Foreign Assistance: U.S. Funds to Two Micronesian Nations Had Little
Impact on Economic Development (Chapter Report, 09/21/2000,
GAO/NSIAD-00-216).

Pursuant to a congressional request, GAO reviewed foreign assistance,
focusing on the: (1) use of the Compact of Free Association funding by
the Federated States of Micronesia (FSM) and the Republic of the
Marshall Islands (RMI) between fiscal years 1987 and 1998; (2) progress
both nations have made in advancing economic self-sufficiency; (3) role
of Compact funds in supporting economic progress; and (4) extent of
accountability by the two nations and the United States over Compact
expenditures.

GAO noted that: (1) Compact funds were used for general government
operations, capital projects such as building roads or investing in
businesses, making debt payments, and improving targeted sectors such as
energy and communications; (2) while FMS concentrated much of its
spending on supporting government activities, the RMI emphasized capital
spending; (3) since 1987, the two countries, particularly FSM, have made
some progress in achieving economic self-sufficiency, as measured by
their governments' lower reliance on U.S. funding; (4) however, both
countries remain highly dependent on U.S. assistance, which still
provides more than half of total government revenues in each country;
(5) scheduled decreases in Compact funding as well as increases in
locally generated funds have reduced reliance on U.S. funding; (6)
although the amount of Compact funding has decreased since 1987 as
required by the terms of the Compact, both countries have received other
U.S. funding through their use of U.S. federal services and programs;
(7) Compact expenditures to date have led to little improvement in
economic development in FSM and RMI; (8) per capita incomes have
stagnated in FSM and fallen in RMI; (9) Compact funds spent to support
general government operations have maintained high government wages and
a large level of public sector employment that has discouraged private
sector growth; (10) Compact spending to create and improve
infrastructure has not contributed to significant economic growth; (11)
in addition, Compact-funded business ventures have generally failed;
(12) while the Compact set out specific obligations for reporting and
consulting regarding the use of Compact funds, the governments of FSM,
RMI, and the U.S. have provided limited accountability over Compact
expenditures and have not ensured that funds were spent effectively or
efficiently; (13) the U.S. government did not meet the Compact
requirement to consult annually with both countries during the first 7
years of Compact assistance; (14) also, the Department of the Interior
has devoted few resources to monitoring Compact assistance; and (15)
disagreements between the Departments of State and the Interior limited
monitoring, as did a Compact provision that guarantees funding to the
two nations.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  NSIAD-00-216
     TITLE:  Foreign Assistance: U.S. Funds to Two Micronesian Nations
	     Had Little Impact on Economic Development
      DATE:  09/21/2000
   SUBJECT:  Territories and possessions
	     Program graduation
	     Foreign economic assistance
	     Reporting requirements
	     International agreements
	     Accountability
	     International relations
	     Foreign governments
	     Financial management
	     Economic development
IDENTIFIER:  Marshall Islands
	     Compact of Free Association with Micronesia
	     Micronesia
	     Trust Territory of the Pacific Islands
	     Kwajalein Atoll (Marshall Islands)
	     Pell Grant
	     UN Development Program

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GAO/NSIAD-00-216

Compact Ended U.S. Administration of the Federated States of
Micronesia and the Republic of the Marshall Islands 14

Self-government, National Security, and Economic
Self-sufficiency Are Compact Objectives 18

Objectives, Scope, and Methodology 22

Marshall Islands Used Nearly $1.6 Billion in Compact Direct Funding

26

The Federated States of Micronesia and the Republic of the
Marshall Islands Targeted Expenditures in Different Areas 26

Capital Funds Spent on Business Ventures and Infrastructure 28

Both Countries Issued Compact Revenue-Backed Bonds 30

Economic Self-sufficiency

34

Government Reliance on U.S. Assistance Has Fallen to 54
Percent in the Federated States of Micronesia 34

U.S. Assistance Comprises 68 Percent of the Republic of the
Marshall Islands' Revenue 36

U.S. Program Assistance Contributes to Government Revenues
in Both Compact Nations 37

Other Donors Also Provide Assistance and Loans 39

Development

40

Compact Funding Supported General Government Operations that Discouraged
Private Sector Growth 40

Targeted Compact Funds Spent on Physical and Social
Infrastructure Have Not Contributed to Significant Economic
Growth 42

Business Ventures That Received Compact Funding Have
Generally Failed 50

Compact-Funded Projects Experienced Problems With Planning, Management,
Construction, Maintenance, and Misuse 56

Provided Limited Accountability Over Compact Expenditures

76

Compact Required Accountability for Use of Funds From the
Federated States of Micronesia, the Republic of the Marshall
Islands, and the United States 76

Planning and Reporting Documents of the Federated States of
Micronesia and the Republic of the Marshall Islands Were
Generally Incomplete and Insufficient 77

The U.S. Government Did Not Meet Many Accountability
Requirements 79

U.S. Oversight Limited by Interagency Disagreements and
Interior's Belief That Compact Provisions Restricted U.S. Actions 81

85

Conclusions 85

Recommendations 87

Agency Comments and Our Evaluation 89

Appendix I: Compact of Free Association Capital
Expenditures, Fiscal Years 1987-98

92

Appendix II: Record of Accountability for the Federated
States of Micronesia, the Republic of the Marshall
Islands, and the United States

95

Appendix III: Comments From the Department of the Interior

96

Appendix IV: Comments From the Department of State

104

Appendix V: Comments From the Republic of the Marshall
Islands

108

Appendix VI: Comments From the Federated States of
Micronesia

118

Appendix VII: GAO Contact and Staff Acknowledgments

151

Table 1: Compact Section 211(a) Annual and Total Funding
Levels for the Federated States of Micronesia and the
Republic of the Marshall Islands, Fiscal Years 1987-2001 19

Table 2: Compact Revenue-backed Bonds Issued by the
Federated States of Micronesia and the Republic of the
Marshall Islands, Fiscal Years 1987-98 31

Table 3: Five-Year Economic Development Plans 95

Table 4: Annual Reports and Meetings 95

Figure 1: Location and Map of the Federated States of
Micronesia and the Republic of the Marshall Islands 15

Figure 2: FSM and RMI Compact Expenditures by Fund Type as a Percentage of
Total Compact Expenditures, Fiscal
Years 1987-98 27

Figure 3: FSM and RMI Compact Capital Account Expenditures,
Fiscal Years 1987-98 29

Figure 4: RMI Debt Service as a Percentage of Annual Compact Expenditures,
Fiscal Years 1987-98 33

