Amended Compact of Free Association: 2004-2023

In 2003, the United States approved an amended compact with the FSM  that (1) continues the defense relationship; (2) strengthens immigration  provisions; and (3) provides an estimated $2.3 billion to the FSM for 2004  through 2023 (see attachment II). The amended compact, which took  effect in June 2004, identifies the additional 20 years of grant assistance as  intended to assist the FSM in its efforts to promote the economic  advancement and budgetary self-reliance of its people. Financial  assistance is provided in the form of annual sector grants and  contributions to the trust fund. In addition, the U.S. and JEMCO are to  approve annual sector grants and evaluate the countries’ management of  the grants and their progress toward program and economic goals. Moreover, the FSM has not enacted  economic policy reforms needed to improve its growth prospects. Total government expenditures in 2006, over half of which were funded by  external grants, accounted for about 65 percent of GDP. The FSM’s government budget is characterized by limited tax revenue  paired with growing government payrolls. The FSM development plan identifies fishing and tourism as key potential  private sector growth industries. Although the FSM has undertaken some efforts aimed at economic policy  reform, it has made limited progress in implementing key tax, public  sector, land, and foreign investment reforms that are needed to improve its  growth prospects. For example:    Tax reform. However, as of April  2008, legislation required for implementing these measures had not yet  been passed. Public sector reform. Further, while JEMCO recently approved some funding to  support FSM efforts at public sector reform, key challenges to improving  private sector growth remain. Numerous Factors Hinder Use of Compact Funds to Advance FSM Development Goals

Although the FSM has allocated compact grants to the sectors targeted by  the compact, immediate problems in some sectors persist, and several  factors have hindered the FSM’s use of the funds to meet long-term  development goals. However, the FSM has completed only three infrastructure projects, and  more than $67 million of the $82.5 million (approximately 82 percent)  allocated for infrastructure grants in 2004 through 2007 remains unspent. 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. Unspent  funds for other sector grants from 2004 to 2007 amounts to an additional  $14.9 million, or around 7 percent of funds allocated (see attachment VI). The allocation of FSM grants among its four states  is not needs based and has resulted in significant differences in per capita  funding, creating varying levels of government services across the states. Lack of accountability over compact funds. The FSM has failed to consistently monitor day-to-day sector grant  operations or report on progress. For example, the FSM’s single audit  reports for 2005 and 2006 showed that the FSM’s ability to account for the  use of compact funds was limited, as shown by weaknesses in its financial  statements and lack of compliance with requirements of major federal  programs. OIA has carried out various duties as administrator of the amended  compact grants but has not addressed the FSM’s worsening compliance  with compact reporting requirements, and several challenges continue to  hamper its compact oversight. However, after 5 years—one  quarter of the amended compact’s duration—the FSM faces significant  challenges in working toward the compact goals of economic  advancement and budgetary self-reliance. The FSM economy shows  continued dependence on government spending of foreign assistance. The FSM has also been unable to utilize more than $67  million in infrastructure and almost $15 million in other sector grant  monies. To maximize the benefits of compact assistance, our prior reports  include recommendations that the Secretary of the Interior direct the  Deputy Assistant Secretary for Insular Affairs, as chair of the FSM  management and trust fund committees, to take a number of actions,  including the following:    ensure that JEMCO address the lack of FSM progress in implementing  reforms to increase investment and tax income;    coordinate with other U.S. agencies on JEMCO to work with the FSM to  establish plans to minimize the impact of declining assistance;    coordinate with other U.S. agencies on JEMCO to work with the FSM to  fully develop a reliable mechanism for measuring progress toward  compact goals; and    ensure the FSM trust fund committee’s assessment and timely reporting of  the fund’s likely status as a source of revenue after 2023. Attachment III: Estimated FSM Per Capita Compact Grant Assistance, Fiscal Years 1987- 2023

Attachment IV: Amended Compact Implementation Framework

	Annual sector grant budget

FSM propo grnt budget for ech ector tht inclde proviion    –  Expenditre, performnce go, nd pecific performnce indictor  –  Brekdown of peronnel expenditre nd other co  –  Informtion on U.S. federl progr nd other donor  United Ste evuate the propoed ector grnt budget for:   –  Contency with fnding requirement in the compct nd relted –  Identify poitive event thccelerte  performnce otcome nd prolem  encontered nd their impct on grnt  ctivitie nd performnce measurereport to used to: – Monitor generopertion to ensure complince with  grnt condition  Submit nnual report to the U.S.

	Joint management and accountability committee

Attachment V: FSM Sector Grant Allocations, Fiscal Years 2004-2008

Attachment VII: Projections of FSM Account Balance with Three Possible Investment Strategies

U.S. dollar (in illion)
U.S. dollar (in illion)

Attachment VIII: Probability of FSM Trust Fund Income Not Reaching the Maximum Disbursement Levels Allowed, Fiscal Years 2024-2050

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Why GAO Did This Study

From 1987 through 2003, the Federated States of Micronesia (FSM) received more than $1.5 billion in economic assistance under the original Compact of Free Association with the United States. In 2003, the U.S. government approved an amended compact with the FSM that provides an additional $2.3 billion from 2004 through 2023. The Department of the Interior's Office of Insular Affairs (OIA) is responsible for administering and monitoring this assistance. The amended compact identifies the additional 20 years of grant assistance as intended to assist the FSM in its efforts to promote the economic advancement and budgetary self-reliance of its people. The assistance is provided in the form of annually decreasing grants that prioritize health and education, paired with annually increasing contributions to a trust fund intended as a source of revenue for the country after the grants end in 2023. The amended compact also contains several new funding and accountability provisions intended to strengthen reporting and bilateral interaction. Among these provisions is a requirement for the establishment of a joint economic management committee and a trust fund committee to, respectively, among other duties, review the FSM's progress toward compact objectives and assess the trust fund's effectiveness in contributing to the country's economic advancement and long-term budgetary self-reliance. In 2003, we testified that these provisions could improve accountability over the assistance provided but that successful implementation of these provisions would require appropriate resources and sustained commitment from both the United States and the FSM. Drawing on several more recent reports as well as updated information, this report will discuss the FSM's economic prospects, implementation of the amended compact to meet its long-term goals, and potential trust fund earnings.

What GAO Found

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.