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«Compacts of Free Association with the Federated States of Micronesia (FSM) and the Republic of the Marshall Islands (RMI) For Fiscal Year 2006 Table ...»

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A part of the explanation for the private and public sectors in the FSM and its four states moving almost in tandem is the peculiar nature of the private sector. As noted in the previous report and elsewhere, the private sector economy in the FSM and its four states is dominated by services that support government activities and households which also depend, in large part, on government payroll and contracts. The traditional production economy in the FSM, including subsistence output, is a small part of the whole and, as it is, does not have the capacity to generate more output and, therefore, more taxes. This unusual structure of the economy, where the private sector is more of a support system for the public sector rather than the engine of growth it ought to be, is at the heart of lackluster economic performance over the last several decades.

A major challenge policy-makers in the FSM face is to change this relationship between the private and public sectors. This is to take place mainly through improvements in public health, public education, public infrastructure, public sector capacity building, support for the private sector and the environment and institutional reforms. Success in changing the nature of the FSM’s private sector would require commitment of all decision-makers to agree what the challenge is and join forces to develop a credible and practical strategy for private sector growth.

Average Real GDP Growth Rates per Year by States and Economic Sector, 1995-2006

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1/ includes the national government Source: Federated States of Micronesia FY 2005 Economic Review, August 2006, p. 2.

(This is the FSM’s Section 214 Report submitted to the President of the United States.)

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The necessity of improving private-sector growth prospects in the FSM can also be discerned from income and standards of living data contained in the FSM’s Section 214 Report. Yap was the only state which had a higher real per capita GDP in 2006 than in

1995. Each of the other three states had a lower per capita GDP in 2006 than a little over a decade earlier. By necessity of their respective weights in the total national income, the states with declining per capita income pushed the FSM as a whole in the direction of loss of purchasing power for the average citizen. Among the state losing ground in terms of real per capita GDP, Kosrae exhibited the greatest potential for future problems, in part, because it relies more heavily on government than any other state. Its real per capita GDP dropped every year in 2003-2006.

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1,900 1,850 1,800 1,750 1,700 1,650 The FSM’s payroll employment data corroborate the evidence of a static economy provided by output and income figures. Total employment in the FSM in 1995-2006 remained remarkably stable, ranging from a high of 17,502 in 1995, the peak of the business cycle during the second phase, and 16,162 in 1999. In the years after 1999, employment recovered somewhat, but did not match the previous peak level. It averaged 16,585 during the 1995-2006 period. Another remarkable aspect of the employment data is the mix of private and public employment. Employment data in the FSM’s Section 214 Report are presented by categories within the private and public sectors. While detailed breakdown of employment types is useful for insight into the FSM’s labor market, the two broader categories, private sector and public sector, have changed little over the years.

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16,000 14,000 12,000 10,000 8,000 6,000 4,000 2,000 Public-sector employment consists of public enterprises, national government, state government, municipalities and government agencies. Private-sector employment is made of private sector businesses, financial institutions and households. The third category is made of non-governmental organizations, non-profit outfits and embassies.

The changes within these three broader categories in the 1995-2006 period reflect the static nature of the underlying production and distribution systems.

As pointed out in last year’s report, a critical and potentially destabilizing factor in the FSM is the low ratio of formal employment to population. In 2006, 15.2 percent of the population of 108,549 was formally employed, with formal employment being defined as work for pay. In 1995, a peak in the business cycle, this ratio was 16.5 percent, the highest. During the 1995-2006 period, employment as a percent of total population averaged 15.5 percent.

By contrast, employment as a share of total population in the United States, for instance, was 47.3 percent in 2003 and averaged 47.2 percent over the 1990-2003 period. This is not to compare the population composition of the FSM to the United States. However, the low ratio of employment to population does suggest that increases in the standard of living will be harder to achieve because of the small percentage of the population participating in the formal economy that supports the rest of the population. Given these facts, it is a reasonable argument to make that more Micronesians, not fewer, would resort to emigration. With subsistence economy still being an important part of the whole, about 15 percent of GDP, it generates both goods for domestic consumption and some work. However, there is no information on the market value of subsistence output or the equivalent of the labor force it employs.

Prospects for Private-Sector and Economic Growth The FSM faces serious challenges in the years ahead. Its public sector, especially the part that relies on U.S. assistance, must be reduced by a certain amount every year through fiscal year 2023, because of mandated decrements. (The amounts of decrements get deposited into the trust fund.) The FSM private sector has traditionally been smaller and lagging and has so far under the amended Compact shown little prospect for growth.

Unless the FSM can significantly increase tax and other revenues through its private sector, U.S. grant assistance reductions necessitate difficult adjustments in state and FSM government budgets every year and, as a result, have the potential for loss in the prevailing standards of living. These circumstances make the call for private-sector growth much more urgent.

Among the challenges FSM must confront are inherent constraints. For example, commercial agriculture holds limited potential because of limited land and lack of major comparative advantages. Among the options to reduce pressures on the limited resources is migration to the United States and its territories. but not everyone in the FSM would be expected to leave. The key question is: for those who stay, what would be the best path to a post-Compact economy that can reasonably offer both work and reward for those who will continue to reside in FSM?

The answer may lie, in part, in putting in place a mix of physical infrastructure and institutional reforms that would make access to the FSM’s land, water and human resources less taxing. The role adequate infrastructure plays in expanding production and distribution possibilities cannot be exaggerated, especially in remote and small markets.