Figure 5: FSM Dependence on U.S. Assistance, Fiscal Years 1987-98 35

Figure 6: RMI Dependence on U.S. Assistance, Fiscal Years 1987-98 37

Figure 7: Compact Investment in Communications 43

Figure 8: Compact Investment in Energy 44

Figure 9: Electric Power and Tuna Processing Plant, Majuro, RMI 45

Figure 10: Investment in Interisland Cargo Transportation, FSM 46

Figure 11: Investment in Air Transportation, RMI 47

Figure 12: FSM Investment in College Facilities 48

Figure 13: FSM Fish Processing and Cold Storage Facilities 53

Figure 14: Pohnpei Pepper Industry Development, FSM 54

Figure 15: RMI Investment in Garment Factory 55

Figure 16: Causeway From Ebeye to Gugeegue, Kwajalein Atoll,
RMI 58

Figure 17: Ponape Coconut Products, Inc., FSM 59

Figure 18: Kosrae Road Pavement, FSM 61

Figure 19: RMI National Capitol Building, Majuro 63

Figure 20: Ohmine Elementary School, Pohnpei, FSM 64

Figure 21: Pohnpei State Hospital, FSM 66

Figure 22: Old and New Ebeye Hospitals Suffer From Corrosion,
RMI 68

Figure 23: Udot Dock Project and Junior High School, Chuuk, FSM 70

Figure 24: Fanapanges Ice Plant: Planned and Actual Locations,
Chuuk, FSM 72

Figure 25: "Boats for Votes," Chuuk, FSM 73

FSM Federated States of Micronesia

GDP gross domestic product

RMI Republic of the Marshall Islands

National Security and
International Affairs Division

B-285711

September 22, 2000

The Honorable Frank H. Murkowski
Chairman, Committee on Energy and Natural Resources
United States Senate

The Honorable Doug Bereuter
Chairman, Subcommittee on Asia and the Pacific
Committee on International Relations
House of Representatives

This report responds to your request that we report on (1) the use of
Compact of Free Association funding by the Federated States of Micronesia
and the Republic of the Marshall Islands between fiscal years 1987 and 1998,
(2) the progress both nations have made in advancing economic
self-sufficiency, (3) the role of Compact funds in supporting economic
progress, and (4) the extent of accountability by the two nations and the
United States over Compact expenditures. This report includes
recommendations to the Secretaries of State and the Interior.

We are sending this report to the Honorable Bruce Babbitt, Secretary of the
Interior; the Honorable Madeleine K. Albright, Secretary of State; the
Honorable William S. Cohen, Secretary of Defense; His Excellency Leo A.
Falcam, President of the Federated States of Micronesia; His Excellency
Kessai Note, President of the Republic of the Marshall Islands; other
appropriate congressional committees; and other interested parties. Copies
will also be made available to others on request.

Please contact me at (202) 512-4128 if you or your staff have any questions
concerning the report. An additional GAO contact and staff acknowledgments
are listed in appendix VII.

Susan S. Westin, Associate Director
International Relations and Trade Issues

Executive Summary

In 1986, the U.S. government entered into an international agreement, the
Compact of Free Association, with the Federated States of Micronesia and the
Republic of the Marshall Islands. U.S. direct financial assistance under the
Compact, which began in 1987, is intended to help the governments of the two
countries in their efforts to advance their economic development and
self-sufficiency. The Compact represents a continuation of U.S. financial
assistance that had been provided by the United States for almost 40 years
after World War II under the United Nations Trust Territory of the Pacific
Islands. The Department of the Interior's Office of Insular Affairs has the
responsibility for disbursing and monitoring this assistance. In the fall of
1999, negotiations between the Department of State and the two nations began
concerning provisions of the Compact regarding economic assistance and
certain national security provisions in the Compact that will expire in
2001.1

To assist Congress in its consideration of any future economic assistance to
the two nations, the Chairman of the Committee on Energy and Natural
Resources, United States Senate, and the Chairman of the Subcommittee on
Asia and the Pacific, Committee on International Relations, House of
Representatives, asked GAO to report on (1) the use of Compact funding by
the Federated States of Micronesia and the Republic of the Marshall Islands
between fiscal years 1987 and 1998, (2) the progress both nations have made
in advancing economic self-sufficiency, (3) the role of Compact funds in
supporting economic progress, and (4) the extent of accountability by the
two nations and the United States over Compact expenditures. GAO's review
focused on the uses of payments the United States made to both countries to
support economic advancement. Successful economic development would include
increased private sector activity and lead to rising incomes. GAO's review
did not include payments to the Republic of the Marshall Islands for nuclear
testing by the United States. In an earlier report, GAO found that the
nations together, in addition to their Compact direct funding, have received
other assistance from 19 U.S. agencies totaling close to $600 million during
fiscal years 1987 through 1999.2 GAO did not include this assistance in this
review, except during the discussion on economic self-sufficiency.

The Federated States of Micronesia and the Republic of the Marshall Islands
spent nearly $1.6 billion in Compact of Free Association funds for fiscal
years 1987 through 1998. The Federated States of Micronesia spent $1.08
billion, while the Republic of the Marshall Islands spent about
$510 million. Compact funds were used for general government operations,
capital projects such as building roads or investing in businesses, making
debt payments, and improving targeted sectors such as energy and
communications. While the Federated States of Micronesia concentrated much
of its spending on supporting government activities, the Republic of the
Marshall Islands emphasized capital spending. Although expenditures were
reported in areas specified by the Compact, annual financial statements do
not always report on the final use of Compact funds. Both countries issued
Compact revenue-backed bonds in order to obtain more funding during the
earlier years of the Compact.

Since 1987, the two countries, particularly the Federated States of
Micronesia, have made some progress in achieving economic
self-sufficiency, as measured by their governments' lower reliance on U.S.
funding. However, both countries remain highly dependent on U.S. assistance,
which still provides more than half of total government revenues in each
country. Scheduled decreases in Compact funding as well as increases in
locally generated funds have reduced reliance on U.S. funding. Although the
amount of Compact funding has decreased since 1987 as required by the terms
of the Compact, both countries have received other U.S. funding through
their use of U.S. federal services and programs.

