Compact of Free Association: Implementation Activities Have	 
Progressed, but the Marshall Islands Faces Challenges to	 
Achieving Long-Term Compact Goals (24-JUL-07, GAO-07-1115T).	 
                                                                 
From 1987 through 2003, the United States provided more than $2  
billion in economic assistance to the Federated States of	 
Micronesia (FSM) and the RMI under a Compact of Free Association;
approximately $579 million of this economic assistance went to	 
the RMI. In 2003, the U.S. government approved an amended compact
with the RMI that provides an additional 20 years of assistance, 
totaling about $1.5 billion from 2004 through 2023. The 	 
Department of the Interior's Office of Insular Affairs (OIA) is  
responsible for administering and monitoring this U.S.		 
assistance. The amended compact with the RMI identifies the	 
additional 20 years of grant assistance as intended to assist the
RMI government 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 trust funds 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  
that strengthen reporting and bilateral interaction. These	 
provisions include requiring the establishment of a joint	 
economic management committee and a trust fund committee to,	 
respectively, among other things, review the RMI's progress	 
toward compact objectives and to assess the trust fund's	 
effectiveness in contributing to the country's long-term economic
advancement and budgetary self-reliance. In 2003, we testified	 
that these provisions could improve accountability over 	 
assistance but that successful implementation will require	 
appropriate resources and sustained commitment from both the	 
United States and the RMI. Drawing on several reports that we	 
have published since 2005, I will discuss the RMI's economic	 
prospects, implementation of its amended compact to meet	 
long-term goals, and potential trust fund earnings.		 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-07-1115T					        
    ACCNO:   A73229						        
  TITLE:     Compact of Free Association: Implementation Activities   
Have Progressed, but the Marshall Islands Faces Challenges to	 
Achieving Long-Term Compact Goals				 
     DATE:   07/24/2007 
  SUBJECT:   Economic growth					 
	     Foreign governments				 
	     Foreign loans					 
	     Funds management					 
	     Grant monitoring					 
	     Internal controls					 
	     International agreements				 
	     Strategic planning 				 
	     Trust funds					 
	     Federal aid to foreign countries			 
	     Federated States of Micronesia			 
	     Republic of the Marshall Islands			 

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GAO-07-1115T

   

     * [1]Summary
     * [2]Background

          * [3]Compact of Free Association: 1986-2003
          * [4]Amended Compacts of Free Association: 2004-2023

     * [5]Current Development Prospects Remain Limited for the RMI
     * [6]The RMI Faces Challenges to Effectively Implementing Compact
     * [7]RMI Trust Fund May Not Provide Sustainable Income After Comp
     * [8]Conclusions
     * [9]Prior Recommendations
     * [10]Contacts and Acknowledgements
     * [11]GAO's Mission
     * [12]Obtaining Copies of GAO Reports and Testimony

          * [13]Order by Mail or Phone

     * [14]To Report Fraud, Waste, and Abuse in Federal Programs
     * [15]Congressional Relations
     * [16]Public Affairs

Testimony

Before the Subcommittee on Insular Affairs, Committee on Natural
Resources, House of Representatives

United States Government Accountability Office

GAO

For Release on Delivery
Expected at 2:00 p.m. EDT
Tuesday, July 24, 2007

COMPACT OF FREE ASSOCIATION

Implementation Activities Have Progressed, but the Marshall Islands Faces
Challenges to Achieving Long-Term Compact Goals

Statement of David B. Gootnick, Director
International Affairs and Trade

Compact of Free Association Compact of Free Association Compact of Free
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Compact of Free Association

GAO-07-1115T

Madame Chairwoman and Members of the Subcommittee:

I am pleased to be here today to discuss GAO's recent work regarding the
Compact of Free Association between the United States and the Republic of
the Marshall Islands (RMI). From 1987 through 2003,1 the United States
provided more than $2 billion in economic assistance to the Federated
States of Micronesia (FSM) and the RMI under a Compact of Free
Association;2 approximately $579 million of this economic assistance went
to the RMI. In 2003, the U.S. government approved an amended compact with
the RMI that provides an additional 20 years of assistance, totaling about
$1.5 billion from 2004 through 2023.3 The Department of the Interior's
Office of Insular Affairs (OIA) is responsible for administering and
monitoring this U.S. assistance.

