PACIFIC ISLANDS REPORT

Pacific Islands Development Program/East-West Center
With Support From Center for Pacific Islands Studies/University of Hawai‘i

[Find full report here: GAO-08-859T]

June 10, 2008

SUMMARY

The FSM has limited prospects for achieving budgetary self-reliance and long-term economic advancement, and the FSM government has not yet implemented policy reforms needed to enable economic growth. The FSM economy depends on public sector spending of foreign assistance; government expenditures, over half of which are funded by external grants, account for about 65 percent of the FSM’s gross domestic product (GDP). The FSM government’s budget is characterized by limited tax revenue and a growing wage bill, and the two private sector industries identified as having growth potential fisheries and tourism face significant barriers to expansion because of the FSM’s remote geographic location, inadequate infrastructure, and poor business environment. Moreover, progress in implementing key tax, public sector, land, and foreign investment policy reforms necessary to improve growth has been slow. For example, although the FSM has agreed on principles of reform to address its tax system that has been characterized by experts as inefficient and inequitable, the FSM government has made limited progress in implementing fundamental tax reform. Also, the FSM’s failure to implement key public sector reforms to reduce wage and subsidy expenditures resulted in fiscal crisis in Chuuk and Kosrae. In August 2006, nearly 2 years after the amended compact entered into force, the FSM Joint Economic Management Committee (JEMCO) began discussions of economic policy reform and has since approved some funding to support FSM reform efforts; however, challenges to private sector growth remain.

Numerous factors have negatively affected the use of the compact grants for FSM development goals. The FSM’s grant allocations have reflected compact priorities by targeting education, health, and infrastructure.

However, as of April 2008, the FSM had completed only three infrastructure projects and approximately 82 percent of the $82.5 million in infrastructure funds remained unexpended. Lack of progress in this sector is owed to national and state disagreements over infrastructure priorities, problems associated with the project management unit, and Chuuk’s inability to secure land leases.

Additionally, the FSM has almost $15 million in unspent funds for other sectors, or around 7 percent of funds allocated from 2004 to 2007.

Furthermore, the FSM’s distribution of grants among its four states has not been based on need, leading to significant differences in per capita funding, while the FSM’s long-term planning has not taken into account the likely effects of the annual funding decrement and other budgetary changes. The FSM has also lacked accountability for the use of compact funds, as demonstrated by weaknesses in its yearly financial statements and lack of compliance with requirements of major federal programs. Moreover, the FSM has not consistently monitored day-to-day grant operations or reported on progress toward program and economic goals, owing to inadequate data, a lack of required reporting, and an unwillingness to dedicate the resources necessary. OIA has conducted administrative oversight of the sector grants, but its oversight has been constrained by the need to assist the FSM with its compact implementation activities such as preparing budgets and addressing financial management problems such as the misuse of compact funds by Chuuk and Kosrae in 2006 and 2007, respectively.

The FSM’s trust fund may not provide sustainable income for the country after compact grants end a potential outcome that the FSM trust fund committee has not yet addressed. Market volatility and the choice of investment strategy could cause the FSM trust fund balance in some years to fall short of the maximum disbursement level allowed—an amount equal to the inflation-adjusted compact grants in 2023—or to be unable to disburse any income. Moreover, the probability of shortfalls increases over time. The trust fund income could be supplemented from several sources, including funding from other donors, increased tax revenue, or securitization. However, the FSM has not attracted other donors, its limited development prospects constrain its ability to raise tax revenues, and securitization—issuing bonds against future U.S. contributions—carries the risk of lower fund balances and reduced income. Furthermore, because management challenges affecting the FSM trust fund committee delayed the fund’s investment, the fund remained in a low-interest savings account for 22 months. Additionally, despite the likely impact of market volatility and investment strategy on the trust fund balance, the trust fund committee has not assessed the fund’s potential adequacy as a source of revenue after the compact grants end in 2023.

Our previous reports on the amended compacts recommended, among other things, that Interior’s Deputy Assistant Secretary for Insular Affairs ensure that the compact management committee addresses the FSM’s lack of progress in implementing economic reforms; work with the FSM to develop plans for minimizing the impact of the declining grants; work with the FSM to fully develop a reliable mechanism for measuring progress toward compact goals; and ensure the trust fund committee’s timely reporting on the fund’s likely status as a source of revenue after 2023. Interior generally concurred with our recommendations and has taken some actions in response to several of them, although key challenges to effective compact implementation remain unaddressed.