II. Social and Macroeconomic Framework

III. Economic Assistance Requirements

A. Overview
B. Base Grant
C. Marshall Islands Intergenerational Trust Fund
D. Federal Programs and Services
E. Title Three, MUORA and Kwajalein Atoll

IV. Monitoring and Evaluation

F. Overview
G. U.S. Joint Economic Review Board
H. U.S. Liaison for Oversight, Reporting, Compliance and Program/Service Development
I. General Provisions

Attachments

A. Revised Table of Compact Funding 20-Year Term
B. Revised Table of Compact Funding 25-Year Term
C. Indicative Medium Term Budget and Investment Framework – Fiscal Year Period 2001-2005
D. Indicative Marshall Islands Intergenerational Trust Fund Model 20-Year Term
E. Indicative Marshall Islands Intergenerational Trust Fund Model 25-Year Term
F. Kwajalein Payments Legal Analysis

I. Introduction

II. Social and Macroeconomic Framework

2. The RMI has gone through various phases of transformation prior to and during the current Compact of Free Association. While the past has been reviewed in documents and discussions, it is important at this point to review some of the major accomplishments in the RMI as well as identify the current social, fiscal and macroeconomic trends. This will allow the United States Government to base its response to the RMI proposal on real needs as well as the necessity to create a steady transition to the implementation of a new phase of economic assistance and create a framework for economic, social and political stability after the renegotiated term of Title Two under the Compact.

3. Economic growth declined in 1995-96 with the last step down of the current Compact funding and stagnated through the late 1990s. This decline and stagnation shows the sensitivity of the economy to Compact funding as well as the weakness of private sector activity to replace the reduction of Compact funds and the inability of the economy to diversify away from government-related services. At the same time, Government expenditures and investments were strapped by making payments on bond obligations up to 2001.

4. Now that past major debts are eliminated, the RMI Government is now concentrating on the opportunity to focus more on fiscal stability and making investments in basic services, though with limited resources, and has been able to set aside “bump-up” year funds for the initial capitalization of the Marshall Islands Intergenerational Trust Fund (MIITF). This fiscal prudence, set aside for substantial investments in future generations, and reduction of the Government’s role in the provision of utility and other non-public activities along with the reduction of Government subsidies, have reduced the Government’s role in economic activity. The Government is still the major contributor to the economy but there are initial indicators that this role has been significantly reduced. For instance, while the number of public service workers was substantially reduced between 1991 and 1999 (by 45 percent), the number of private sector employees increased by 15 percent. This trend is expected to continue in current years. The Government’s contribution to GDP has remained about the same in dollar figures while the private sector contribution has grown in terms of the percentage of total GDP. These trends are expected to continue as long as the Government’s emphasis remains concentrated on private sector led development and the Government maintains a stable fiscal environment.

5. The RMI has recently attempted to achieve fiscal stability. However, the demands of the formation and implementation of governance activities of a resource poor small island nation has created fiscal challenges. The current Government is grappling with much needed investments in critical services and basic infrastructures against a fiscal position exacerbated by past cumulative budget deficits and liabilities. Many lessons were learned by the RMI Government and citizens, the first being the current resistance to invest in commercial enterprises and the second being the reduction of the size of Government and subsidies. As an example, compared to 1994/95 levels, FY 2002 expenditure will be 25 percent lower in current dollar terms. Even with these lessons and corresponding adjustments, the RMI remains in a precarious fiscal situation. This current situation is highlighted not by overspending, but by the Government’s interest to set aside funds for future investments, such as the MIITF; increasing investments in health, education and the environment; and applying a steady flow of funds for capital investment to maintain and improve the infrastructure.

6. Compact funding has and will remain a substantial input to the Government’s budget. In FY 2001 and 2002 Compact grant economic assistance provided 34 and 32 percent of budget revenue, respectively. At the same time, it is anticipated that domestic revenue generation will increase though at a minimal rate and not sufficient to substantially replace Compact funding. Also, while additional external assistance revenues may continue from other donors, again any increase would most likely be minimal unless the RMI excessively taps into foreign credits and loans. The Government does not wish to further expose itself to foreign debt given current obligations and expected future obligations. The RMI believes it is not in its interest to do this and that it would not be in the interest of the United States given the strategic relationship.