The argument that adequate infrastructure leads to a greater productive capacity may be presented to global and regional bodies such as the World Bank and individual governments such as Japan that may, in turn, consider the FSM for infrastructure and reform assistance. Adequate infrastructure would particularly aid tourism and fishing.

To initiate projects of such a scale to make a difference in the national output would require concrete proposals from the FSM that would demonstrate both the technological and financial feasibilities of greater output.

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14,000 12,000 10,000 8,000 6,000 4,000 2,000 For example, to bring large numbers of Japanese tourists to the FSM to explore World War II wreckage sites, dive, and do other things in the unspoiled waters of the Central Pacific, would require ground facilities that can accommodate wide-bodied jets and large numbers of visitors. To extend runways, for example, and build regionally competitive hotels would require large sums of money. To convince regional banks or other bodies that they should invest large sums in small markets such as the FSM or its individual states would require diligent work on what the production and distribution possibilities are, how they are going to be developed, and how they are going to change the social, economic and financial realities so that the average standard of living would rise.

In the FSM, tourism and the fishing industry are about the only realistic options for economic growth in the context of traditional goods-production possibilities. To haul large quantities of fresh fish from the region to Asian markets such as Japan would require runways and commercial aircraft or other means of transport that carry large quantities of perishable products over long distances. Processing some of the fish in the islands so some of the value added stays would require processing facilities. Taking steps to create the next economy of the FSM and, for that matter, of the Republic of the Marshall Islands (RMI) and the Republic of Palau may require the direct involvement of regional and global institutions and regional economic powers such as Japan, Taiwan and Australia. Engaging global and regional resource centers also falls within the scope and spirit of the FSM’s own Strategic Development Plan (SDP), which is required by the amended Compact. Realization of the sustainable growth strategy, as outlined in the SDP, would require, more or less, the same infrastructure.

As the FSM contemplates how to make its case to the outside world for resources to enlarge its production and distribution possibilities, it may also undertake the institutional reforms that would make the FSM a more open, transparent and attractive market, despite the disadvantages of distance and small landmass. Reform efforts would focus on land tenure, the tax system, foreign investment control and improvements of local telecom systems that would make access to global sources of information convenient. With transparency and adherence to global and regional trade and commerce rules, service industries such as shipping registries, offshore financial services outfits, web hosting and others may be feasible. Collectively, these reforms would have the capacity to improve the FSM’s business climate which has recently received considerable attention in the context of regional and global development discussions.

Recent studies of regional and global business climates by the World Bank and the Asian Development Bank (ADB), in particular, have highlighted deficiencies in the business climate of small economies, not just in the Pacific but around the world. Because of small landmasses and remoteness, small economies do not get the attention large ones do, especially in the context of foreign trade and capital flows. However, when they do, they often get less than glowing reviews because small economies tend to be slow to follow global and regional changes and trends. Also, cultural perceptions and practices of small and isolated places tend to be out of phase with regional and global changes. As the ADB points out in a recent economic report on the FSM, “In Micronesia, land is wealth, power, spirituality, identity, and the basis for life itself. Land is a valuable cultural asset and a priceless heritage to be passed on to future generations.” 2 It is for this and similar reasons that landownership in the Pacific in general and Micronesia in particular is restricted to indigenous persons. Putting limits on market parameters that are contrary to regional and global standards is popular because land is, essentially, the only reliable source of sustenance in most of the small economies. Alienation of land is generally considered to be an unacceptable price to pay for change.

Meanwhile, to deal with the needs of the land market, land lease laws have been enacted in some of the FSM states, but they are not uniform and lack the flexibility of the region’s more open markets such as Guam and Hawaii. A more open and flexible land market, where lease rights are transferable, would be an important step to establishing a dynamic economy with a more favorable business climate.

The business climate studies the ADB has conducted in the Pacific in recent years have particularly been useful in pointing out not only what the business climate issues are, but how to resolve them so small and isolated economies can be, at least on the basis of some criteria, considered to be in the game. Among ADB’s recent business climate studies of the Pacific is Swimming Against the Tide? The message of the study is quite simple. It says, “The private sector in the Pacific is handicapped by common problems including a Asian Development Bank, Federated States of Micronesia 2005 Economic Report (Pacific Studies Series), 2006, p. 20.

weak macroeconomic environment, poor governance, often political instability, extensive state involvement combined with weak regulations and, underdeveloped financial markets, and a poor legal and investment policy environment for business.” 3 Improving the business climate in small and isolated markets of the Pacific may be like swimming against the tide, but the necessity of market realities of this day and age calls for it. In the context of the FSM’s post-Compact economic future, swimming against the tide amounts to accepting the proposition that the private sector has to expand to its fullest potential so the declining Compact grants do not mean declining living standards or inevitable migration.

Recognition of the business climate challenge in the Pacific is also an important issue with the World Bank, whose nine Pacific members include the FSM, the Republic of the Marshall Islands and the Republic of Palau. In its Pacific Islands Strategy, the World Bank says about the FSM that, “To maximize the potential of agriculture, fishing and tourism, structural reforms are requires in land tenure, human capital investment, the public enterprise systems, and the legal and institutional framework to foster private sector activity.” 4 To be sure, this and other reform messages are not new. They have been reiterated by world and regional institutions over the years. What may be new is the reality that the public sector cannot sustain the FSM’s economy any more, even at stagnant standards of living.

Migration from the Freely Associated States

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