On April 23, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Republic of Palau.¹

After two years of strong expansion, growth is estimated at around zero in fiscal year 2013 (FY2013, ending in September) owing to declines in construction and tourism. Inflation moderated to 2¾ percent (annual average) in FY2013 thanks to stable international food and fuel prices, and it is expected to stay around 3 percent in FY2014. Growth is projected to increase to 1¾ percent in FY2014 and to 2¼–2½ percent over the medium term driven by the recovery in tourism and infrastructure developments. This modest outlook is subject to downside risks from financial market volatility and growth slowdown in Asia, a U.S. dollar appreciation, natural disasters, and the heavy reliance on food and fuel imports.

The current account deficit deteriorated slightly in FY2013 due to lower tourist arrivals and large reconstruction imports associated with typhoon Bopha, but tourism recovery and moderating food and fuel prices are expected to reduce the deficit in FY2014–15. After worsening slightly in FY2016–18 due to imports related to infrastructure projects, the deficit would narrow to 5½ percent of GDP over the medium term and remain fully funded by grants, loans, and FDI.

The current fiscal deficit excluding grants (fiscal anchor) is estimated to have remained unchanged at 12¼ percent of GDP in FY2013. Tax revenue continued to rise thanks to increases in tourism-related taxes, higher prices in the tourism industry, and improvement in tax compliance, but current spending was larger than budgeted due to natural disasters. In view of the authorities’ intention to contain spending and save additional revenue gains from the recent revenue measures, the current fiscal deficit excluding grants is projected to narrow by 1½ percent of GDP in FY2014, putting the fiscal consolidation back on track. In view of the expiration of Compact grants in FY2024, substantial fiscal adjustment over the medium term is needed to build adequate government deposits and to ensure long-term fiscal sustainability.

Executive Board Assessment

Executive Directors noted that Palau’s near-term outlook is generally favorable but exposed to the risks inherent to the geography and narrow production base of a small island economy. With full dollarization ruling out recourse to monetary and exchange rate policies against adverse shocks, Directors encouraged the authorities to build up fiscal buffers and step up reforms to diversify the economy and develop the private sector.

Directors welcomed the authorities’ commitment to a sustained fiscal adjustment to secure sound public finances once grants under the Compact of Free Association expire in 2024. They supported plans to enact soon a comprehensive tax reform bill which, if complemented by improvements in revenue administration, promises a significant increase in budgetary resources over the medium term. Directors also recommended reforms to contain the growth of current spending as a key element of the consolidation strategy. More broadly, Directors agreed that fiscal adjustment should be accompanied by further steps to improve public financial management, strengthen the pension and social security systems, and ensure that the public utility company achieves full cost recovery in its operations.

Directors considered that promoting private sector development and economic diversification would bolster Palau’s resilience to shocks. Additional improvements in infrastructure, and reforms to strengthen the investment climate, including a more flexible foreign investment regime, would also lift long-term prospects and promote more inclusive growth.

Directors welcomed progress in strengthening financial supervision and preserving the soundness of the financial sector. They noted that broadening financial supervision to include the national development bank and other non-bank financial institutions is essential to preserve the sector’s stability. Directors also encouraged the authorities to further improve their regime against money-laundering and the financing of terrorism.