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«Compacts of Free Association with the Federated States of Micronesia and the Republic of the Marshall Islands For Fiscal Year 2005 Table of Contents ...»

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Beginning in 1987, real GDP grew every year through 1995, with the growth rate averaging 3.9 percent a year. That growth rate was higher than the average for the independent economies of the Pacific. Per capita real GDP, a measure of the average comparative standards of living, increased during six of the eight years, and its growth rate averaged roughly 1.9 percent annually in 1987–1995. To put it differently, the standard of living of the average FSM resident improved almost every year in 1987– 1995, with the exceptions of small decreases in 1989 and 1994.

FSM's Real GDP (Millions of 1998 Dollars) In part, because of built in step-downs in Compact funding and, in part, because of factors such as lower than expected growth in the private sector, the economy took a turn for the worse in 1996 and continued to decline for four consecutive years. Real GDP declined in 1996-1999. As a result of this reversal of collective fortune, the FSM’s real per capita GDP in 1999 was about where it had been in 1991. A strong rebound occurred in 2000 when real GDP increased, only to be followed by smaller gains in 2001–2003.

These gains elevated real GDP to where it had been in 1994, the year before the peak in the FSM’s GDP. However, even with the growth in 2005, the FSM’s real GDP was smaller in fiscal year 2005 than it was in 1994 or 1995.

The decline and stagnation in the 1996–2004 period can also be seen in real per capita GDP. Real per capita GDP peaked at $2,118 in 1995 and declined or stagnated during most of 1996–2004, ending the period of the original Compact with a real per capita GDP of $1,977 in 2004. Although it rose to $1,997 in 2005, it remained notably below the previous peak. On a favorable note, total real GDP has increased steadily, although modestly, since 1999, and it appears to be on its way back to the mid-1990s level. If the amended Compact’s provisions are accompanied by reforms in the institutional structure that would make the FSM a more attractive market, there is a good chance that the FSM’s total output could surpass its previous peak.

Per Capita Real GDP (Dollars) 2,150 2,100 2,050 2,000 1,950 1,900 1,850 1,800 1,750 1,700 1,650 During the 1987–2004 period, the FSM’s consolidated government finances also reflected two phases, but they were not as clearly defined as they were with respect to total output. Given the peculiar nature of the FSM’s financial structure, where most of the public sector funding has come from U.S. Compact funds, it may have been expected that revenue and spending would have been more in line with each other and shown a more predictable pattern over the years.

Weak financial management, one of the dilemmas throughout the original Compact period, was only a part of the explanation. Uncertainty built into any financial management plan, regardless of the degree of competence of planners and governments, and the differences in practices and levels of competence within the four states have often spilled over to the national financial management scheme. However, it was mainly because of the weak financial management practices during the period of the original Compact that the amended Compacts incorporated more rigorous accountability measures. With control of the amended Compact funds allocation residing with the United States majority on the JEMCO, as opposed to the arrangement under the original Compact when the FSM government had unilateral control over the use of Compact funds, there is greater likelihood that financial management will improve. At the same time, transfer of allocation decisions to the United States majority on JEMCO has created a certain level of tension, especially in the FSM national government because this is seen as loss of financial control. As both sides get accustomed to the new Compact regime, the tension is expected to dissipate.

The FSM’s employment data tell a story that is in line with the economic and financial statistics. Total employment in the FSM increased every year, although sometimes by small increments, in 1987–1995. It rose from 12,209 to peak at 16,003. Beginning in 1996, total employment declined for three consecutive years, reaching a level it had been in 1991. Small gains followed in 1999–2002, but they turned into losses once again in 2003–2004. In 2004, total employment was where it had been in 1992–93. (No employment data are available for 2005.) A significant change in employment during the 1987–2004 period was the decline in public administration (government) employment as a share of the total. In 1987, public administration accounted for 61.0 percent of the FSM’s total employment. Even during the growth and prosperity period of 1987–1995, when both total output and employment increased, government’s share of employment decreased steadily from 61.0 percent to

49.0 percent. Government’s share of employment continued to decline through the economic decline and stagnation phase when it reached an all-time low of 42.7 percent in

2004. That employment continued to decline as a share of the total during the entire 1987–2004 period was a reflection of the realization that a bloated and inefficient public sector had to be brought in line with economic and financial realities. Still, government’s share of employment is much larger than in most market economies, but is similar to other U.S.-backed economies in the region where U.S. subsidy of the public sector has made it almost customary to depend on government as the ultimate provider of income and livelihood.

A critical and potentially highly destabilizing force in the FSM is the low ratio of formal employment to population. Only 13.5 percent of the population of 90,200 in 1987 was formally employed, with formal employment being defined as work for pay. In 1995, the peak of the business cycle, this ratio rose to 15.1 percent, a record and population had risen to 105,800. In 2004 when the total population was 108,000, the ratio was 14.0 percent, only slightly higher than in 1987.

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, a small island economy nearly totally dependent on U.S. economic and financial support, to the United States, the world’s largest and one of its most productive economies. However, the low ratio of formal employment to population does suggest that increases in the standards of living will be harder to achieve because of the small percentage of the population participating in the formal economy supports the rest of the population. The fact that only a small portion of the population can find gainful employment at home likely leads to emigration and displacement of families and communities.

