Public Financial Management Reform Program (RRP NAU 45032)

ECONOMIC ANALYSIS

A. Economic Background

1. Following its independence in 1968, enjoyed a very high standard of living until the mid-1990s as a result of income from its strong and the associated royalty income, which flowed to the Nauru Phosphate Royalties Trust (NPRT). NPRT was established and designed to manage long-term investments to support Nauruans once the phosphate reserves were exhausted. The government’s fiscal situation deteriorated after phosphate resources exports peaked in the 1980s, after which Nauru entered an era of budget deficits where the government borrowed extensively from the of Nauru (BON) and used NPRT’s assets as collateral. NPRT’s deteriorating financial position was also exacerbated by losses arising from numerous poor investments.

2. By 1995, following the collapse of the BON, the country found itself facing a serious financial crisis. Difficulties in servicing interest payments led to further government borrowing and indebtedness that is now substantial. Government debt amounted to A$549 million as at 30 June 2011. NPRT’s overseas investments were heavily mortgaged, and there was little ability to pay for investment in and maintenance of infrastructure and basic services. A reform-minded government, elected in 2004, initiated an ongoing process of economic and fiscal consolidation for the Nauruan economy.

3. The decline in Nauru’s fiscal position in the mid-1990s was accompanied by a severe downturn in the volume of phosphate exports which had been declining from the late 1980s as primary phosphate reserves were depleted. Nauru had negligible phosphate exports in 1999– 2006. Seeking revenue to offset loss of income from phosphate and finance budget deficits, the country also became center for offshore banking and tax haven during the 1990s, only to run afoul of anti- efforts. Since the early 2000s, the economy has been largely dependent on , primarily from . In (FY) 2011, budget support is expected to be A$32.8 million and donor expenditure (not channeled through the budget), A$31.0 million. Some of the Australian assistance was linked to payments for holding asylum seekers and for an out-of-court settlement (A$73.0 million payable from 1993 to 2013) as compensation for damage ( and the UK also had one time A$8.2 million settlements).

B. Structure of the Economy

4. The economy of Nauru is dominated by the government and its state-owned enterprises (SOEs). There is little in the way of formal, private sector activity apart from restaurants and retail trade. Estimates from 2001 indicate about 95% of employed workers in Nauru worked in the public sector.1 There are a number of historical reasons for this, including most importantly the way phosphate mining proceeds were dispersed to the population prior to the early 2000s. Rather than being used for direct transfers such as wage subsidies, the money not allocated to the trust funds was dispersed through the provision of free services e.g., electricity, water, housing and, in the case of Air Nauru, heavily subsidized air fares, and the provision of government jobs, virtually on demand, for citizens. The high wages available for low skilled work in the public sector reduced the incentive of Nauruans to engage in other activities or to develop their own skills, and reduced the prospective returns on private investment for anyone contemplating starting a business. The availability of high wages and free services on the island consequently stifled the development of private sector activity. Most recent figures show 67.4%

1 The Economist, December 20, 2001. 2 of the population is not longer part of the labor force (Nauru Bureau of Statistics, 2002, http://www.spc.int/prism/country/nr/stats/Statistics/stats_index.htm).

5. Adding to the problem was the complex system of land tenure. In Nauru, each piece of land has a large number of owners—both individual and family. Non-Nauruans are not allowed to own land. The system of joint ownership means there is no real estate market, which dampens the incentive of individual occupants to maintain or improve the housing stock. In fact, very little of Nauru’s capital stock is individually owned, and lack of maintenance is pervasive. The development of business activity is further constrained by the need for any business operated on the island by non-citizens to have a Nauruan licensee.

6. Phosphate mining provided the main source of the nation’s income until the late 1980s, and production average about 2 million tons per year in the 1970s and early 1980s. However, the industry contracted substantially subsequently, while other industries became relatively more important to the economy. Since the resumption of phosphate exports in 2007, phosphate mining and processing (included in manufacturing) has regained some of its prominence and now accounts for close to 40% of .

Gross Domestic Product by Industry (A$ millions) FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 Primary Industries 3.05 2.84 3.09 4.43 9.05 12.99 , Hunting and Forestry 1.49 1.33 1.02 0.93 0.94 0.80 Fishing 1.22 1.35 1.60 1.63 1.66 2.03 Mining and Quarrying 0.34 0.16 0.48 1.87 6.44 10.15 Secondary Industries (1.00) (2.39) 0.23 3.00 12.41 25.39 Manufacturing 3.02 1.22 (0.33) 0.19 7.10 17.29 Electricity, Gas and Water Supply (5.10) (4.76) (2.05) 1.53 3.12 5.76 Construction 1.08 1.15 2.61 1.28 2.19 2.34 Tertiary Industries 35.52 33.98 30.40 20.19 28.07 31.18 Trade 4.65 4.07 4.54 6.03 6.58 6.68 Hotel and Restaurants 2.58 2.65 2.20 2.28 2.11 2.41 Transport, Storage and Communications 9.42 8.19 3.89 (0.35) 6.11 6.42 Finance, Real Estate and Business Services 1.55 1.58 1.83 1.81 1.97 2.90 Public Administration & Defense 11.70 11.69 11.78 4.08 4.09 4.86 Services 0.80 0.84 0.99 1.08 1.53 1.92 Health Services 1.04 1.08 1.27 1.39 1.59 1.60 Other Cultural, Recreation and Personal Services 0.52 0.56 0.64 0.65 0.67 0.80 Owner Occupied Dwellings 3.25 3.31 3.26 3.23 3.42 3.58 Gross Domestic Product 37.56 34.43 33.72 27.62 49.53 69.55 Market 18.95 15.81 14.77 16.08 36.89 55.64 Non Market 18.61 18.62 18.95 11.54 12.64 13.91 FY = financial year. Source: Nauru Bureau of Statistics. 7. The arrival of Digicel in Nauru has transformed telecommunications on the island. Digicel took over the telecommunication assets of the government in exchange for a 20% share of the government telecommunications company. There is now a workable phone and wireless internet , replacing the slow and erratic land line and cable system. Further development 3 of the service may require additional contributions from the government to retain its share of the company. This service has the potential to facilitate other developments including mobile money transfer, which has proven successful in other Pacific countries served by Digicel (e.g., PNG).

