Background

		Compact of Free Association: 1986-2003

In 1986, the United States, the FSM, and the RMI entered into the original  Compact of Free Association. The compact provided a framework for the  United States to work toward achieving its three main goals: (1) to secure  self-government for the FSM and the RMI, (2) to ensure certain national  security rights for all of the parties, and (3) to assist the FSM and the RMI  in their efforts to advance economic development and self-sufficiency.  Under the original compact, the FSM and RMI also benefited from  numerous U.S. federal programs, while citizens of both nations exercised  their right under the compact to live and work in the United States as  “nonimmigrants” and to stay for long periods of time.
Although the first and second goals of the original compact were met,  economic self-sufficiency was not achieved under the first compact. The  FSM and the RMI became independent nations in 1978 and 1979,  respectively, and the three countries established key defense rights,  including securing U.S. access to military facilities on Kwajalein Atoll in  the RMI through 2016. The compact’s third goal was to be accomplished  primarily through U.S. direct financial assistance to the FSM and the RMI  that totaled $2.1 billion from 1987 through 2003. However, estimated FSM  and RMI per capita GDP levels at the close of the compact did not exceed,  in real terms, those in the early 1990s, although U.S. assistance had  maintained income levels that were higher than the two countries could  have achieved without support. In addition, we found that the U.S., FSM,  and RMI governments provided little accountability over compact  expenditures and that many compact-funded projects experienced  problems because of poor planning and management, inadequate  construction and maintenance, or misuse of funds.

		Amended Compacts of Free Association: 2004- 2023

In 2003, the United States approved separate amended compacts with the  FSM and RMI that (1) continue the defense relationship, including a new  agreement providing U.S. military access to Kwajalein Atoll in the RMI  through 2086; (2) strengthen immigration provisions; and (3) provide an  estimated $3.6 billion in financial assistance to both nations from 2004  through 2023, including about $1.5 billion to the RMI (see app. I). The  amended compacts identify the additional 20 years of grant assistance as  intended to assist the FSM and RMI governments in their efforts to  promote the economic advancement and budgetary self-reliance of their  people. Financial assistance is provided in the form of annual sector  grants and contributions to each nation’s trust fund. The amended  compacts and their subsidiary agreements, along with the countries’  development plans, target the grant assistance to six sectors—education,  health, public infrastructure, the environment, public sector capacity  building, and private sector development—prioritizing two sectors,  education and health. Further, the amended compact stipulates that  certain funding be made available to address the population’s needs on  Kwajalein Atoll. To provide increasing U.S. contributions to the FSM’s and  the RMI’s trust funds, grant funding decreases annually and will likely  result in falling per capita grant assistance over the funding period and  relative to the original compact (see fig. 1). For example, in 2004 U.S.  dollar terms, FSM per capita grant assistance will fall from around $1,352  in 1987 to around $562 in 2023, and RMI per capita assistance will fall from  around $1,170 in 1987 to around $317 in 2023.
Under the amended compacts, annual grant assistance is to be made  available in accordance with an implementation framework that has  several components (see app. II). For example, prior to the annual  awarding of compact funds, the countries must submit development plans  that identify goals and performance objectives for each sector. The FSM  and RMI governments are also required to monitor day-to-day operations  of sector grants and activities, submit periodic financial and performance  reports for the tracking of progress against goals and objectives, and  ensure annual financial and compliance audits. In addition, the U.S. and  FSM Joint Economic Management Committee (JEMCO) and the U.S. and  RMI Joint Economic Management and Financial Accountability Committee  (JEMFAC) are to approve annual sector grants and evaluate the countries’  management of the grants and their progress toward compact goals. The  amended compacts also provide for the formation of FSM and RMI trust  fund committees to, among other things, hire money managers, oversee  the respective funds’ operation and investment, and provide annual  reports on the effectiveness of the funds.