Compact expenditures to date have led to little improvement in economic
development in the Federated States of Micronesia and the Republic of the
Marshall Islands. Per capita incomes, when adjusted for inflation, have
stagnated in the Federated States of Micronesia and fallen in the Republic
of the Marshall Islands since the beginning of the Compact. Compact funds
spent to support general government operations have maintained high
government wages and a large level of public sector employment that have
discouraged private sector growth. Compact spending to create and improve
infrastructure has not contributed to significant economic growth. In
addition, Compact-funded business ventures have generally failed. For
example, the Federated States of Micronesia spent $60 million in
unsuccessful fisheries ventures. During its work and site visits to
80 Compact-funded projects, GAO found that many of these projects had
experienced problems because of poor planning and management, inadequate
construction and maintenance, or misuse of funds.

While the Compact set out specific obligations for reporting and consulting
regarding the use of Compact funds, the governments of the Federated States
of Micronesia, the Republic of the Marshall Islands, and the United States
have provided limited accountability over Compact expenditures and have not
ensured that funds were spent effectively or efficiently. For example, the
governments of the Federated States of Micronesia and the Republic of the
Marshall Islands provided the U.S. government with inadequate economic
development plans and Compact spending reports. Further, the U.S.
government, specifically the Departments of the Interior and State, did not
meet the Compact requirement to consult annually with both countries during
the first 7 years of Compact assistance. In addition, the Department of the
Interior has devoted few resources to monitoring Compact assistance.
Moreover, disagreements between the Departments of State and the Interior
limited monitoring, as did a Compact provision that guarantees funding to
the two nations.

In 1986, the United States entered into a Compact of Free Association with
the Federated States of Micronesia (a nation comprised of the four states of
Pohnpei, Chuuk, Kosrae, and Yap) and the Republic of the Marshall Islands.
Through this Compact, the Federated States of Micronesia and the Republic of
the Marshall Islands became Freely Associated States, no longer subject to
U.S. administration under the United Nations Trust Territory of the Pacific
Islands. The Compact, which consists of separate international agreements
with each country, was intended to achieve three principal U.S. goals. These
goals were to (1) secure self-government for each country; (2) assure
certain national security rights for the Federated States of Micronesia, the
Republic of the Marshall Islands, and the United States; and (3) assist the
Federated States of Micronesia and the Republic of the Marshall Islands in
their efforts to advance economic development and self-sufficiency.

The first two objectives have been met. The Federated States of Micronesia
and the Republic of the Marshall Islands are independent nations and are
members of international organizations such as the United Nations. However,
both countries maintain a special relationship with the United States
through the Compact, and citizens of both nations are able to live and work
in the United States as non-immigrants. Additionally, national security
objectives were achieved. Under the Compact, the United States agreed to
defend the Federated States of Micronesia and the Republic of the Marshall
Islands, gained access to their territory for military use, and secured the
right to deny military access to other countries. These security provisions
will continue indefinitely unless mutually terminated. Through a
Compact-related agreement with the Republic of the Marshall Islands, the
United States has secured continued access to military facilities (a missile
testing and space operations site) on Kwajalein Atoll until 2016.

The third objective of the Compact, promoting economic development and
self-sufficiency (a term that is not defined in the Compact), was to be
accomplished primarily through direct financial payments to the Federated
States of Micronesia and the Republic of the Marshall Islands. The largest
Compact funding provision provides specific levels of direct funding for the
Federated States of Micronesia and the Republic of the Marshall Islands over
a 15-year period (1987-2001), with amounts decreasing every 5 years. These
funds were provided to cover general government and capital expenditures.
Additional Compact provisions target funding for use in specific sectors,
such as energy, communications, maritime surveillance, health, and
education. Most of this assistance is partially adjusted annually for
inflation.

Islands Spent Nearly $1.6 Billion in Compact Funds From 1987 Through 1998

The Federated States of Micronesia and the Republic of the Marshall Islands
spent about $1.6 billion in Compact funds on general government operations,
capital projects such as building roads and investing in businesses, and
targeted sectors such as energy and communications, from fiscal years 1987
through 1998. The two countries have used the funding differently. The
Federated States of Micronesia used about 47 percent
($510 million) of its $1.08 billion in Compact funds to support general
government operations such as salaries and travel. The Republic of the
Marshall Islands spent 46 percent ($233 million) of its $510 million in
Compact funds on capital projects such as developing physical
infrastructure, establishing businesses, and servicing debt. GAO determined
overall spending in these broad categories from the countries' audited
financial statements. However, these statements do not provide information
on the final usage of Compact funds due to the commingling of Compact funds
with locally generated revenues and because of fund transfers that occur
that are not tracked to their final use.

Both countries together issued $389 million in Compact revenue-backed bonds
from the late 1980s to the mid-1990s in order to obtain more funding during
the earlier years of the Compact. The Federated States of Micronesia issued
about $114 million in Compact revenue-backed bonds, while the Republic of
the Marshall Islands issued about $275 million. As a result of issuing these
bonds, the Republic of the Marshall Islands has spent 42 percent ($217
million) of its Compact funds for debt service, which reduced the funds
available in the later years of Compact assistance for government operations
and investment.

Islands Have Made Some Progress Toward Self-sufficiency, but Remain Highly
Dependent on U.S. Assistance

The Federated States of Micronesia and the Republic of the Marshall Islands
have made some progress in achieving economic self-sufficiency since 1987,
although both countries remain highly dependent on U.S. assistance. This
assistance has maintained standards of living that are artificially higher
than could be achieved in the absence of compact funding. GAO used
dependence on U.S. assistance, or total U.S. funds3 as a percentage of total
government revenues in each country, as an indicator to gauge economic
self-sufficiency. The reliance on U.S. funding as a percentage of total
government revenue in the Federated States of Micronesia fell from 83
percent in fiscal year 1987 to 54 percent in 1998. The Republic of the
Marshall Islands also reduced its reliance on U.S. funding somewhat, from 78
percent in 1987 to 68 percent in 1998. Reductions in Compact direct payments
that have occurred every 5 years have contributed to a lower reliance on
U.S. funding. Both countries also receive technical and project assistance
from other nations, although these contributions are not fully reported in
government financial statements.

