by foreign grants. Protecting social spending will become more important as grants decline over the medium-term.

“The team supports and welcomes the authorities’ plan to focus on a comprehensive tax reform as a first pillar of the fiscal adjustment strategy. The tax reform should aim to increase the efficiency and fairness of the tax system, and to mobilize domestic revenue, relying on measures including the introduction of the Goods and Services Tax (GST) with a single rate and the Net Profit Tax, in place of the existing Gross Revenue Tax (GRT) and import duties.

“Strengthening public financial management reforms will help prioritize expenditure. Given the authorities’ intention to finance capital projects through Public-Private Partnerships (PPPs), the team also recommends the authorities build adequate risk assessment expertise, including a legal and institutional framework to identify and monitor risks related to PPPs, while limiting overall exposure from PPPs. Integrating PPP projects within the budgetary process is also important for medium-term fiscal sustainability.

“Palau can strengthen growth potential by implementing a comprehensive tourism strategy on high-value and environmentally sustainable tourism, while filling in infrastructure gaps. While Palau’s economic growth rate has been volatile due to its strong reliance on tourism, there is room for greater geographical diversification of the source markets of tourists and the tourism locations and products within Palau, which would help reduce sectoral and macroeconomic volatility. The team supports the authorities’ efforts to adopt a broad strategy for sustainable tourism development, while protecting the environment and upgrading infrastructure to increase resilience to natural disasters and climate change.

“Palau’s banking system remains sound, with adequate liquidity, a low non-performing loans ratio, and stable returns on assets. But banks continue to lend little domestically despite the rapid rise in deposits. Staff recommends relaxing the interest rate ceiling for corporate loans to better reflect riskiness and helping small and medium size enterprises (SMEs) prepare business plans. The National Development Bank of Palau (NDBP) can also help fill the financing gap for SMEs and households in outer islands. The team supports the authorities’ continuing efforts to strengthen bank supervision and broaden supervision to non-bank financial institutions such as credit unions.

“The team encourages the authorities to continue to improve anti-money laundering and combating the financing of terrorism (AML/CFT) regime. The recent assessment in the Financial Action Task Force (FATF) standards highlights a number of areas for improvements in the AML/CFT framework. As the money laundering risks in Palau are related to foreign-originated financial flows rather than the domestically originated, more cooperation and exchange of information with foreign jurisdictions are needed. Against this background, cryptocurrency-related plans could pose significant financial integrity risks, among others, unless strong AML/CFT measures are implemented.

“The IMF team wishes to express its appreciation to the authorities and other stakeholders for frank discussions and constructive exchange of views on recent economic developments and the outlook, and economic reform progress and policy challenges.”

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