7. At the same time, the Government realizes the need to further achieve governance efficiencies and to reduce subsidies. In its Medium Term Budget and Investment Framework (MTBIF), the Government is proposing that subsidies and special appropriations will continue to decline and that expenditure increases for department and agency activities will be held to a responsible level of 2-3 percent. This will allow the Government to increase expenditure in critical areas, such as in health, education and environment. It is expected that these sectors will have 4-8 percent increases in 2003, with further increases in 2004-5 pending the amount provided in the proposed Compact base grant.

8. Another major focus area is capital improvements for which there is a pent-up demand. The reason for this demand is that the RMI has consciously decided to set-aside untied Compact capital funds as well as the “bump-up” amounts in FY 2002 and 2003 for the initial capitalization of the MIITF, amounting up to $30 million over the two years. This has left a total of $6-7 million annually for capital investments. Thus, additional attention is needed to address the establishment and upgrading of certain infrastructure in Majuro and Ebeye as well as further infrastructure development in the outer islands to help stem emigration to the urban areas. This investment will be allocated to capital investments in the priority areas as mentioned above: health, education, environment and basic infrastructure. The RMI will develop an Infrastructure Improvement and Maintenance Plan before year’s end to identify these needs.

9. The bottom-line of the social, macroeconomic and fiscal situation is that if Compact funding is substantially reduced from 2003 levels, there will be a period of social degradation that could lead to political, social and economic instability, economic decline and the elimination of recently developed fiscal prudence. As shown in the 1996 Compact step-down, there was a severe negative impact not only on Government operations but also on the economy as a whole with local tax revenue and overall GDP substantially declining. Subsequently, living standards and the delivery of services deteriorated, notably in the health and education sectors. This shows the extreme sensitivity of the economy to changes in income/expenditure flows. Thus, it is in the RMI Government’s best interest to maintain the flows of Compact financial assistance during the next term of Title Two at a level where there are no financing gaps and the grant is replaced at a time when MIITF distributions can supplant the Compact funds.

10. As an example, as shared with the U.S. Office of Compact Negotiations, the application of the initial Title Two economic assistance proposed by the United States in the MTBIF show negative effects from the start. Even with minimal expenditure increases of 2-3 percent, the Government would run mounting budget deficits plus other dire socioeconomic consequences. Two of these consequences would be the inability of the Government to invest in health, education and environmental improvements, and the deterioration of basic infrastructure—major objectives the United States which has stressed Title Two assistance should be directed towards. Also, the amounts proposed for the trust fund contribution would create a distribution in 2024 that would be much more than the U.S. grant assistance provided annually over the previous 20 years. In other words, there would be 20 financially strapped years before the trust fund injected budgetary support in 2024. Such a fiscal situation would pressure the Government to resort to borrowing to fill the “financial gap” during the 20 years to maintain essential services. As stated previously, the Government is not committed to deficit financing. The Government is also not interested in jeopardizing fiscal stability and the MIITF for future generations.

11. It is therefore urged that the United States recognize that the new Title Two funding will remain a considerable component of Government revenue during the next term and that any changes will be incremental, such as with the decremented approach. As experienced in other countries in transition, and as stressed by the International Monetary Fund (IMF) in its recent 2001 Article IV consultations and other RMI donors, the RMI must follow a course of incremental changes since any sharp adjustments would have negative socioeconomic impacts.

III. Economic Assistance Requirements

A. Overview

12. The RMI initially responded to the U.S. Chief Negotiator’s offer of March 27, 2002 on March 28, 2002. The RMI’s response highlighted the fact that the RMI agrees with the U.S. offer to extend the next term of the Title Two economic assistance to 2023 provided that the trust fund contributions are adequate. The RMI is concerned that the trust fund contribution the United States has proposed is not sufficient to build the targeted corpus amount by 2023.

13. To help further negotiations, it is proposed that the U.S. Chief Negotiator consider the following components so that a fair and development-oriented agreement is concluded that will provide for beneficial support and investment throughout the term of the new Title Two as well as sufficient contributions to the MIITF so that the trust fund’s distributions will be able to realistically supplant grant assistance in 2024. A summary of the assistance is provided as Attachment A, based on the revised trust fund contribution that the RMI is requesting. If the trust fund contribution is not changed from the level the United States has proposed, the RMI therefore finds it necessary to propose an alternative time frame for the grant assistance. The alternative summary of assistance is provided as Attachment B.