The use of Compact funds to date has led to little improvement in economic
development in the Federated States of Micronesia and the Republic of the
Marshall Islands. Substantial expenditures of Compact funds to maintain high
levels of public sector employment at high wages have acted as a
disincentive to private sector growth. High public sector wages have raised
the threshold for private sector wages, making the private sector less
competitive in international markets. Both countries have also spent Compact
funds on infrastructure projects, such as electrical power and
telecommunications systems, that they viewed as critical to creating an
environment attractive to private businesses. However, these projects have
not generated significant private sector activity and have not been
sufficient to overcome other obstacles to growth such as a remote location,
a lack of natural resources, and limited managerial expertise. Finally,
investment of Compact funds in business ventures such as fish processing
facilities or manufacturing has been a failure. For example, the Federated
States of Micronesia spent $60 million in fisheries ventures that failed due
to inexperience and poor business judgment. The Republic of the Marshall
Islands has made unsuccessful investments in a garment factory that has
never operated and a resort hotel that requires annual subsidies. Thus,
primary, export-oriented industries remain small contributors to both
economies. During its work and site visits to 80 Compact-funded projects,
GAO found that many projects had experienced problems because of poor
planning and management, inadequate construction and maintenance, or misuse
of funds. For example, poor planning and management resulted in the
incomplete construction of a costly and high-priority road in the Republic
of the Marshall Islands. In numerous cases GAO found leaking roofs as the
result of poor construction and maintenance. Finally, GAO identified several
projects that appeared to be a misuse of funds in that it is questionable
whether these projects will promote widespread economic advancement. For
example, in the state of Chuuk in the Federated States of Micronesia, an ice
plant intended to support community fishing operations was never built,
despite receiving Compact funding, and an ice machine intended for the plant
was moved to a Mayor's property.

The governments of the Federated States of Micronesia, the Republic of the
Marshall Islands, and the United States have provided limited accountability
over Compact expenditures. Although the Compact established accountability
requirements for all three countries, none of the governments fully used
these mechanisms to ensure that Compact funds were spent effectively or
efficiently. For example, the Federated States of Micronesia and the
Republic of the Marshall Islands generally prepared planning and reporting
documents required under the Compact, but many of the documents were of
limited usefulness and did not contain sufficient information to determine
if Compact funds were being spent to promote economic development. For
fiscal years 1987 through 1999, the Federated States of Micronesia submitted
annual reports each year except for 1999, while the Republic of the Marshall
Islands submitted 7 of the 13
Compact-required annual reports. Neither nation provided adequate financial
or programmatic control over Compact funds, as documented in audit reports
prepared by independent and country auditors since 1987. In addition, the
U.S. government did not meet many of its oversight obligations. For example,
the Departments of the Interior and State did not hold required annual
consultations with the two countries to assess progress under the Compact
until 1994. Further, the Department of the Interior, which had projected in
1987 that it would need 15 staff positions to implement the Compact,
currently has 2 people that work exclusively with the Compact nations.
Moreover, disagreements between the Departments of the Interior and State
regarding Compact monitoring responsibilities, as well as Interior's view
that the "full faith and credit" provision in the Compact (which legally
guarantees funding) impaired its ability to withhold funds for
noncompliance, further limited oversight.

GAO recommends that the Secretary of State work with Congress to outline
negotiating objectives; determine the level, duration, and composition of
future economic assistance; and identify the appropriate agency to provide
and oversee future funding. GAO also recommends that the Secretary of State
direct the State Department official responsible for negotiating future
Compact economic assistance to include specific measures in any future
economic assistance provisions for the Compact that will ensure improved
effectiveness of, and accountability over, future spending. Further, GAO
recommends that the Secretary of the Interior, as the official responsible
for providing and monitoring Compact assistance, strengthen oversight over
remaining Compact assistance.

We received comments from the Departments of State and the Interior and the
governments of the Federated States of Micronesia and the Republic of the
Marshall Islands. The Department of State agreed with three of GAO's
recommendations. It agreed that the Department should (1) consult with
Congress to determine U.S. policy objectives for future Compact assistance,
(2) negotiate Compact provisions to establish greater control and
effectiveness of future U.S. assistance, and (3) negotiate Compact
provisions to achieve greater oversight over expenditures. While the
Department of State agreed with GAO that any future Compact provisions
should allow for the withholding of funds, the Department reserved judgment
on GAO's recommendation that any future funding exclude a "full faith and
credit" provision until the Department better understands the ramifications
of this action on budget procedures. The Department of the Interior did not
respond to GAO's recommendations.

The Departments of State and the Interior, as well as the government of the
Federated States of Micronesia, stressed that it is important to acknowledge
the challenges faced by Pacific Island nations, such as geographic isolation
and a lack of natural resources, in achieving economic advancement. GAO
further emphasized this point in the report. All four respondents also
stated that GAO's report downplays successes under the Compact. GAO added
information summarizing State and Interior views regarding the importance of
expenditures to support general government operations in both countries. The
governments of the Federated States of Micronesia and the Republic of the
Marshall Islands expressed concern over GAO's view that Compact expenditures
have led to little economic development in either country. GAO maintains
that this conclusion is accurate. A discussion of these comments appears in
chapter 6, and the comments appear in full, along with GAO's specific
responses, in appendixes III-VI.

Introduction

The 1986 Compact of Free Association ended almost 40 years of U.S.
administration of the Federated States of Micronesia (FSM), and the Republic
of the Marshall Islands (RMI), two Pacific Island nations. The U.S.
objectives for the Compact were to advance the island nations'
self-government and economic self-sufficiency and to secure certain national
security rights.

Micronesia and the Republic of the Marshall Islands

In 1986, the United States entered into a Compact of Free Association with
the FSM and the RMI. Through the Compact, the FSM and the RMI became Freely
Associated States, no longer subject to U.S. administration under the United
Nations Trust Territory of the Pacific Islands that was created following
World War II.

The two island nations are located just north of the equator in the Pacific
Ocean (see fig. 1) with populations of 116,268 and 50,840, respectively, as
of 1999.4

The FSM is a grouping of 607 small islands in the western Pacific totaling
270 square miles, of which 65 are occupied. The islands stretch out over
1,115 miles of the Pacific Ocean, creating an exclusive economic zone of
1 million square miles. It is a nation comprised of four states (Kosrae,
Pohnpei, Chuuk, and Yap) and nine ethnic groups. English is the official and
common language, with each state having its own language as well.

The RMI is made up of more than 1,200 islands, islets, and atolls, with a
total land area of about 70 square miles. The Marshall Islands are located
in the central Pacific, about 2,100 miles southwest of Hawaii. The Marshall
Islands occupy about 750,000 square miles of the Pacific Ocean. English is
the official language of the RMI, with two major Marshallese dialects and
Japanese in use as well.

Both the FSM and the RMI spent almost a century under the administration of
foreign powers. Spain occupied the islands of the current FSM in 1875, and
Germany established a protectorate over the Marshall Islands in 1885. In
1899, Germany purchased the FSM islands from Spain after Spain lost its
other Pacific possessions following the Spanish-American War. At the
beginning of World War I, Japan occupied the FSM islands and the Marshall
Islands, receiving a League of Nations mandate to administer them in 1920.
After leaving the League in 1935, Japan declared the islands to be an
integral part of the Japanese Empire and established and reinforced military
installations there. The United States occupied the islands of the FSM and
the RMI in 1944 following heavy fighting.