The amended compact with the RMI identifies the additional 20 years of
grant assistance as intended to assist the RMI government 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 trust funds 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 that strengthen
reporting and bilateral interaction. These provisions include requiring
the establishment of a joint economic management committee and a trust
fund committee to, respectively, among other things, review the RMI's
progress toward compact objectives and to assess the trust fund's
effectiveness in contributing to the country's long-term economic
advancement and budgetary self-reliance. In 2003, we testified that these
provisions could improve accountability over assistance but that
successful implementation will require appropriate resources and sustained
commitment from both the United States and the RMI.4

1In this testimony, all annual references refer to the fiscal year rather
than the calendar year.

2In 2000, we reviewed assistance under the compact and determined that the
U.S. and RMI governments had provided limited accountability over spending
and that U.S. assistance had resulted in little impact on economic
development in the RMI. See GAO, Foreign Assistance: U.S. funds to Two
Micronesian Nations Had Little Impact on Economic Development,
[17]GAO/NSIAD-00-216 (Washington, D.C.: Sept. 22, 2000).

3This figure is based on a Department of Interior projection as of July,
2007.

Today, drawing on several reports that we have published since 2005,5 I
will discuss the RMI's economic prospects, implementation of its amended
compact to meet long-term goals, and potential trust fund earnings.

Summary

The RMI has limited prospects for achieving its long-term development
objectives and has not enacted policy reforms needed to enable economic
growth. The RMI depends on public sector spending of foreign assistance
rather than on private sector or remittance income; public sector
expenditure accounts for more than half of its gross domestic product
(GDP). The RMI government budget largely depends on foreign assistance
and, despite annual decrements in compact funding to support budgetary
expenditures, is characterized by a growing wage bill. Meanwhile, the two
private sector industries identified as having growth potential--fisheries
and tourism--face significant barriers to expansion because of the RMI's
remote geographic locations, inadequate infrastructure, and poor business
environment. In addition, RMI emigrants lack marketable skills that are
needed to increased revenue from remittances. Moreover, progress in
implementing key policy reforms necessary to improve the private sector
environment has been slow. For example, although economic experts describe
the RMI's current tax system as complex and regressive, the RMI government
has not implemented fundamental tax reform. Further, although the RMI has
established land registration offices, continued uncertainties over land
ownership and land values hamper the use of land as an asset. Foreign
investment regulations remain burdensome, and RMI government involvement
in commercial activities continues to hinder private sector development.
Moreover, at the time of our 2006 report, the RMI's compact management
committee had not addressed the country's slow progress in implementing
reforms.

4GAO, Compact of Free Association: An Assessment of the Amended Compacts
and Related Agreements, [18]GAO-03-988T (Washington, D.C.: June 18, 2003),
testimony before the Committee on Resources, House of Representatives.

5The amended compacts' implementing legislation instructs GAO to report 3
years following the enactment of the legislation and every 5 years
thereafter on the RMI's use and effectiveness of U.S. financial, program,
and technical assistance as well as the effectiveness of administrative
oversight by the United States. See GAO, Compacts of Free Association:
Implementation of New Funding and Accountability Requirements is Well
Under Way, but Planning Challenges Remain, [19]GAO-05-633 (Washington,
D.C.: July 11, 2005); GAO, Compacts of Free Association: Development
Prospects Remain Limited for the Micronesia and the Marshall Islands,
[20]GAO-06-590 (Washington, D.C.: June 27, 2006); GAO, Compacts of Free
Association: Micronesia and the Marshall Islands Face Challenges in
Planning for Sustainability, Measuring Progress, and Ensuring
Accountability, [21]GAO-07-163 (Washington, D.C.: Dec. 15, 2006); GAO,
Compacts of Free Association: Trust Funds for Micronesia and the Marshall
Islands May Not Provide Sustainable Income, [22]GAO-07-513 (Washington,
D.C.: July 15, 2007); and GAO, Compact of Free Association: Micronesia and
the Marshall Island's Use of Sector Grants, [23]GAO-07-514R (Washington,
D.C.: May 25, 2007).