It should also be pointed out that subsistence economy accounts for a relatively large part of the total economy, averaging 15.0 percent of GDP through 1987–2004, with small variations from year to year. Although there is no information on how to translate the market value of subsistence economy to formal employment, either in terms of employees or wages and salaries, it is safe to say that it accounts for a significant share of total output and the work that goes into it.

Economic Reviews of the States of the FSM

Pohnpei, and to a lesser degree, Chuuk show patterns of economic growth similar to that of the FSM as a whole. Pohnpei, not only the most powerful state economically but also the seat of the national government, shows a pattern similar to that of the FSM as a whole. Real GDP increased steadily from $67.7 million in 1987 to a record high of $106.7 million in 1995, but was down to $102.1 million in 2003 and slightly up again to an estimated $103.5 million in 2005.

Chuuk’s real GDP increased steadily from $56.5 million in 1987 to $67.6 million in

1995. It contracted for three years thereafter until it began to rise again in 1999 and continued to regain some of the lost ground until it reached $63.3 million in 2003. In 2004, it was back down to $58.2 million and virtually unchanged at an estimated $58.3 million in 2005. The more notable point about Chuuk’s real GDP is that it has yet to recover to the previous peak of 1995. Given the financial management problems that have plagued the state of Chuuk for years, including those at the beginning of the amended Compact’s implementation, the prospect for a higher level of output and the associated lift in the average standard of living does not appear very bright.

Kosrae, the smallest state in terms of population, experienced growth in the 1987–1994 period, lost some ground in 1997–2000, but regained momentum earlier this decade to surpass the 1994 peak and reach a new high in 2003. However, it lost ground again in 2004 and even more in 2005 when it finished with a real GDP that was at the 1998 level.

Yap, the third largest of the four states in terms of population, had the most distinctive economic record in 1987–2004. Its real GDP was $24.2 million in 1987, $31.9 million in 1995, $37.4 million in 1998, but declined and remained flat in 1999-2002. In 2003, it was up to a record $38.1 million. It dropped to $36.7 million in 2004, but was estimated for 2005 to be up to another record of $39.6 million. It is the only state of the FSM that showed relatively steady gain in real output during the entire 1987–2004 period.

Prospects for Private Sector and Economic Growth Despite its increase as a share of GDP, which rose from 23.0 percent in 1987 to an estimated 29.6 percent in 2005, the FSM’s private sector is a small piece of the economy.

Since the days of the Trust Territory of the Pacific Islands (TTPI), the FSM private sector has been a secondary economic contributor with the public sector as the primary economic engine. Unlike economies of the 50 states and others where the private enterprise drives the economy and supports a certain level of government, in the FSM, the public sector has thus far been the driving force. Although the public sector’s share of the economy has declined over the last 18 years, government is still the driving force and will remain so into the foreseeable future unless major changes are made. It should be recognized, however, that market reforms to make the institutional structure more efficient and transparent, and improved infrastructure, would go only a limited distance.

With physical realities remaining the same, regardless of the state of technology, expectations for private sector growth have to be adjusted to physical and institutional realities. Isolation and high transport costs, small mass, and limited land constrain the potential for most economic activities.

The FSM faces a fundamental challenge in that commercial agriculture and farming holds limited potential because of limited land and lack of major comparative advantages.

Naturally, among the options to reduce pressures on the limited resources and fragile ecosystems in the islands is migration to the United States and its territories allowed under the Compact. However, this provision does not necessarily mean that everyone in the FSM would leave. A certain portion of the population will stay, regardless of social, economic and financial conditions in the FSM. And those who stay in the islands will still have families and the normal needs of families and communities. The key question is: for those who stay or cannot leave, what is the best path to a post-Compact economy that can reasonably offer both work and reward for those who will continue to call the FSM home. To put it differently, the question is: how does the FSM translate potentials in tourism and the fishing industry into output that would mean jobs, income and a tax base? Before specific proposals come to the fore, there are some basic infrastructure and financial issues that have to be considered.

Unlike large developing economies that can rely on loans in commercial markets as well as under preferential terms of global and regional lending institutions and other sources of funds in the global markets, the FSM is too small as an economy, as a regional power or a source of future income to be an appealing client for global lenders. These disadvantages, however, do not mean that the needs of the FSM are different from those of large markets. The question is: what can world and regional bodies do to increase the long-term productive capacities of small and isolated economies?

The answer lies in putting in place the types of physical and intellectual infrastructure that would enable the FSM to increase its productive capacity. The critical role that adequate infrastructure plays in expanding production and distribution possibilities may be the argument that the FSM would take to world and regional bodies. This argument that adequate infrastructure leads to a greater productive capacity may be presented to global and regional bodies such as the World Bank, the Asian Development Bank, and individual governments such as Japan that may, in turn, consider the FSM for large infrastructure project loans. Adequate infrastructure would aid tourism and the fishing industry. To initiate projects of such a scale would require concrete proposals from the FSM that would demonstrate both the technological and financial feasibilities of greater output.

For example, to bring large numbers of Japanese tourists to the FSM to explore World War II wreckage sites, dive, undertake other recreational activities in the unspoiled waters of the Central Pacific, or engage in other activities on the ground would require, first and foremost, ground facilities that can accommodate wide-bodied jets and large numbers of visitors. To extend the runway on the Island of Pohnpei, for example, and build world and regionally competitive hotels and other guest facilities 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 rises.

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