	Current Development Prospects Remain Limited for the RMI

The RMI economy shows limited potential for developing sustainable  income sources other than foreign assistance to offset the annual decline  in U.S. compact grant assistance. In addition, the RMI has not enacted  economic policy reforms needed to improve its growth prospects.
The RMI’s economy shows continued dependence on government  spending of foreign assistance and limited potential for expanded private  sector and remittance income.
Since 2000, the estimated public sector share of GDP has grown, with  public sector expenditure in 2005—about two-thirds of which is funded  by external grants—accounting for about 60 percent of GDP.
The RMI’s government budget is characterized by limited tax revenue  paired with growing government payrolls. For example, RMI taxes have  consistently provided less than 30 percent of total government revenue;  however, payroll expenditures have roughly doubled, from around $17  million in 2000 to around $30 million in 2005.
The RMI development plan identifies fishing and tourism as key  potential private sector growth industries. However, the two industries  combined currently provide less than 5 percent of employment, and  both industries face significant constraints to growth that stem from  structural barriers and a costly business environment. According to  economic experts, growth in these industries is limited by factors such  as geographic isolation, lack of tourism infrastructure, inadequate  interisland shipping, a limited pool of skilled labor, and a growing  threat of overfishing.
Although remittances from emigrants could provide increasing  monetary support to the RMI, evidence suggests that RMI emigrants  are currently limited in their income-earning opportunities abroad  owing to inadequate education and vocational skills. For example, the  2003 U.S. census of RMI migrants in Hawaii, Guam, and the  Commonwealth of the Northern Marianas Islands reveals that only 7  percent of those 25 years and older had a college degree and almost  half of RMI emigrants lived below the poverty line.
Although the RMI has undertaken efforts aimed at economic policy  reform, it has made limited progress in implementing key tax, land,  foreign investment, and public sector reforms that are needed to improve  its growth prospects. For example:    The RMI government and economic experts have recognized for  several years that the RMI tax system is complex and regressive, taxing  on a gross rather than net basis and having weak collection and  administrative capacity. Although the RMI has focused on improving  tax administration and has raised some penalties and tax levels,  legislation for income tax reform has failed and needed changes in  government import tax exemptions have not been addressed.  In attempts to modernize a complex land tenure system, the RMI has  established land registration offices. However, such offices have lacked  a systematic method for registering parcels, instead waiting for  landowners to voluntarily initiate the process. For example, only five  parcels of land in the RMI had been, or were currently being, registered  as of June 2006. Continued uncertainties over land ownership and land  values create costly disputes, disincentives for investment, and  problems regarding the use of land as an asset.
Economic experts and private sector representatives describe the  overall climate for foreign investment in the RMI as complex and  nontransparent. Despite attempts to streamline the process, foreign  investment regulations remain relatively burdensome, with reported  administrative delays and difficulties in obtaining permits for foreign  workers.
The RMI government has endorsed public sector reform; however,  efforts to reduce public sector employment have generally failed, and  the government continues to conduct a wide array of commercial  enterprises that require subsidies and compete with private  enterprises. As of June 2006, the RMI had not prepared a  comprehensive policy for public sector enterprise reform.
Although the RMI development plan includes objectives for economic  reform, until August 2006—two years into the amended compact— JEMFAC did not address the country’s slow progress in implementing  these reforms.

	The RMI Faces Challenges to Effectively Implementing Compact Assistance for Its Long-Term Development Goals