The RMI has made progress in implementing compact assistance, but 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--for
example, funding construction of nine new schools. However, in the case of
Kwajalein Atoll, political disagreement over management of public entities
and government use of leased land has negatively affected the construction
of schools and the use of compact funds set aside for Ebeye special
needs.6 The RMI also has not planned for long-term sustainability of
services that takes into account the annual funding decrement. Capacity
limitations have further affected its ability to ensure the effective use
of grant funds. The RMI currently lacks the capacity to adequately measure
progress, owing to inadequate baseline data and incomplete performance
reports. Moreover, although accountability--as measured by timeliness in
single audit reporting and corrective action plans to single audit
findings--has improved, insufficient staff and skills have limited the
RMI's ability to monitor day-to-day sector grant operations as the
compacts require. Inadequate communication about grant implementation may
further hinder the U.S. and RMI governments from ensuring the grants'
effective use. Although Interior's Office of Insular Affairs (OIA) has
conducted administrative oversight of the sector grants, its oversight has
similarly been constrained by staffing challenges and the need to assist
the FSM with its compact implementation activities.

The RMI trust fund may not provide sustainable income for the country
after compact grants end, potential sources for supplementing trust fund
income have limitations, and the trust fund committee has experienced
management challenges. 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. The trust fund committee's reporting has not analyzed the fund's
potential effectiveness in helping the RMI achieve its long-term economic
goals. Although the RMI has supplemented its trust fund income with a
contribution from Taiwan, other sources of income are uncertain or entail
risk. For example, the RMI's limited development prospects constrain its
ability to raise tax revenues to supplement the fund's income, and options
such as securitization--issuing bonds against future U.S.
contributions--include the risk of lower fund balances and reduced income.
Furthermore, according to U.S. government officials, trust fund management
processes have been problematic. As of June 2007, for example, 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.

6Kwajalein Atoll is the RMI's second most populated atoll, where many
residents were displaced to provide space for U.S. missile testing. Many
of these residents now reside on Ebeye Island.

Our previous reports on the amended compacts recommended, among other
things, that Interior's Deputy Assistant Secretary for Insular Affairs
ensure that the compact management committee address the RMI's lack of
progress in implementing economic reforms; work with the RMI to develop
plans for minimizing the impact of the declining grants; work with the RMI
to fully develop a reliable mechanism for measuring progress toward
compact goals; and ensure the trust fund committee's timely reporting on
the fund's likely status as a source of revenue after 2023. Interior
generally concurred with our recommendations and has taken some actions in
response to several of them.

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 2003.7 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,8 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.9

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).10 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.11 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 app. II).12 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.

7This estimate is based on Interior data and represents total nominal
outlays. It does not include payments for compact-authorized federal
services or U.S. military use of Kwajalein Atoll land, nor does it include
investment development funds provided under section 111 of Public Law
99-239.

8Estimated FSM per capita GDP, in fiscal year 2003 U.S. dollars, was
$2,151 in 2003 compared with an average of $2,093 from 1990 to 1995.
Estimated RMI per capita GDP, in fiscal year 2003 U.S. dollars, was $2,247
in 2003 compared with an average of $2,336 from 1990 to 1995.

9 [24]GAO/NSIAD-00-216 .

10The RMI and FSM amended compacts went into effect on May 1, 2004, and
June 25, 2004, respectively. The $1.5 billion in assistance to the RMI
includes (1) compact grants; (2) trust fund contributions; (3) lease
payments; and (5) inflation adjustments.

Under the amended compacts, annual grant assistance is to be made
available in accordance with an implementation framework that has several
components (see app. III). 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.

11The RMI compact requires its infrastructure grant to be 30 to 50 percent
of its total annual sector grants. Additionally, the RMI must target grant
funding to Ebeye and other Marshallese communities within Kwajalein Atoll.

12U.S. contributions to trust funds were conditioned on the FSM and the
RMI making their own required contribution. The RMI made its required
initial contribution of $30 million to its trust fund on June 1, 2004.