In 1947, the United Nations created the Trust Territory of the Pacific
Islands. The United States entered into a trusteeship with the United
Nations Security Council and became the administering authority of the
current four states of the FSM, as well as the Marshall Islands, Palau, and
the Northern Mariana Islands. The Trust Territory of the Pacific Islands
made the United States responsible financially and administratively for the
region. The President of the United States appointed a High Commissioner of
the Trust Territory of the Pacific Islands, which remained under the civil
administration of the U.S. Navy until 1951, when authority was passed to the
Department of the Interior. During the 1940s and 1950s the Marshall Islands
were the site of 67 U.S. nuclear weapons tests. The economy of the

Trust Territory of the Pacific Islands was dominated by government
employment and reliant on external assistance from the United States.5

In 1978, four of the "districts" of the Trust Territory of the Pacific
Islands voted in a referendum to form the Federated States of Micronesia. In
1979, the Marshall Islands voted to form its own national government. In
1982, an international agreement between the United States and the Federated
States of Micronesia--the Compact of Free Association--was completed; the
following year, the Compact was signed between the United States and the
Republic of the Marshall Islands.

The economic viability of both nations was uncertain at the time the Compact
was negotiated. In 1983, we reported that both countries faced serious
obstacles to becoming economically self-sufficient, such as inadequate
planning for and maintenance of infrastructure and low savings levels. We
also noted that both governments lacked sufficient managerial and technical
expertise and management systems to overcome such obstacles.6 The economic
growth potential of these countries and their ability to generate revenue to
replace U.S. assistance was limited by factors such as geographic isolation,
limited natural resources, and the large and costly government structure
left by the United States.7

In the case of the FSM, the Compact entered into force on November 3, 1986,
while the RMI Compact entered into force October 21, 1986. With the entry
into force of the Compact, both nations became Freely Associated States, no
longer subject to U.S. administration under the United Nations Trusteeship.

Self-sufficiency Are Compact Objectives

The Compact, which consists of separate international agreements with each
country, was intended to achieve three principal U.S. goals. These goals
were to (1) secure self-government for each country; (2) assure certain
national security rights for the FSM, the RMI, and the United States; and
(3) assist the FSM and the RMI in their efforts to advance economic
self-sufficiency.

The first two objectives have been met. The FSM and the RMI are independent
nations and are members of international organizations such as the United
Nations. Nevertheless, both countries maintain a special relationship with
the United States through the Compact, and citizens of both nations are able
to live and work in the United States as
non-immigrants. Additionally, national security objectives were achieved. At
the time of the Compact's negotiation, the United States was concerned about
an expanded Soviet Union military presence in the Pacific Ocean. Under the
Compact, the United States agreed to defend the FSM and the RMI, gained
access to their territory for military use, and secured the right to deny
military access to the region to other countries (known as "strategic
denial"). These security provisions will continue indefinitely unless
mutually terminated. A security provision that gave the United States the
ability to preclude any FSM or RMI government action that the United States
believes is incompatible with its defense responsibilities (the "defense
veto") will expire in 2001 and is subject to renegotiation. In a 1986
Compact-related agreement with the RMI, the United States secured continued
access to military facilities (a missile testing and space operations site)
on Kwajalein Atoll for a period of 15 years and the right to extend the
access for an additional 15 years (a right the United States exercised in
September 1999).

The third objective of the Compact, promoting economic self-sufficiency (a
term that is not defined in the Compact), was to be accomplished primarily
through direct financial payments to the FSM and the RMI. This Compact
assistance represented a continuation of U.S. financial support that had
been supplied to these areas for almost 40 years after World War II. The
largest funding provision (sec. 211(a) of the Compact) provides specific
levels of funding for the FSM and the RMI over a 15-year period
(1987-2001), with amounts decreasing every 5 years (see table 1). The total
funding for section 211(a) over this period for both countries, before
adjusting for inflation, is almost $1.1 billion.

 Dollars in millions
             FSM                       RMI                      FSM & RMI
                                                                Total
                         Total funding            Total funding funding
 Fiscal yearsAnnual      over 5-year   Annual     over 5-year   over
             funding                   funding
                         period                   period        5-year
                                                                period
 1987-91     $60.0       $300.0        $26.1      $130.5        $430.5
 1992-96     51.0        255.0         22.1       110.5         365.5
 1997-2001   40.0        200.0         19.1       95.5          295.5
 Total for 15
 years                   $755.0                   $336.5        $1,091.5

Note: Compact section 211(a) funding is partially adjusted for inflation.
Inflationary adjustments are not included in this table.

Source: Compact of Free Association section 211(a).

The Compact provided section 211(a) funds to cover general government and
capital expenditures. The Compact requires that over the 15-year period of
Compact economic assistance, an average of no less than
40 percent of section 211(a) funding be used in a "capital account."
According to an agreement related to the Compact, 17 types of projects or
activities are eligible expenditures under the capital account, including
construction or major repair of capital infrastructure, public and private
sector projects, training activities, and debt service. The remainder of
section 211(a) funding, or no more than 60 percent of the funds, is eligible
for use in a "current account," which covers the general operations of the
government.

Additional Compact sections target funding for use in specific sectors, such
as energy, communications, maritime surveillance, health, and education
(total funding provided for both countries for targeted assistance is
approximately $397 million over 15 years). Most of the Compact assistance,
including section 211(a), is partially adjusted annually for inflation.

In addition to direct payments, the Compact provides certain federal
services through 20018 and gives the FSM and the RMI access to other federal
services and programs at the discretion of the United States.9 Program
assistance can include grants, loans, goods, and services provided by
numerous U.S. agencies, such as the Departments of Education and Health and
Human Services.