B. Base Grant

14. Factoring in the 20-year term, the RMI proposes an overall base grant amount of $36.6 million in 2004. The amount includes: an operations and capital investment grant of $26.6 million; $5.5 million to meet the special needs of Ebeye and surrounding communities on Kwajalein Atoll; and $4.5 million to contribute to catastrophic health care needs.

15. The RMI proposes that the base grant will be adjusted per the current Section 217 formula with the base year being 1999. The setting of the base year as 1999 allows for a 5-year accumulation of the adjustment factor. This approach is consistent with Section 217 and Article V of the Fiscal Procedures Agreement. Also, given the experience of the last 20 years, to keep the base grant at a reasonable adjustment rate, the RMI sees no reason to reduce the cap to 5 percent from 7 percent.

16. With the overall base grant proposed above, the RMI agrees with the U.S. proposed approach of decrementing $500 thousand per year with the amount being added as part of the RMI contribution to the MIITF. If the overall base grant is reduced below the amount proposed by the RMI, then the annual decrements will have negative repercussions similar to the economic shocks caused by the incremental step-downs during the last term of the Title Two assistance.

17. The base grant will be allocated through the MTBIF, including special needs of Ebeye and surrounding communities and the catastrophic health care needs. The MTBIF will aim to increase spending in the areas of health, education and the environment by at least 56, 68, and 39 percent, respectively, by 2005. After sufficient increases in these sectors, the increases will be decreased so as to provide a steady stream of funding. All other ministry and agency expenditures would be limited to 2-3 percent increases to keep current with inflation. The indicative MTBIF for the period FY 2001 to 2005 is provided as Attachment C.

18. Capital investment increases are expected to be substantial in FY 2004 and 2005, by 150 percent compared to 2002. The reason for the substantial increase is that capital investment resources were used in 2001 for the last bond payment. In 2002, the RMI is devoting $14 million of capital investment funds from the Compact as well as transition “bump up” funds and up to $16 million in 2003 to the MIITF to adhere to an agreement with the Asian Development Bank (ADB) and to its own internal policy. Thus, there is a pent-up demand for infrastructure improvements and increased maintenance. Capital investment funding will be allocated by meeting the capital investment project criteria submitted in the RMI December 2001 Compact proposal. With the completion of the Infrastructure Improvement and Maintenance Plan, the Government will also set a fixed annual percentage of capital fund allocation to the priority areas of health, education, environment, and infrastructure.

19. Future budget allocations will be based on a set of performance indicators to insure the funds are being targeted at primary objectives and achieving results. As projected, the MTBIF indicates that overall revenues will increase in FY 2004. The increase is mainly attributable to the U.S. trust fund contribution and increased domestic revenue generation, not increased Title Two grant funding.

20. The financing for Ebeye special needs, as identified in the submission of March 7, 2002, will also be allocated within the MTBIF. While a majority of funds will be for capital improvements, some of the funds will add to operational costs to ensure the provision of improved health, education, utility and other services. The capital improvement projects, as presented in the previous proposal, will also be integrated into the Infrastructure Improvement and Maintenance Plan. The funds will be managed and overseen by the RMI Government.

21. The catastrophic health care needs will be addressed by contributing to the already established Health Care Fund. The funds will be used to cover catastrophic health care cases for the entire population so as to have universal coverage and access. In essence, the funds will be a stop/loss insurance program so that the RMI health system is not overburdened by excessive health care service costs received domestically or overseas. Specific criteria will be established on how the funds will be applied. It is especially noted that given the emphasis on improved health facilities and services, the RMI domestic health services are expected to significantly improve in the next 20 years. Given these expected improvements, the importance of such a funding resource is essential so that affordable services can be provided and that the services are not a burden to citizens or the health budget. The health fund will also relieve the health recurrent budget so its funds will be used more for operations and infrastructure development and maintenance rather than covering excessive health care service costs.

22. The RMI proposes that the activities of the Health Care Fund be one of the key areas reviewed by the RMI-U.S. Joint Economic Review Board, as will other components of the base grant. The two key indicators should be: 1) the reduction in overseas medical referrals; and 2) increased and improved domestic health care services.

C. Marshall Islands Intergenerational Trust Fund

21. The MIITF is expected to fill the funding gap after the Title Two assistance ends in 2023. Thus, in 2024, it is expected that the trust fund’s distribution will supplant the Title Two economic assistance funding. The RMI MIITF model projects an annual distribution of about $31 million starting in 2024 . An indicative MIITF model is provided as Attachment D.