The RMI has allocated funds to priority sectors, although several factors  have hindered its use of the funds to meet long-term development needs.  Further, despite actions taken to effectively implement compact grants,  administrative challenges have limited its ability to ensure use of the  grants for its long-term goals. In addition, although OIA has monitored  early compact activities, it has also faced capacity constraints.
The RMI allocated compact funds largely to priority sectors for 2004-2006.  The RMI allocated about 33 percent, 40 percent, and 20 percent of funds to  education, infrastructure, and health, respectively (see fig. 2). The  education allocation included funding for nine new school construction  projects, initiated in October 2003 through July 2006. However, various  factors, such as land use issues and inadequate needs assessments, have  limited the government’s use of compact funds to meet long-term  development needs. For example:    Management and land use issues in Ebeye. The RMI government and  Kwajalein landowners have been disputing the management of public  entities and government use of leased land on the atoll. Such tensions  have negatively affected the construction of schools and other  community development initiatives. For example, the government and  landowners disagreed about the management of the entity designated  to use the compact funds set aside for Ebeye special needs;  consequently, about $3.3 million of the $5.8 million allocated for this  purpose had not been released for the community’s benefit until after  September 2006. In addition, although the RMI has completed some  infrastructure projects where land titles were clear and long-term  leases were available, continuing uncertainty regarding land titles may  delay future projects.
Lack of planning for declining U.S. assistance. Despite the goal of  budgetary self-reliance, the RMI lacks concrete plans for addressing the  annual decrement in compact funding, which could limit its ability to  sustain current levels of government services in the future. RMI  officials told us that they can compensate for the decrement in various  ways, such as through the yearly partial adjustment for inflation  provided for in the amended compacts or through improved tax  collection. However, the partial nature of the adjustment causes the  value of the grant to fall in real terms, independent of the decrement,  thereby reducing the government’s ability to pay over time for imports,  such as energy, pharmaceutical products, and medical equipment.  Additionally, the RMI’s slow progress in implementing tax reform will  limit its ability to augment tax revenues.
The RMI has taken steps to effectively implement compact assistance, but  administrative challenges have hindered its ability to ensure use of the  funds for its long-term development goals. The RMI established  development plans that include strategic goals and objectives for the  sectors receiving compact funds. Further, in addition to establishing  JEMFAC, the RMI designated the Ministry of Foreign Affairs as its official  contact point for compact policy and grant implementation issues.  However, data deficiencies, report shortcomings, capacity constraints, and  inadequate communication have limited the RMI and U.S. governments’  ability to consistently ensure the effective use of grant funds to measure  progress, and monitor day-to-day activities.
Data deficiencies. Although the RMI established performance  measurement indicators, a lack of complete and reliable data has  prevented the use of these indicators to assess progress. For example,  the RMI submitted data to JEMFAC for only 15 of the 20 required  education performance indicators in 2005, repeating the submission in  2006 without updating the data. Also, in 2005, the RMI government  reported difficulty in comparing the health ministry’s 2004 and 2005  performance owing to gaps in reported data—for instance, limited data  were available in 2004 for the outer island health care system.
Report shortcomings. The usefulness of the RMI’s quarterly  performance reports has also been limited by incomplete and  inaccurate information. For example, the RMI Ministry of Health’s 2005  fourth-quarter report contained incorrect outpatient numbers for the  first three quarters, according to a hospital administrator. Additionally,  we found several errors in basic statistics in the RMI quarterly reports  for education, and RMI Ministry of Education officials and officials in  other sectors told us that they had not been given the opportunity to  review the final performance reports compiled by the statistics office  prior to submission.
Capacity constraints. Staff and skill limitations have constrained the  RMI’s ability to provide day-to-day monitoring of sector grant  operations. However, the RMI has submitted its single audits on time.  In addition, although the single audit reports for 2004 and 2005  indicated weaknesses in the RMI’s financial statements and compliance  with requirements of major federal programs, the government has  developed corrective action plans to address the 2005 findings related  to such compliance.
Lack of communication. Our interviews with U.S. and RMI department  officials, private sector representatives, NGOs, and economic experts  revealed a lack of communication and dissemination of information by  the U.S. and RMI governments on issues such as JEMFAC decisions,  departmental budgets, economic reforms, legislative decisions, and  fiscal positions of public enterprises. Such lack of information about  government activities creates uncertainty for public, private, and  community leaders, which can inhibit grant performance and  improvement of social and economic conditions.
As administrator of the amended compact grants, OIA monitored sector  grant and fiscal performance, assessed RMI compliance with compact  conditions, and took action to correct persistent shortcomings. For  example, since 2004, OIA has provided technical advice and assistance to  help the RMI improve the quality of its financial statements and develop  controls to resolve audit findings and prevent recurrences. However, OIA  has been constrained in its oversight role owing to staffing challenges and  time-consuming demands associated with early compact implementation  challenges in the FSM.