The RMI's economy shows continued dependence on government spending of
foreign assistance and limited potential for expanded private sector and
remittance income.

           o 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.
           o 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.
           o 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.
           o 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.13

Although the RMI has undertaken efforts aimed at economic policy reform,14
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:

13See [25]GAO-06-590 . However, a preliminary survey of RMI emigrants in
Springdale, Arkansas suggests that the emigrant population there has
higher education levels and lower poverty levels relative to the emigrant
population in Hawaii, Guam, and the CNMI.

14For example, the Asian Development Bank has recently assisted the RMI in
holding "Dialogue for Action" retreats that enable public and private
sector representatives to develop a common vision for sustainable
development through economic reform.

           o 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.
           o 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.
           o 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.
           o 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--2 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 app. IV). 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:

           o Management and land use issues. 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.15 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 2006.16 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.
           o 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.

15In addition to these examples, land issues remain an issue for U.S.
access to Kwajalein Atoll through the defense provisions of the amended
compact. The RMI government is bound by an agreement with the U.S.
government that allows for U.S. access to Kwajalein Atoll until 2086. To
date, the RMI government has not reached an agreement with Kwajalein Atoll
landowners (who own the land under use by the U.S. government) that allows
for this long-term access.

16The funds were supposed to be allocated to the Kwajalein Atoll
Development Authority, which experienced problems in effectively and
efficiently using funds in the past. In early 2005, RMI legislation
stipulated the authority's restructuring; however, the law was
subsequently repealed by the RMI government. Kwajalein landowners are
challenging this decision in court.

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.17 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.18 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.

           o 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.
           o 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.
           o 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.
           o 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.

17The RMI's development plan consists of three documents: Vision 2018,
Meto 2000, and the Medium Term Budget and Investment Framework. In
addition, the annual portfolio submissions include strategic goals and
indicators for each of the sectors. We refer collectively to all of these
RMI documents as "the development plan."

18Prior to designating the Ministry of Foreign Affairs as a compact
implementation unit, the RMI had identified the Office of the Chief
Secretary as the official point of contact for all communication and
correspondence with the U.S. government concerning compact sector grant
assistance. The RMI's Economic Policy, Planning, and Statistics Office
also works with the ministries receiving grants to prepare the annual
budget proposals, quarterly reports, and annual monitoring and evaluation
reports.

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 202319 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.

19Under a projected conservative investment strategy, our analysis
estimates that the RMI trust fund could range from $439 million to $862
million in 2023. Under a projected aggressive investment strategy, the RMI
trust fund could range from $438 million to $1.4 billion in 2023.

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 app. V). 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.20

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.21 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.

20According to Interior officials, the trust fund committees are reviewing
this option but have not initiated an independent study to objectively
evaluate its potential risks.

21For the months before the investment of the RMI trust fund's
approximately $49 million in October 2005, the fund earned a return of
approximately 3 percent, compared with a stock market return of about 4
percent. Given the small difference in returns, as well as the fees that
the fund would have paid if invested in the stock market, we estimate that
this delay reduced the fund's earnings by approximately $51,000.

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 compacts22 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,

           o ensure that JEMFAC address the lack of RMI progress in
           implementing reforms to increase investment and tax income;
           o coordinate with other U.S. agencies on JEMFAC to work with the
           the RMI to establish plans to minimize the impact of declining
           assistance;
           o 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
           o ensure the RMI trust fund committee's assessment and timely
           reporting of the fund's likely status as a source of revenue after
           2023.

22 [26]GAO-05-633 , [27]GAO-06-590 , [28]GAO-07-163 , [29]GAO-07-513 ,
[30]GAO-07-514R .

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.23

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 [31][email protected] . 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.

23 [32]GAO-07-163 , p. 50.

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

(Dollars in millions)
                               FSM trust               RMI trust    Kwajalein 
                                    fund  RMI grants        fund       Impact 
                                                                              