In May 2000, in response to a request to identify how much money the United
States has provided to the FSM and the RMI, we reported that the United
States had supplied more than $2.6 billion in total U.S. assistance to both
countries from fiscal years 1987 through 1999, based on figures that
19 U.S. government agencies gave to us.10 The report included three
categories of U.S. assistance: Compact funds provided directly to the FSM
and the RMI as economic assistance, funds provided to the RMI as
compensation for nuclear testing, and U.S. program assistance. The report
concluded that the Department of the Interior has not maintained reliable
data on the amount of assistance provided to the FSM and the RMI. Further,
the report determined that inconsistencies within Interior's own records, as
well as between Interior's records and those of other U.S. federal agencies
and the FSM and RMI independent auditors, call into question Interior's
ability to report accurately on assistance provided to the two nations. In
response to the report's recommendations, the Department of the Interior
stated that (1) in the event that it retains monitoring and coordination
oversight of other federal agency programs as a result of the current
Compact negotiations, it will develop a system to obtain and maintain data
on all financial and program assistance provided and (2) it will reconcile
the amounts reimbursed to other agencies. The Department of State concurred
fully with the report's recommendation that during the ongoing Compact
negotiations, provisions should be negotiated that require the maintenance
of reliable data to ensure better accountability of the assistance provided.
In addition, State said it is committed to ensuring that any revised Compact
will include the necessary authority and an effective mechanism to ensure
complementarity of purpose and accountability of future assistance.

Direct financial assistance under the Compact is provided by the Department
of the Interior.11 Additionally, Interior and 18 other U.S. government
agencies administer programs in the FSM and the RMI. The Secretary of the
Interior has responsibility for federal program coordination, as well as
disbursement and monitoring of U.S. funds annually provided to the FSM and
the RMI under the terms of the Compact. Monitoring is conducted, in part,
through a Compact requirement for an annual financial and compliance audit
within the meaning of the Single Audit Act of 1984.12 The single audit
process is an important vehicle in informing the Department of the Interior
and other federal oversight officials about FSM and RMI stewardship of
federal funds. The Department of State is actively involved in U.S.
relations with the FSM and the RMI as the agency responsible for
government-to-government relations. In the fall of 1999, negotiations
between the Department of State and the two nations began on whether and how
to renew economic assistance and to continue certain national security
provisions in the Compact that will expire in 2001. To date, the United
States has had two negotiating sessions with the FSM, while formal talks
with the RMI government have been delayed due largely to a change in the
RMI's government in January 2000. If negotiations to establish future
economic assistance are ongoing between the United States and the FSM or the
RMI, or both island governments, at the end of fiscal year 2001, Compact
assistance will be extended until 2003 to the

nation(s) still negotiating at a rate that is the average of the annual
direct funding amounts granted under the Compact.13

The Chairman of the House Subcommittee on Asia and the Pacific, Committee on
International Relations, and the Chairman of the Senate Committee on Energy
and Natural Resources asked us to report on the
(1) the use of Compact of Free Association funding by the Federated States
of Micronesia and the Republic of the Marshall Islands, (2) the progress
both nations have made in advancing economic self-sufficiency, (3) the role
of Compact funds in supporting economic progress, and (4) the extent of
accountability by the two nations and the United States over Compact
expenditures.

For our first objective, we reviewed how the FSM and the RMI used direct
Compact funding for fiscal years 1987-1998 provided as economic assistance
through title II of the Compact to further the countries' economic
self-sufficiency. In reporting on the use of Compact funds, we did not
assess payments made to the Republic of the Marshall Islands under the
Compact for nuclear testing compensation (sec. 177) or the assistance
provided to either country through federal services and programs (secs. 221
and 224).

We relied on 72 sets of financial statements of the RMI and the FSM,
including the four states of the FSM (Pohnpei, Chuuk, Kosrae, and Yap). We
also relied on the audits of these financial statements that were prepared
by Deloitte Touche Tohmatsu, the governments' independent auditor for fiscal
years 1987-98. We also read financial statements and audits for other
government entities in the RMI. These financial records include data on
government revenues, expenditures, and U.S. assistance levels. The revenue
data identify Compact funds and other U.S. assistance as specific funding
sources and show how these funds were allocated by fund type (general,
special revenue, capital, expendable trust, and so on). The expenditure data
identify how each government entity used its funds, including payment of
Compact funds to Kwajalein landowners. The expenditure sheets in the
financial statements enabled us to identify, in many cases, how the
governments used the Compact funds by fund type. However, Compact funds
allocated to the general fund were commingled with local revenues. Further,
transfers between fund types take place and, in some cases, information on
the use of transferred funds is unavailable or the Compact funds are
subsequently commingled with other government revenue. Thus, details
regarding the final usage of some Compact funds are not identified in the
financial statements (with a few notable exceptions such as the use of
transfers for debt service). This situation is a limitation in our
reporting.

To identify capital account spending, we used lists of specific capital
projects financed with Compact funds contained in the Deloitte Touche
Tohmatsu audits. We also obtained lists of capital projects for the FSM and
summaries of capital projects by sector from the FSM Joint Committee on
Compact Economic Negotiations. We applied the FSM sector categories, such as
infrastructure and economic development, to the capital projects identified
in the audits of the RMI in our presentation of capital project funding.

To determine the debt service ratios for the FSM and the RMI, we extracted
data from the Deloitte Touche Tohmatsu audits of the FSM and the RMI on the
amount of bonds issued, the payment schedules, and the annual bond debt
payments. We calculated the percentage of debt service by dividing the
annual debt payments by the Compact direct funding provided to the FSM and
the RMI.

For our second objective, we reviewed data and economic studies regarding
the progress these countries have made in achieving economic
self-sufficiency. As an indicator of economic self-sufficiency, we
calculated the ratio of U.S. assistance (direct Compact funding plus program
assistance) to total FSM or RMI government revenue.14 The FSM recently
adopted a similar approach to measure its self-sufficiency. We relied on
data from available annual financial statements and single audits (referred
to as annual audits in this report) for all governments for fiscal years
1987-98 to make our calculations. The revenue data used understate the value
of U.S. government contributions to the FSM and the RMI governments. U.S.
government services provided in-kind, such as weather service, disaster
relief, development loans, and national defense, do not appear as revenue in
the FSM and RMI government financial accounts. We also reviewed Asian
Development Bank documents for available data on other donors.

For our third objective, we examined budget and project documents for over
150 projects undertaken with Compact capital account funds and visited 80
Compact-funded projects in order to assess the role of Compact funds in
supporting economic progress. We reviewed the budget and project documents
to determine how Compact funds were used and what procedures the FSM and the
RMI used to review the projects prior to implementation. We chose over 150
projects for an extensive file review and made selected site visits. Our
selection criteria included the largest areas of investment by the
governments as well as projects that represented a wide range of sectors.
For example, we reviewed projects such as schools, hospitals, roads,
electric power and telecommunications facilities, and business ventures. We
chose projects that were funded at different points during the life of the
Compact. In our file review, we looked for feasibility studies, evidence of
competitive bidding, contracts, and inspections. We visited 80 projects that
the Compact funded to determine if the projects met their objectives and the
status of the projects. At the project sites we met with officials to
discuss how Compact funds contributed to the project and to evaluate the
success of the project.

