CHAPTER 5: The Economy

The Uncertain Future

The Federated States of Micronesia has reached a critical point in its road toward economic development. After some 40 years of support from the US as a Trust Territory, FSM inaugurated a period of Free Association with the US that provided an additional 15 years of funding at declining levels. The last of the step-downs in the Compact funding became effective in October 1996. FSM now faces the prospect of the termination of US funding , at least at the level it has enjoyed for the past 30 years.

With Compact funds running down, FSM faces a dilemma that is different from that of most other Pacific Island nations. Most of the latter must weigh the social costs of industrialization and their impact on the old cultural ways against improving the living standard for a growing population. While FSM must deal with these concerns, it faces the more serious problem of replacing the US aid that has provided for the social and government services that its citizens have enjoyed in the past. Hence, economic growth and dynamic change is necessary in FSM simply to maintain the status quo.

The Upside-down Economy?

In most countries, the private sector is larger than the government sector, and it is through taxes on this private sector that government supports itself and provides essential services to the people. However, in the FSM, the process is reversed. The national, state, and municipal governments are the major sources of employment and cash. The small businesses that make up most of the FSM private sector are service rather than production oriented.

Micronesians passed a crucial point in the 1960s and early 1970s. With the great infusion of US funding, they came to rely on wage employment that depended on a large government bureaucracy. The character of their very families was being altered to accommodate the reality of a regular cash income. Education, the most expensive of the social services provided by the government, was regarded as a necessity. People had come to expect not six or eight years of schooling but twelve or even sixteen years. The population had acquired a taste for modernity.

In the face of such monetary abundance from the US, bad habits abounded. Rather than developing the private sector, great quantities of funding were spent on "pork" projects and short-lived equipment and amenities. Bureaucracies were expanded, hiring yet more citizens into government employ. When budgets ran short, the US found supplemental money to keep things going. The net result was to encourage governments to quickly spend and exhaust their annual budgets, so that they were ensured an early position in the queue for supplemental aid.

Attempts to boost production for export--through fishing, copra, and farm produce--were not successful. In recent years, the government has turned to the sale of rights as a source of income. The most notable example of this is the licensing of fishing rights to foreign countries.

With government being the largest "engine" running the economy, the question (and concern) is just how nation-states that lack a substantial resource base and a well-developed private sector economy will support their acquired tastes under their own government as US subsidies continue to dwindle.

In the early 1960s the US greatly increased its subsidies to what was then known as the Trust Territory of the Pacific. The US decided to abandon its earlier "go slow" policy and move towards rapid modernization, using the development theory that supported investment in social services as the key to modernization. There was little emphasis on economic development as such - the main targets were administration and social services, in addition to infrastructure projects such as roads, docks, and runways. Overall, one of the most visible effects of the increase in budgets was to employ hundreds of previously unemployed Micronesians. As more Micronesians found employment with the largest employer in the region, the government, a corresponding service economy evolved in the private sector.

In 1962, just before the period of rapid growth began, Micronesians' total wages and salaries were about equal to the value of their yearly exports, $2.3 million. By 1977, the total yearly earnings from salaries had shot up to $42 million, while the value of exports remained at about the 1962 level (Hezel, 1984). The economy was based on government wages rather than productivity. The linchpin of the village cash economy throughout the territory was the local public elementary school, which brought in more money through teachers' salaries than anything else (Hezel, 1982).

The Compact of Free Association

The country continues to rely heavily on grant aid from the US under the Compact of Free Association, which became effective in November 1986, and lasts for a 15-year period. The major element is a block grant, adjusted for inflation, of $60 million annually for the first five years, $51 million annually for the next five years, and $40 million annually for the final five years. By the terms of the Compact, 40 percent of the annual subsidy is to be used for capital projects, while the remainder may be spent on current operations. The Compact also provides for many smaller annual grants for specified purposes supervised by different federal agencies. Including non-Compact assistance, mainly for health and education, US grant receipts have amounted to over $100 million in recent years. The high level of external funding has enabled the governments to expand their operations with limited reliance on domestic revenue collection (FSM Economic Summit, 1995).

The first increment of Compact funds was targeted for infrastructure development, a stage referred to as "Transition and Reconstruction." The second increment was to be used in investments and economic ventures, and was called "Sustained Economic Growth." The last five years of Compact funds were to further refine earlier investment, "Achievement of Economic Self-Reliance" (FSM/OPS, 1992a)

The Compact is scheduled to end in 2001. While there are provisions to negotiate an extension, it would be dependent on the willingness of the US to provide continued funding.