Fiscal         FSM grants    (Section    (Section    (Section     (Section 
year        (Section 211)        215)        211)        216)        212)a 
2004                $76.2       $16.0       $35.2        $7.0        $15.0 
2005                 76.2        16.0        34.7         7.5         15.0 
2006                 76.2        16.0        34.2         8.0         15.0 
2007                 75.4        16.8        33.7         8.5         15.0 
2008                 74.6        17.6        33.2         9.0         15.0 
2009                 73.8        18.4        32.7         9.5         15.0 
2010                 73.0        19.2        32.2        10.0         15.0 
2011                 72.2        20.0        31.7        10.5         15.0 
2012                 71.4        20.8        31.2        11.0         15.0 
2013                 70.6        21.6        30.7        11.5         15.0 
2014                 69.8        22.4        32.2        12.0         18.0 
2015                 69.0        23.2        31.7        12.5         18.0 
2016                 68.2        24.0        31.2        13.0         18.0 
2017                 67.4        24.8        30.7        13.5         18.0 
2018                 66.6        25.6        30.2        14.0         18.0 
2019                 65.8        26.4        29.7        14.5         18.0 
2020                 65.0        27.2        29.2        15.0         18.0 
2021                 64.2        28.0        28.7        15.5         18.0 
2022                 63.4        28.8        28.2        16.0         18.0 
2023                 62.6        29.6        27.7        16.5         18.0 

Source: Pub. L. No. 108-188.

Notes:

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.

a"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: Estimated FSM and RMI per Capita Compact Grant Assistance for
Fiscal Years 1987 - 2023

Note: Compact grant assistance was decreased in 1991, 1996, and 2001 and
increased in 2002 and 2003 to equal an average of the funding provided
during the previous 15 years. Compact grant assistance under the amended
compacts (2004-2024) is decreased annually. U.S. contributions to each
country's trust funds increase by the same amount as the grant decrement.
Funding for compact-authorized federal services, trust-fund contributions,
and U.S. military use of Kwajalein Atoll land is not included.

Appendix III: Amended Compact Implementation Framework

Note: This figure does not list all of the compact or fiscal procedures
agreements requirements.

Appendix IV: RMI Sector Grant Allocation, 2004 through 2006

Note: Supplemental Education Grant funds, which started in 2005, are not
depicted. In cases where funds were unspent and deobligated in one year
and reobligated in a subsequent year, we included the funds only in the
year in which they were initially obligated. In 2006, the special needs
grant to Ebeye for the first time consolidated amounts provided to Ebeye
across the other sectors. In this figure, these amounts are included in
the other sector allocations for consistency.

Appendix V: Probability of RMI Trust Fund Income Not Reaching the Maximum
Disbursement Levels Allowed

Market volatility and choice of investment strategy could result in the
RMI trust fund's inability to disburse the maximum level of income allowed
in the trust fund agreement, or any income, in some years.1 Trust fund
income levels will depend on the investment strategy chosen, with a more
conservative strategy carrying a lower level of market volatility and a
lower level of expected returns over time than an aggressive investment
strategy. Figure 1 illustrates projected RMI trust fund balances under the
conservative, moderate, and aggressive investment strategies that we
projected.2 As shown in figure 2, under all three strategies, the RMI
trust fund's annual income will likely not reach the maximum disbursement
allowed, with the probability of shortfall increasing with time. For
example, our analysis of the moderate investment strategy shows
probability of about 10 percent that the RMI trust fund's income will not
reach the maximum allowed disbursement after 2031, with the probability
rising to around 40 percent by 2050.

1The trust fund agreements specify that in 2024 and thereafter, the RMI
trust fund committee may disburse amounts up to the annual grant
assistance in 2023, fully adjusted for inflation, provided that funds are
available in the B account to reach such a level.

2Our methodology for projecting trust fund income is based on a technique
known as Monte Carlo simulation. We built a Monte Carlo simulation
model--based on the trust fund agreements, contributions to date, and
historical returns of the market--to project the trust fund's likely
income levels given market volatility as well as historical returns of
various asset classes, including large company stocks, treasury bills, and
international stocks from 1970 to 2005. (See [33]GAO-07-513 .)

Figure 1: Projections of RMI Account Balance with Three Possible
Investment Strategies

Figure 2: Probability of RMI Trust Fund Income Not Reaching the Maximum
Disbursement Levels Allowed, Fiscal Years 2024 - 2050

Note: This analysis includes Taiwan's contribution to the A account. The
chart depicts results from 1,000 trial runs. The change from one year to
the next may not always be monotonic, but the general time trend is clear.
As the number of trial runs increase, the time trend becomes smoother.

(320517)

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