Additionally, we relied on assessments prepared by the World Bank, the Asian
Development Bank, and the International Monetary Fund regarding economic
performance in each nation. We reviewed available development plans, annual
reports, and internal audits prepared by each country. We also met with
senior government and business officials from the FSM at the national and
state level, and from the RMI to discuss how Compact funds were used and the
status of various Compact-funded projects.

For our fourth objective, we undertook an analysis of accountability
requirements contained in the Compact. We interviewed senior government
officials in the FSM, the RMI, and the United States regarding their
compliance with Compact provisions. Additionally, we reviewed documentation
from the three governments. We reviewed the content of the economic
development plans and annual reports prepared by the FSM and the RMI. We
read the reports prepared by the independent auditor of the FSM and the RMI
contained in 72 sets of financial statements, including the four states of
the FSM (Pohnpei, Chuuk, Kosrae, and Yap). We read audits of Compact-funded
projects performed by the Office of the Public Auditor in the FSM to
identify how well the FSM spent Compact funds and the extent to which it
responded to findings involving the use of Compact funds. We also discussed
the responses to findings with the FSM Public Auditor. In order to
understand the oversight activity of the U.S. government, we relied on
records of the Departments of the Interior and State and interviews with
current and former senior officials.

We conducted our work from December 1999 through June 2000 in accordance
with generally accepted government auditing standards.

We received comments on this report from the Departments of State and the
Interior as well as from the governments of the FSM and the RMI.

The Federated States of Micronesia and the Republic of the Marshall Islands
Used Nearly $1.6 Billion in Compact Direct Funding

The Federated States of Micronesia and the Republic of the Marshall Islands
spent about $1.6 billion in Compact funds on general government operations,
capital projects, and targeted sectors, such as energy and communications,
from fiscal years 1987 through 1998. Spending on capital projects, a
priority area of the Compact, focused on infrastructure and business
ventures, although we could not determine from financial records how some
funds were used. Although expenditures were in the general areas designated
by the Compact, the financial statements do not report on the final specific
use of Compact funds. Both countries combined issued $389 million in Compact
revenue-backed bonds from the late 1980s to the mid-1990s in order to obtain
more funding during the earlier years of the Compact.

Islands Targeted Expenditures in Different Areas

For fiscal years 1987 through 1998, our analysis shows that the FSM spent
about $1.08 billion and the RMI spent about $510 million in funding provided
by the Compact (see fig. 2).15 Each government has used the money
differently to pursue its development objectives. The largest area of
expenditures in the FSM was for general government operations, which
accounted for over 47 percent ($510 million) of total Compact expenditures.
In the RMI, the largest amount of total expenditures,
46 percent, or $233 million, went to support capital fund activities such as
building infrastructure, supporting economic activities, and servicing debt.

Total Compact Expenditures, Fiscal Years 1987-98

Notes:

1: The general fund consists of Compact assistance to support general
government expenses such as salaries, supplies, and contractual services.

2: The special revenue fund consists of Compact assistance earmarked for
specific uses, such as medical referrals, scholarships, and marine
surveillance.

3: The expendable trust fund consists of Compact assistance that the RMI
government uses to pay about 80 RMI landowners as compensation for the land
used by the U.S. military on Kwajalein Atoll.

4: Figures may not add to 100 percent due to rounding.

Source: GAO analysis of FSM and RMI financial statements and audits of those
statements prepared by Deloitte Touche Tohmatsu for fiscal years 1987-98.

These figures report on the initial breakdown of Compact funds by government
accounts. They may or may not indicate the final use of funds, as these
figures for the FSM and the RMI include expenditures from, as well as
transfers out of, the accounts. Details regarding the final use of transfers
are unavailable in the FSM and RMI financial statements, with a few
exceptions, such as the use of transfers for debt service.

Based on our review of expenditure data for the FSM and the RMI between 1987
and 1998, both countries met the Compact requirement that an average of no
less than 40 percent of funding provided for 15 years under section 211(a)
be used for capital expenditures. The FSM spent
40.5 percent of its section 211(a) funds from its capital account, while the
RMI spent 63.9 percent.16 However, officials from the Departments of State
and the Interior noted that the broad range of eligible uses of capital
funds listed in an agreement related to the Compact makes it difficult to
demonstrate that a questionable capital expenditure is not allowed. For
example, in fiscal year 1998 the FSM state of Kosrae spent $58,080 in
Compact capital funds for the travel expenses of state athletes to regional
games in order to develop their skills and as a requirement for their
participation in the 2000 Summer Olympics in Sydney, Australia.17

For the capital funds where we could identify specific types of
expenditures, we found that the FSM and the RMI spent most of their capital
funds to build infrastructure and support economic development ventures. The
financial statements of the FSM and the RMI list projects that were paid for
from the capital fund. Our assessment here of capital fund project
expenditures includes these data only. Capital fund transfers and capital
expenditures made from bond proceeds are not included. (Therefore, specific
capital fund expenditures described here and in fig. 3 are a subset of
capital fund expenditures listed in fig. 2.) Of these projects, the FSM and
the RMI spent a total of $484 million from 1987 to 1998 for purposes that
included building infrastructure such as roads and schools, and supporting
economic development. (See app. I for detailed information on capital
project categories for the FSM and the RMI.)

The FSM spent a total of $344 million out of the capital fund, with
$156 million (45 percent) of these capital project funds going for economic
development and business ventures, such as for fishing boats or processing
plants (see fig. 3). Expenditures on infrastructure followed closely at
$133 million, or 39 percent.

1987-98

Notes:

1: "Other" expenditures include land lease and acquisition, resource
management, and unspecified uses of funds. In the RMI this category includes
expenditures by the Marshall Islands Development Agency and the Kwajalein
Atoll Development Authority that are not itemized in the RMI government
financial statement.

2 "Social services" expenditures include spending on health, education,
housing, training, and social services projects.

3: Amounts for the four areas of RMI spending do not add to the total RMI
figure due to rounding.

Source: GAO analysis of FSM data, compiled by the Joint Committee on Compact
Economic Negotiations, and of RMI financial statements and audits of those
statements prepared by Deloitte Touche Tohmatsu for fiscal years 1987-98.