C. Money, Banking, and Prices

8. The Republic of Nauru has been without a financial institution capable of providing commercial banking services since the collapse of BON in the early 2000’s. Reserves held by BON were drawn down to the point where it could no longer meet its obligations to depositors, and it effectively ceased operating in 1998. The BON facilities are now used by the government only for storing cash to pay salaries and collect local revenue There is currently no formal domestic system for consumers and business to hold deposits or access credit, and only limited international transactional services are available. The lack of a formal financial system is an impediment to the development of the private sector on the island. Individuals have no avenue or incentive to save or invest surplus income, while they continue to receive royalties from phosphate mining and potentially from trust funds. A cash economy is facilitated by a payments and receipts office under the direction of the Ministry of Finance.

9. Proposals have been mooted since 1999 for the government to arrange for foreign institutions to establish banking and insurance services on the island. Blacklisting by the Financial Action Task Force on Money Laundering and the associated international financial counter-measures of Nauru has prevented the establishment of a branch of a foreign bank in Nauru. The counter measures were lifted on 13 October 2005 when the Financial Action Task Force on Money Laundering removed Nauru from the list. Although a Western Union money transfer agency has been established on the island, recent discussions with foreign operating in the region have as of yet been unable to secure a commitment to establish in Nauru. The small size of the economy, the relatively high cost of establishing banking and inexistent insurance operations will impede efforts to re-establish a finance sector. The unresolved position of the BON and the situation of its borrowers and depositors—who constitute the main customers for a new bank—may also impede the sector. BON is expected to be wound up and liquidated by the end of 2013.

10. Digicel has approached the government with a proposal to introduce a money transfer service through its mobile phone network. Developing a regulatory framework governing mobile banking for Nauru is challenging given the country’s lack of a bank in operation. Digicel proposed to have a consolidated single pool bank account with the National Bank of Vanuatu held in the Government of Nauru’s name. Given the history of financial mismanagement in the BON, Nauru’s government did not support the proposal.

11. The government is lobbying to have a reputable commercial bank set up a branch in Nauru. ADB is providing assistance to help attract a bank to Nauru. This work is at an early stage. Preliminary work, however, indicates that there are sufficient deposits that could be mobilized to interest an overseas financial institution.

12. Nauru uses the as its means of exchange, so it has no control over monetary policy or interest rates, and cannot issue to fund deficit spending. This lessens the chance of being driven upwards by uncontrolled government expenditures. The inability to issue currency also has important implications for government financing, as the government’s non donor revenue is dependent on fluctuating income from fishing licenses and phosphate exports. 4

13. Prices were thought to be anchored largely to those in Australia. Since Nauru began compiling its own Consumer Price Index (CPI) during the last two years, however, data shows that the country has experienced modest deflation due to declining telecommunications and clothing costs. The Statistics Bureau attributes at least a portion of the deflation to incorrect weighting of the basket due to changes in household consumption patterns since the last household survey was conducted in 2006.

D. Economic Prospects

14. Some increase in phosphate exports is now taking place; estimated phosphate exports of 385,000 tons were achieved in FY2011 compared with 17,200 tons in FY2006 and 319,000 tons in FY2010. The world phosphate rock market is improving after declining in FY2009. The long-term outlook is favorable at present with demand expected to grow at an average rate of around 3% per annum in 2009–2019. Recently improved phosphate-loading facilities and improved management of RONPHOS are expected to lift phosphate exports to over 500,000 tons in FY2012 taking economic growth to 4.8% in FY2012 and 4.2% in FY2013.

15. Primary phosphate reserves are estimated to be enough for 1–2 years of production, and deeper, secondary reserves might last 20 years. Full exploitation of the phosphate resource, however, requires considerable investment to refurbish the necessary infrastructure. Improved governance, especially of the SOEs that dominate the economy, is also needed to encourage the public and private investment required.

16. In addition to phosphate, other possible industries include niche tourism, commercial tuna fishing and the manufacture of dolomite tiles. Australia, in its recent aid review, acknowledged that the growth prospects of Pacific microstates such as Nauru were limited and flagged a planned doubling of aid to these states to offset this. The possible re-opening of Australian Offshore Processing Centre for refuges would also provide an additional source of employment and income for Nauruans.

17. NPRT is currently in the process of being liquidated. NPRT still contains assets in excess of A$100 million but there is uncertainty around the medium term future of the NPRT: (i) whether the trust will liquidate in full through payouts to the beneficiaries, or (ii) whether the capital base will be maintained and distributions of interest are made to the beneficiaries. The resolution of the NPRT will have a major impact on consumption growth and incomes in Nauru.