	RMI Trust Fund May Not Provide Sustainable Income After Compact Grants End

Market volatility and choice of investment strategy could lead to a wide  range of RMI trust fund balances in 2023 (see app. III) and potentially  prevent trust fund disbursements in some years. Although the RMI has  supplemented its trust fund balance with additional contributions, other  sources of income are uncertain or entail risks. Furthermore, the RMI’s  trust fund committee has faced challenges in effectively managing the  fund’s investment.
Market volatility and investment strategy could have a considerable  impact on projected trust fund balances in 2023. Our analysis indicates  that, under various scenarios, the RMI’s trust fund could fall short of the  maximum allowed disbursement level—an amount equal to the inflation- adjusted compact grants in 2023—after compact grants end, with the  probability of shortfalls increasing over time (see fig. 3). For example,  under a moderate investment strategy, the fund’s income is only around 10  percent likely to fall short of the maximum distribution by 2031. However,  this probability rises to almost 40 percent by 2050. Additionally, our  analysis indicates a positive probability that the fund will yield no  disbursement in some years; under a moderate investment strategy the  probability is around 10 percent by 2050. Despite the impact of market  volatility and investment strategy, the trust fund committee’s reports have  not yet assessed the fund’s potential adequacy for meeting the RMI’s long- term economic goals.
RMI trust fund income could be supplemented from several sources,  although this potential is uncertain. For example, the RMI received a  commitment from Taiwan to contribute $40 million over 20 years to the  RMI trust fund, which improved the RMI fund’s likely capacity for  disbursements after 2023. However, the RMI’s limited development  prospects constrain its ability to raise tax revenues to supplement the  fund’s income. Securitization—issuing bonds against future U.S.  contributions—could increase the fund’s earning potential by raising its  balances through bond sales. However, securitization could also lead to  lower balances and reduced fund income if interest owed on the bonds  exceeds investment returns.
The RMI trust fund committee has experienced management challenges in  establishing the trust fund to maximize earnings. Contributions to the trust  fund were initially placed in a low-interest savings account and were not  invested until 16 months after the initial contribution. As of June 2007,  the RMI trust fund committee had not appointed an independent auditor  or a money manager to invest the fund according to the proposed  investment strategy. U.S. government officials suggested that contractual  delays and committee processes for reaching consensus and obtaining  administrative support contributed to the time taken to establish and  invest funds. As of May 2007, the committee had not yet taken steps to  improve these processes.

	Conclusions

Since enactment of the amended compacts, the U.S. and RMI governments  have made efforts to meet new requirements for implementation,  performance measurement, and oversight. However, the RMI faces  significant challenges in working toward the compact goals of economic  advancement and budgetary self-reliance as the compact grants decrease.  Largely dependent on government spending of foreign aid, the RMI has  limited potential for private sector growth, and its government has made  little progress in implementing reforms needed to increase investment  opportunities and tax income. In addition, JEMFAC did not address the  pace of reform during the first 2 years of compact implementation.  Further, both the U.S. and RMI governments have faced significant  capacity constraints in ensuring effective implementation of grant funding.  The RMI government and JEMFAC have also shown limited commitment  to strategically planning for the long-term, effective use of grant assistance  or for the budgetary pressure the government will face as compact grants  decline. Because the trust fund’s earnings are intended as a main source of  U.S. assistance to the RMI after compact grants end, the fund’s potential  inadequacy to provide sustainable income in some years could impact the  RMI’s ability to provide government services. However, the RMI trust fund  committee has not assessed the potential status of the fund as an ongoing  source of revenue after compact grants end in 2023.

	Prior Recommendations

Our prior reports on the amended compacts include recommendations  that the Secretary of the Interior direct the Deputy Assistant Secretary for  Insular Affairs, as chair of the RMI management and trust fund  committees, to, among other things,    ensure that JEMFAC address the lack of RMI progress in implementing  reforms to increase investment and tax income;    coordinate with other U.S. agencies on JEMFAC to work with the the  RMI to establish plans to minimize the impact of declining assistance;    coordinate with other U.S. agencies on JEMFAC to work with the RMI  to fully develop a reliable mechanism for measuring progress toward  compact goals; and    ensure the RMI trust fund committee’s assessment and timely reporting  of the fund’s likely status as a source of revenue after 2023.
Interior generally concurred with our recommendations and has taken  actions in response to several of them. For example, in August 2006,  JEMFAC discussed the RMI’s slow progress in implementing economic  reforms. Additionally, the trust fund committee decided in June 2007 to  create a position for handling the administrative duties of the fund.  Regarding planning for declining assistance and measuring progress  toward compact goals, JEMFAC has not held an annual meeting since the  December 2006 publication of the report containing those  recommendations.
Mr. Chairman and members of the subcommittee, this completes my  prepared statement. I would be happy to respond to any questions you  may have at this time.

	Contacts and Acknowledgements

For future contacts regarding this testimony, please call David Gootnick at  (202) 512-3149 or gootnickd@gao.gov. Individuals making key  contributions to this testimony included Emil Friberg, Jr., Ming Chen,  Tracy Guerrero, Julie Hirshen, Leslie Holen, Reid Lowe, Mary Moutsos,  Kendall Schaefer, and Eddie Uyekawa.