22. To help initiate the capitalization of the MIITF, the RMI has set aside $17.5 million by 2002; another $16 million will be set aside in 2003 to meet the RMI’s initial contribution target of $30 million by 2004. To add to this amount, the RMI requests that the U.S Government contribute $12 million annually, adjusted to inflation in the same manner as the base grant. The attached indicative MIITF model assumes an inflation adjustment using 1999 as the base year. If the United States adheres to its proposed $8 million, the MIITF model projects a 25-year time frame for the trust fund to build a corpus of at least $900 million. This is demonstrated in the indicative MIITF model in Attachment E.

23. Furthermore, if 2004 is used as base for inflation, then the targeted corpus amount of at least $900 million necessary to generate no less than $30 million at a maintained value after 2024 will require increasing the level of U.S. contribution or a longer period of investment.

24. The amount to be decremented annually from the base grant starting in 2005 will be added as part of the RMI contribution. According to reasonable assumptions, the RMI, United States and other anticipated donor contributions should allow the MIITF to fill the expected financing gap of approximately $33-35 million in 2024.

25. However, the RMI’s view is that the 25-year time frame affords both parties the ability to insure that the proceeds of the trust fund are more than adequate at the end of the Title Two term to supplant the grant assistance with a lesser risk of a financing gap. Such a timeframe will allow a more appropriate transition at term end so that political, social, economic and fiscal stability is maintained.

26. Upon review of the U.S. proposed trust fund outline, the RMI requests that the outline be considered in view of the recently revised RMI Act to establish the MIITF. This will allow for the possible adjustment to the MIITF Act so that the expected Compact Subsidiary Agreement and the Act are consistent.

27. The RMI will continue to seek contributions to the MIITF from other parties. It is requested that the United States not consider these contributions as a substitute for the proposed U.S. contributions. The RMI has already considered other contributions in its model.

D. Federal Programs and Services

28. The RMI should have continued access to existing U.S. Federal programs with the ability to add other Federal programs as may be beneficial and agreed to. In this connection, the RMI proposes that transition and carryover language be inserted in any final economic assistance package that will continue to make available to the RMI all Federal programs, which are in effect as of an agreed to date. In addition, the RMI proposes that specific statutory changes be made to governing U.S. laws in respect to eligibility of other Federal program assistance for the RMI as may be agreed.

E. Title Three, MUORA and Kwajalein Atoll

29. As stated in the RMI’s March 28, 2002 response to the U.S. Title Two offer, the RMI does not consider the land-use payments and KADA development funds as part of the economic assistance to the Government. A legal analysis of the RMI’s position is provided as Attachment F.

30. The RMI looks forward to receiving the U.S. Department of Defense’s response regarding its long-term requirements for Kwajalein Atoll. The RMI will respond to the U.S. position when this information is officially presented.

IV. Monitoring and Evaluation

F. Overview

31. The RMI reemphasizes its policy to improve not only Compact and U.S. Government program and service monitoring and evaluation, but to improve overall fiscal and economic management oversight so that the Government, people of the RMI, U.S. and other donors see real progress and results from the significant investments that are made. However, while the RMI is aware of responsibilities and is willing to work in a cooperative manner with the United States, the RMI believes that the monitoring, reporting and auditing and other forms of evaluation should not be overbearing. Excessive requirements can prove extremely expensive for the RMI to absorb and can also overburden the public service.

32. As an example of the Government’s cooperative and participatory attitude, the RMI has begun implementing the MTBIF. Components of the MTBIF were shared with the U.S. Office of Compact Negotiations. The MTBIF and performance indicator approach has been approved by the RMI Cabinet and is starting to be implemented. The MTBIF was applied in the preparation of the FY 2003 budget cycle, also recently approved by the Cabinet. The MTBIF will be expanded to include 2004 and 2005 once an agreement is made for the new Title Two economic assistance. The attached indicative MTBIF has factored RMI proposed economic assistance for the trend years. The ADB has committed to support this system and capacity building effort for at least the next 3 years. The ADB is also currently considering expanding the MTBIF to improve departmental administration to improve fund management and effectiveness as well as establish sector performance indicators. This will allow the Government to measure not only the amounts of investment, but also the results of the investments and the impact on the users.