The Structure

The resulting dual economy has a small modern sector concentrated in the urban districts of the main islands, and a traditional sector prevalent in rural and remote areas. The modern sector is thoroughly monetized. The traditional sector relies largely on subsistence activities in agriculture and fisheries. In general, while a few rural families may have an adequate cash income, people who live outside of the immediate area of the developed urban districts and towns tend to support themselves by subsistence or semi-subsistence activities. Subsistence production, estimated at 35 percent of the nation's Gross Domestic Product (GDP) in 1986, decreased to 21 percent of GDP by 1995. This reduction in the subsistence share of GDP is largely due to the expansion of the monetized economy since the start of the Compact, and not due to any real reductions in subsistence activity itself. Subsistence activity remains very important to the people of the FSM (Pohnpei State Economic Summit, 1996).

Imbalances

The economy is characterized by two major economic imbalances: 1) a large and growing internal fiscal deficit, an indication that the FSM government costs are not diminishing along with outside grants, and 2) a large foreign debt. Fiscal surpluses for the first four years of the Compact period have been followed by a series of fiscal deficits reaching as high as 5 percent of GDP. The external imbalance is characterized by large deficits, though the relative size of the deficit has decreased in recent years. The deficit has been financed by a combination of external borrowing and drawing down reserves, in effect getting "advances" against future Compact revenues (FSM Economic Summit, 1995). The government has been drawing on its future funds so it can finance projects it feels are important now. To date, two of the projects focus on infrastructural development - telecommunications and water and sewage development - and one project on agriculture. The remaining six focus on fishing, and range from the creation of cold-storage facilities to the purchase of vessels.

GDP and Growth

Government expenditures account for a large portion of the real GDP. In 1994, with a GDP of $200.9 million, government expenditures came to over 80 percent of the GDP, some $162.7 million.

GDP growth has been slow and erratic. The most recent contraction of real output was in 1992, resulting from a drought, a typhoon, and the first stepdown in Compact funding.

GDP per capita was estimated at $1,904 in 1994. Per capita growth has been negative in seven of the first nine years of the Compact, and the real per capita income level is slightly less in 1995 than in 1988.

Inflation has been somewhat higher than US rates - currently at about 4 percent - and has had the effect of diminishing the real value of Compact monies. This is significant since this diminishment accompanies scheduled stepdowns in Compact funds.

Exports account for about 30 percent of GDP and imports are equivalent to over 85 percent of GDP. Merchandise exports increased thirty-fold from 1986 to 1994, largely due to the fish and garment industries. The garment industry alone accounted for over $2 million in export value during 1994. Unfortunately, these exports offer a very low value-added potential to the FSM. For instance, the garment industry uses imported textiles and foreign employees, minimizing the possible contributions of the industry to the local economy and increasing imports for the material it uses. Likewise, the FSM has collected fees from other governments in exchange for allowing them to fish within the FSM economic zone, but does not yet have its own full-fledged fishing industry. This has been exacerbated by FSM policy which has, in the instance of fish, placed emphasis on quantity rather than quality, further discounting value added potential. For instance, while the nation receives around $22 million annually for fish licensing and access fees, the market value of the catch is about $250 million. This explains the slow and sporadic domestic output growth in the face of expanding exports.

Employment

The public sector has historically been the largest employer in the country. Predominant are jobs in the public administration and educational fields. In 1992, along with the first step-down in funds from the Compact (resulting in government job cutbacks), the number of jobs in the private sector finally surpassed those of the public sector (FSM/OPS, 1996a).

While the private sector increases are welcome, they come largely in the service industries - transportation, trade (including small stores), hotels and restaurants, etc., and do not normally command the highest earning power. Neither do they contribute to a balance of foreign exchange by providing goods and services that can be marketed abroad.

However, while job numbers in the private sector exceed those of the public sector, public sector wages have increased markedly since the early Compact years and significantly outpace private sector wages. This indicates that the earning power still rests within the public sector, a disincentive to those seeking employment in the private sector. Although males hold most of the jobs in both the public and private sectors, the proportion of males in the public sector is higher. However, these trends have shown declines recently, in the face of government hiring slowdowns and private sector growth, mainly in the wholesale and retail trade and in manufacturing. The wage gaps should close even further, given the intentions of national and state governments to freeze wages and reduce the number of employees.