Appendix I: U.S. Assistance to Be Provided to the FSM and the RMI under the Amended Compacts, 2004-2023

FSM grants (Section 211) (Section 215) (Section 211) (Section 216) (Section 212)a For both the FSM and the RMI, annual grant amounts include $200,000 to be provided directly by the  Secretary of the Interior to the Department of Homeland Security, Federal Emergency Management  Agency, for disaster and emergency assistance purposes. The grant amounts do not include the  annual audit grant, capped at $500,000, that will be provided to both countries.
These dollar amounts shall be adjusted each fiscal year for inflation by the percentage that equals  two-thirds of the percentage change in the U.S. gross domestic product implicit price deflator, or 5  percent, whichever is less in any one year, using the beginning of 2004 as a base. Grant funding can  be fully adjusted for inflation after 2014, under certain U.S. inflation conditions.  “Kwajalein Impact” funding is provided to the RMI government, which in turn compensates Kwajalein  Atoll landowners for U.S. access to the atoll for military purposes.

Appendix II: Amended Compact Implementation Framework

	Annual sector grant budget

FSM/RMI propoe grnt budget for ech ector tht inclde proviion  report to used to: – Monitor gener  –  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 measureopertion to ensure complince with  grnt condition  Submit nnual report to the U.S.

	Joint management and accountability committees

Appendix III: Projections of RMI Account Balance with Three Possible Investment Strategies

U.S. dollar (in illion)
U.S. dollar (in illion)
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Summary:
Why GAO Did This Study

In 2003, the U.S. government extended its economic assistance to the Republic of the Marshall Islands (RMI) through an Amended Compact of Free Association. From 2004 to 2023, the United States will provide an estimated $1.5 billion to the RMI, with annually decreasing grants as well as increasing contributions to a trust fund. The assistance, targeting six sectors, is aimed at assisting the country's efforts to promote economic advancement and budgetary self-reliance. The trust fund is to be invested and provide income for the RMI after compact grants end. The Department of the Interior (Interior) administers and oversees this assistance. Drawing on prior GAO reports ( GAO-05-633 , GAO-06-590 , GAO-07-163 , GAO-07-513 , GAO-07-514R), this testimony discusses (1) the RMI's economic prospects, (2) implementation of the amended compact to meet long-term goals, and (3) potential trust fund earnings. In conducting its prior work, GAO visited the RMI, reviewed reports, interviewed officials and experts, and used a simulation model to project the trust fund's income. Prior GAO reports recommended, among other things, that Interior work with the RMI to address lack of progress in implementing reforms; plan for declining grants; reliably measure progress; and ensure timely reporting on the fund's likely status as a source of revenue after 2023. Interior agreed with GAO's recommendations.

What GAO Found

The RMI has limited prospects for achieving its long-term development goals and has not enacted policy reforms needed to achieve economic growth. The RMI economy depends on public sector spending of foreign assistance rather than on private sector or remittance income. At the same time, the two private sector industries identified as having growth potential--fisheries and tourism--face significant barriers to expansion because of a costly business environment. RMI emigrants also lack marketable skills needed to increase revenue from remittances. Despite declining grants under the compact, RMI progress in implementing key policy reforms to improve the private sector environment, such as tax or land reform, has been slow. In August 2006, the RMI's compact management committee began to address the country's slow progress in implementing reforms. Although the RMI has made progress in implementing compact assistance, it faces several challenges in allocating and using this assistance to support its long-term development goals. RMI grant allocations have reflected compact priorities by targeting health, education, and infrastructure. However, political disagreement over land use in Kwajalein Atoll, where the United States has a missile testing facility, and over management of public entities has negatively affected infrastructure projects. The RMI also has not planned for long-term sustainability of services that takes into account declining compact assistance. Inadequate baseline data and incomplete performance reports have further limited the RMI's ability to adequately measure progress. Although single-audit reporting has been timely, insufficient staff and skills have limited the RMI's ability to monitor day-to-day sector grant operations. Interior's Office of Insular Affairs (OIA) has conducted administrative oversight of the sector grants but has been constrained by competing oversight priorities. The RMI trust fund may not provide sustainable income for the country after compact grants end. Market volatility and the choice of investment strategy could cause the RMI trust fund balance to vary widely, and there is increasing probability that in some years the trust fund will not reach the maximum disbursement level allowed--an amount equal to the inflation-adjusted compact grants in 2023--or be able to disburse any income. In addition, although the RMI has supplemented its trust fund income with a contribution from Taiwan, other sources of income are uncertain or entail risk. Trust fund management processes have also been problematic; as of June 2007, the RMI trust fund committee had not appointed an independent auditor or a money manager to invest the fund according to the proposed investment strategy.