33. Also, the Government has amended the Act establishing the Marshall Islands Intergenerational Trust Fund (MIITF). The amendment establishes an Interim Board of Directors and the process to appoint a Fund Manager for initial implementation. The Government deems it vital to transfer the funds set aside for the MIITF, as indicated previously, into an investment fund. The MIITF Act, previously provided to the U.S. Office of Compact Negotiations, is very similar to the outline proposed by the U.S. Government in its March counter proposal. It is requested that a Working Group be established so that the Act and U.S. proposed framework are parallel and the MIITF can be adjusted prior to the new Title Two implementation.

G. RMI-U.S. Joint Economic Review Board

34. In line with the RMI’s Compact Proposal of December 2001 and the U.S. proposal of March 2002, the RMI remains committed to the formation and participation in the RMI-U.S. Joint Economic Review Board (JERB). The RMI agrees to the design and function of the JERB per the U.S. proposal with one exception. It is requested that the JERB have equal representation (2 RMI representatives and 2 U.S. representatives) with the fifth member being the chairperson and rotating between the RMI and U.S. annually.

35. It is also requested that the JERB have two ex officio members: one being for a regional multi-lateral financial institution such as the ADB; and a second being a regional technical advisory organization, such as the Secretariat of the Pacific Community (SPC).

36. The RMI remains committed to establishing the Economic Policy, Planning, and Statistics Office (EPPSO) so it will function as a central economic management and policy making body as well as serve as the RMI’s secretariat for the JERB. Initial steps have been taken to establish this office.

H. U.S. Liaison for Oversight, Reporting, Compliance and Program/Service Development

37. As previously stated in the RMI’s December 2001 proposal and as discussed in RMI-U.S. technical meetings, more resources and emphasis must be provided by the United States to ensure oversight and compliance as well as for the RMI to reap the full benefits of the Compact. As stated above, the RMI is committed to do its part with the implementation of the MTBIF, the initiation of a performance orientation, and the establishment of EPPSO.

38. In its December 2001 proposal the RMI requested the presence of 2 U.S. personnel stationed at the U.S. Embassy. One person was to assist in providing Compact and other U.S. program and service oversight and reporting, and the second was to provide liaison for accessing of U.S. programs and services.

39. The RMI modifies this request so that a Project Implementation Unit (PIU) is established in Majuro. The ADB has suggested that it would participate in such a PIU by providing specialists to assist in the allocation and reporting oversight of capital improvement and maintenance projects. It is requested that the U.S. provide one person to assist this office in the monitoring and reporting of Compact-provided capital improvement funds.

40. The RMI will place more of an emphasis on targeting U.S. Federal programs and services. Given the size and breadth of the U.S. Government, the RMI requests that one person is provided to help access these programs and services and maintain liaison with the United States’ Compact implementation point (such as the U.S. Department of Interior’s Office of Insular Affairs).

41. The RMI Government sincerely believes that with the aforementioned monitoring and oversight reporting mechanisms, the application of the economic assistance will have a greater positive impact on the citizens of the RMI, greatly improve the United States’ monitoring and oversight, and help to maintain fiscal stability so that at the end of the extended Title Two term, sufficient capacity building will have taken place to prepare the RMI for post Compact stability.

I. General Provisions

42. Section 236 of the Compact is a non-expiring provision, and although the RMI deems the current “full faith and credit” provisions as a fundamental component of economic assistance under the Compact, a complete response will be provided to the specific draft language that has been recently made available by the United States.

43. As indicated above, the RMI will fully address the specific language with respect to grant conditions. However, in response to the U.S. proposal of March 27 the RMI would raise the following points:

a. Any requirements concerning grant conditions premised on the “common rule” should be based on local (RMI) law and standards to the extent that such laws and standards are in place or enacted in the future. Compliance with such standards should be coordinated through reporting mechanisms of the JERB, and not in a unilateral separate process. The potential imposition of “special grant” conditions on an annual basis to already agreed to economic assistance may undermine the MTBIF, since the terms and conditions of assistance could change from year to year.

b. The RMI objects to absorbing the costs associated to compliance with the U.S. Single Audit Act. This represents a substantial departure from the existing Fiscal Procedures Agreement and imposes additional costs on the RMI not taken into account in its proposal.

c. Finally, care must be taken not to impose duplicative reporting requirements and procedures. The capacity of the RMI to comply with new requirements may also be an issue. An effort to achieve better economic performance and accountability will be undermined if the process becomes more important than results.

To view entire MS Word file & Attachments, click here.