Approximately seven percent of the FSM employed labor force is non-FSM citizens, over three-quarters of those being male. The foreign labor force seems to be concentrated in the following professions: doctors and medical personnel, accountants, mechanics, fishermen, craftsmen and construction workers.

Unemployment

Unemployed persons are defined, for the purpose of the 1994 census, as those who were looking and available for work in the four weeks preceding the census. At the time of the census, the working age population (15-64) numbered 59,573, or 56 percent of the total population. Those in the labor force-that is, those who were employed (either for wages or in the subsistence sector) and those actively seeking work-constituted about 44 percent of the working age population.

Table 5.5 shows that 4,216 persons, or 7.1 percent of the working-age population were unemployed. This number, when divided by the total labor force, yields an unemployment rate of 16.2 percent for the FSM population. The same table indicates that an even greater number of people-6,125 persons-who were not employed claimed that they could have taken a job but, because they were not actively seeking work, were not counted in the labor force. The inclusion of these discouraged potential workers, as they might be termed, would bring the number of unemployed to over 10,300 persons and yield an unofficial but possibly more accurate unemployment rate of 32 percent for the nation.

The formal unemployment rate in FSM reveals a wide disparity by sex and age cohort, as Table 5.6 indicates. The unemployment rate for males was 10 percent, while the rate for females was almost 27 percent. Unemployment rates were highest at the ends of the age spectrum, as might be expected. Those in the age 15-19 age bracket had the highest rate, 37.4 percent.

Education, as might be expected, is the largest factor in deciding who will get the relatively few salaried positions available. The figures in Table 5.7 suggest that educational achievement is a much more reliable predictor of wage employment than either sex or age. For those with a two- or four-year college degree, unemployment rates in FSM are lower than in many developed countries. At the level of a high school diploma and lower, the unemployment rates rise sharply and the differences between males and females become accentuated. The female rate is over twice as high as the male rate for those in the two lower educational levels.

In general, the high unemployment figures underline the contrast between the high interest in employment and the low job availability at present. In view of this disparity, many young people have chosen to leave FSM for other islands in search of jobs over the past ten years. If they had not, the unemployment figures we have reviewed here would have been even more alarming. The recent stepdown in Compact funds will almost certainly put a freeze on further public sector hiring. This, coupled with the high unemployment rate among the young, will put a considerable burden on the private sector for new job creation.

Subsistence

In the 1994 Census, subsistence workers were defined as those who farm or fish without selling or intending to sell their produce, and therefore have virtually no cash income. In Table 5.5, however, we stretched the definition to include those who lived chiefly off the land even if they marketed some of what they produced. The number of persons working at the subsistence level, according to the 994 Census, was over 7,300-about 12 percent of all in the working age population and 28 percent of all in the labor force. This figure hardly does justice to the importance of this economic sector. We may suppose that many of those recorded as "not in the labor force" as well as most of the "unemployed" contributed to their household by fishing and working on the land. Even those with full-time wage employment frequently find some time to do farming and fishing.

Subsistence activity is a significant component of FSM's economy, although it may be easily underestimated because of the difficulty in assigning monetary value to what is produced at this level. It is virtually the only economic activity of any importance in the outer islands of Yap, Pohnpei and Chuuk. It is also important as a fall-back option as jobs become fewer and increasingly competitive. In the difficult years ahead subsistence activity, like emigration, may reduce the competition for the few jobs available.

Deficit Reduction Performance

There have been wide performance variations between the five governments within the FSM. These variations are the result of greatly differing degrees of fiscal discipline. While all of the governments espouse reducing current operating deficits through a combination of revenue increases and cuts in expenditures, the primary effort has been on revenue increases. The principal revenue increase has come from fees for fishing access which have increased from $3.7 million in 1987 to approximately $22 million in 1994. The governments have been less successful in expenditure reduction. Throughout the Compact period, the appropriated budgets have consistently exceeded planned budgets, and expenditures have had to be increased by supplemental appropriations. At neither the state nor national levels has there been any significant reduction in total expenditures since the first stepdown in Compact funding in FY 1992 (FSM Economic Summit, 1995).

Development Targets

Past development plans point to three main industries that hold future promise for development and the enhancement of the local economy. They are fisheries, tourism, and agriculture.

Fisheries It is widely agreed that fisheries will probably be the leading sector for FSM development in the near future. With license fee revenues already accounting for approximately 14 percent of the nation's total revenue, there is considerable interest - and some disagreement - as to how the FSM should proceed. Should they merely stand back and license rights to their resources? Should they actively participate in harvesting, processing, and marketing the resource themselves? Should their position be somewhere in between? Past approaches have reflected these wide feelings, and resulting actions have ranged from the purchase of fishing vessels to the establishment of processing plants. To date, there has been no unified decision-making, or direction.

Recommendations of the Marine Resources Committee report to the 1995 FSM Economic Summit pointed out the need for the formulation and establishment of comprehensive policy, management and conservation practices, and the standardization of taxes, fees, and tariffs. The Committee also noted the need for the five government entities to take coordinated and unified approaches to fisheries development. In addition, the Committee recognized traditional subsistence coastal and marine resource use as paramount, and the need to improve human resource development by giving priority to public education, training, and capacity building.

Tourism The FSM has an attractive natural tropical setting, as well as historic and archaeological features. In addition, it is located closer to Asian markets than other island alternatives. Contributions made by tourism to date have been quite modest. Gross receipts rose from about $3 million in 1986 to about $7 million by 1990. However, in that tourism depends on imported supplies and often expatriate personnel, net values are probably considerably less. Visitor counts were essentially flat during the years 1992-1994, at about 25,300 visitors per year. Past reviews have noted that promotion, infrastructure, and transportation are areas that need further development.

What is the Fishing Industry Doing for FSM?

Fishing is the main hope of the FSM for replacing revenue presently being supplied by the US under the Compact of Free Association. It is the vastest and most abundant resource in the FSM.

As an alternative to fishing its own waters, the FSM has been collecting fees from other governments, and allowing them to fish within the FSM economic zone. It currently has agreements with Taiwan, Korea and Japan that are bringing in about $20 million a year, about 14 percent of the FSM government's revenue. Aside from the direct license payments, there are associated sources of additional revenue - shoreside spending and ship servicing, and fines for violations.

Why doesn't FSM exploit the fish resource itself? To some extent, it has. The FSM established the National Fisheries Corporation (NFC), a government-sponsored partnership that can enter into joint-venture fishing operations. NFC is presently involved in joint ventures in each of the states. However, there are any number of problems being encountered. There are existing processing plants that are not designed for the efficient processing of tuna; there are companies that do not have their own fleets of boats, and must depend on purchasing their product from others; some companies have the wrong kinds of boats - considerable investments were made by two states for the purchase of purse-seiners, which have not worked as expected - interestingly, despite this experience, another state is presently considering the purchase of similar technology; most of those fishing are foreigners - Micronesians do not like the long periods at sea that commercial fishing requires.

If the FSM is to develop its own successful fishing industry, it will have to do several things:

1. It will have to provide strong leadership and coordination for the industry. This may mean creating a single national entity, rather than the collection of national and state companies that exist, many of which compete with one another.

2. It will have to create a national fisheries policy, which looks at long-term sustainable development of the resource and industry, and not just short-term opportunities.

3. It will have to develop a strong enforcement presence and monitoring oversight capability.

4. Designate the in-shore fisheries for subsistence use only.

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The Tourism Committee report to the 1995 FSM Economic Summit set, as their primary objective, the intention to attract 100,000 visitors per year for an average stay of 5 days. This reflects an increase of 300 percent over present visitor figures, it should be noted.

In terms of strategies to address the objective, the Committee also recognizes the need for more promotion, infrastructure development, respect of culture and lifestyle, and coordination among all levels of government, especially in role and program development.

Agriculture The development of domestic agriculture can have benefits for both domestic and export markets. Along with its ability to reduce the country's dependence imports, it is an important way for people to supplement other incomes. Agricultural produce had a value of $1.6 million in 1994. Agriculture can be a good supporter of the growth of other industries - for instance, serving the needs of an increased tourist industry. In this way, agriculture might best be in a support role to other industries.

The Agriculture Committee report to the 1995 FSM Economic Summit notes the need to improve the institutional and technical aspects of agriculture, and to help increase and diversify agricultural products. The strengthening of sustainable traditional farming was also recommended.

No Free Lunch

As the FSM heads towards a significant reduction in its outside aid in 2001, the question then becomes, what will replace it? One of the industries offered up as a partial solution is that of tourism. Micronesia has numerous attractions, and there is justifiable interest in capitalizing on them.

More specifically, there is interest in the segment of tourism called "Eco-Tourism." Ecotourism, as the name implies, features visitor offerings pertaining to nature. Ideally, it also offers experiences in ways that are culturally sensitive, and ensures the sustainability of the resources.

Increasingly, ecotourism is being offered up as a "magic bullet." It has something for everyone. It gives a visitor a unique, environmentally-oriented experience, while enhancing local economies, and doing it all in a sustainable way.

That is the plus side. What is not often mentioned in even the succeeding breath, is that there is a price to ecotourism as well, and it may be too high for communities or organizations to bear.

As tourists commit to visiting, so must the supporting organization - be it a community or business - also make commitments. What are the resources to be featured? What is special and why? How will this be communicated to visitors, by self-guided walks, or by formal guides? How will the resources be maintained in a safe and attractive way? How will visitors be managed and treated? How will the resource - and impacts to it - be monitored, and mitigated? In community settings, how intrusive can visitors be? Will they be allowed free access to anywhere they want? How many are tolerable, and how will limits be imposed? How does visitor use impact on use by local people of the same resources? What will visitors do when they are not participating on an organized activity? What happens if the weather is bad, or if a guide cannot show up? How will liability issues be handled? In short, managing resources for tourism is a demanding and work-intensive commitment.

Ecotourism is, by its very nature, of minimal impact, and that also means fewer paying customers, and fewer paid employees. Revenue expectations are often unrealistic. If use levels get too high, and the resources become unduly impacted, it is no longer ecotourism, but eco-exploitation.

Ecotourism has its place. Unfortunately, it is often represented only from the benefit side, and as the solution, rather than as a part of a solution. However, it must be developed and managed with a very clear idea of not only the expected benefits, but the costs and inputs required on the part of its sponsors.

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Changing the Situation

In recent years, the FSM has had economic and financial reviews conducted by several institutions - ADB, IMF, and the World Bank. Their findings generally recognize the same issues identified earlier. They also share many similarities in their suggestions for actions to mitigate present situations, and to move the FSM into a more fiscally independent status.

In November, 1995, the FSM convened its First FSM Economic Summit. As a result of that meeting, a number of economic reform objectives were formulated, which closely parallel the institutional reviews and suggestions.

• All assessments identify the key issue as that of using the FSM's own resources and those remaining under the Compact to expand the productive capabilities of the country to offset declining external assistance. The short time remaining under the Compact is recognized.
• All assessments recommend downsizing the public sector - reducing the costs of government, and promoting growth of the private sector. The attractive differences between public and private sector employment have to be removed.
• All assessments suggest the development of fisheries, tourism, and agriculture as the main future sources of revenue, but note that additional studies, strategies, and policies are needed.
• All assessments indicate the need for internal structural actions.

a) There has to be a higher level of communication, cooperation and unanimity between the 5 political entities-the National government and the states-to ensure that all have the same information, and that there is no competition or counter-productive activity going on between them.

b) States, like the national government, have to exercise strict fiscal controls to the extent of their authorities.

c) There is a need for a national consensus on policy and strategy.

d) There is a need for a development program with clear priorities, one that is program and policy oriented rather than project oriented.

e) There has to be better use made of taxes, tariffs, and subsidies.

f) Wherever possible, governments should commercialize/privatize public utilities.

• Several assessments recommended the revitalization of the Banking Board.
• Several assessments recommended that better economic data are needed to aid in monitoring and evaluating progress.
• There is a recognition that the nation will be dependent on outside aid-both financial and technical-for some time to come.

The Economy and SHD

The primary goal of the FSM should be "to strengthen the economy and make it more resilient to changes in the world economy" (FSM Economic Summit, 1995). This can only be achieved through the development of the productive economic sectors. Changing the balance of the economy away from the public sector towards the productive sectors is the main challenge currently facing the nation.

Major impediments to economic development are the dispersion of islands and consequent internal transport problems, distance from major markets, lack of adequate infrastructure, limited resource bases, small pools of skilled labor, and rapid population growth.

The key is to employ both the country's own resources and those received under the remaining years of the Compact to ensure that the productive base of the FSM is expanded in order to progressively offset the declining Compact funds. The FSM will also need to seek other sources of foreign assistance to help meet continuing development finance requirements.

The dilemma for the people of FSM is how to maintain the present standard of living and the quality of public services in the future without the level of foreign aid they have been receiving. They must establish productive industries that will supply a tax base large enough to support their large government. They are being rallied to produce economic miracles in their resource-poor nation, while somehow retaining their natural resources, customs and traditions in the face of the social changes that will surely accompany economic modernization.