For the RMI, 46 percent ($65 million) of total capital fund expenditures of
$140 million are classified as "other" expenditures. Most of this amount
($54 million) was listed as unidentified capital expenditures in the RMI
financial statements. The Marshall Islands Development Authority and the
Kwajalein Atoll Development Authority reported $4.5 million and
$49.5 million, respectively, of unidentified "other" expenditures in the RMI
financial statements.18 RMI expenditures for infrastructure and economic
development accounted for 25 percent ($35 million) and 23 percent
($33 million), respectively, of these capital funds.

Revenue-Backed Bonds

The Compact did not preclude the FSM or the RMI from borrowing funds in
anticipation of U.S. assistance. Using this flexibility, from the late 1980s
to the mid-1990s, the FSM and the RMI issued nearly $389 million in Compact
revenue-backed bonds in order to obtain greater funding in the earlier years
of the Compact. This funding was used to retire existing debt, pay for
capital projects, and make financial investments. As shown in table 2, the
RMI issued about $275 million in Compact revenue-backed bonds, and the FSM
issued approximately $114 million.

 Dollars in millions
     Fiscal year       FSM      RMI
 1987                0        $65.00
 1988                0        0
 1989                0        20.00
 1990                $14.65   0
 1991                84.96    60.00
 1992                0        0
 1993                14.30    99.96
 1994                0        30.00
 1995                0        0
 1996                0        0
 1997                0        0
 1998                0        0
 Total               $113.91  $274.96

Source: GAO analysis of financial statements of the FSM and the RMI for
fiscal years 1987-98.

By fiscal year 1998, the FSM had repaid $119 million in bond debt (principal
and interest), with these repayments accounting for 11 percent of total
Compact expenditures. However, the RMI has used a higher percentage of its
Compact funding than the FSM to repay bond debt (42 percent, or
$217 million) through 1998. The debt payments have limited the availability
of Compact funds for other uses, particularly in recent years (see fig. 4).
For example, in 1998, the RMI spent $39 million in Compact funds.19 Of this
total amount, $25 million went to service debt. The RMI was also required to
spend an additional $8 million to compensate landowners for U.S.

military use of Kwajalein Atoll.20 This left only $6 million (15 percent) in
Compact expenditures to support new capital investment, general government
operations, or particular sectors identified in the Compact.21 According to
the RMI financial statements, the RMI is not scheduled to pay off its bond
debt until fiscal year 2002.

Source: GAO analysis of financial statements and audits of the RMI prepared
by Deloitte Touche Tohmatsu for fiscal years 1987-98.

The Two Compact Nations Have Made Some Improvements in Economic
Self-sufficiency

The FSM and the RMI have made some progress toward achieving economic
self-sufficiency, but both remain highly dependent on U.S. assistance. This
assistance has maintained standards of living that are artificially higher
than could be achieved in the absence of Compact funding.22 The dependence
of these two countries on total U.S. assistance, the indicator we have
chosen to gauge economic self-sufficiency, is identified by calculating the
percentage of total FSM and RMI government revenues accounted for by all
U.S. funding--Compact direct funding and U.S. program assistance.

Total U.S. assistance (Compact and all other U.S. program assistance)23
still accounts for at least half of total government revenue in both
countries, although government dependence on U.S. funds has fallen from 1987
levels in both countries. Reliance on U.S. assistance as a percentage of
total government revenue stood at 54 percent in the FSM and 68 percent in
the RMI in 1998. U.S. program assistance has proven to be an important
supplement to direct Compact funding in both nations.24 The FSM and the RMI
also receive loans from the Asian Development Bank as well as assistance
from other donors.

the Federated States of Micronesia

While the United States is the main contributor to the FSM government's
revenues, this dependence has fallen substantially since the Compact was
enacted, from 83 percent in fiscal year 1987 to 54 percent in fiscal year
1998 (see fig. 5). In 1987, total FSM government revenue (including all
states) was $143.5 million and by 1998 had risen to $184.5 million. The
reduction in dependence on U.S. assistance was due to scheduled decreases in
direct Compact funds, increases in locally generated revenue, and a change
in how government revenues are reported. Although the FSM is increasingly
less reliant on Compact funds, officials of the FSM Department of Foreign
Affairs predicted that there would be chaos without Compact assistance. In
1998, total U.S. assistance represented 47 percent of FSM gross domestic
product, or about $895 per capita.25

Note: Total FSM government revenues are comprised of direct Compact funds,
U.S. program assistance, and other revenue such as taxes, fees, and interest
income.

Source: GAO analysis of FSM financial statements and audits of those
standards prepared by Deloitte Touche Tohmatsu for fiscal years 1987-98.

Islands' Revenue

The RMI has also reduced its dependence on U.S. funding, though not as
dramatically as the FSM, and its dependence remains higher than that of the
FSM. In 1987, U.S. assistance represented 78 percent of total RMI government
revenue of $75 million (see fig. 6). This figure fell to 68 percent by
fiscal year 1998. In 1998, total government revenues were $81 million.
However, the 1998 level of dependence represents an increase from 1995, when
dependence on total U.S. funding reached a low of 51 percent. The increase
since 1995 is due to decreased local fees, sales, and taxes, and to a change
in how government revenues are reported.26 The RMI Foreign Minister reported
that continued U.S. funding remains necessary for the RMI to develop. In
1998, total U.S. assistance represented 58 percent of RMI gross domestic
product, or about $1,085 per capita.

Note: Total RMI government revenues are comprised of direct Compact funds,
U.S. program assistance, and other revenue such as taxes, fees, and interest
income.

Source: GAO analysis of RMI financial statements and audits of those
statements prepared by Deloitte Touche Tohmatsu for fiscal years 1987-98.

Compact Nations

While Compact direct funding continues to provide most U.S. assistance to
both nations, U.S. program assistance remains an important source of
government revenue. When program assistance is combined with Compact direct
funds to identify total U.S. assistance, the FSM and the RMI are even more
dependent on U.S. assistance. Total U.S. program assistance revenues for
fiscal years 1987-98 for both countries were $368 million. The FSM and RMI
composition of government revenues shown in figures 5 and
6, respectively, demonstrates the importance of program assistance as a
supplement to direct Compact payments in both countries, particularly in the
RMI. Since implementation of the Compact, the largest direct financial
payment (sec. 211(a)) was reduced following the 5th and 10th year per the
terms of the Compact. This reduction in funding did not, however, apply to
U.S. program assistance.

The RMI has been able to offset, in some cases, the scheduled reduction in
U.S. direct payments by increasing its use of U.S. program assistance
immediately following the reductions. For example, aside from direct Compact
funding, the RMI in fiscal year 1991 received $6.2 million in U.S. program
assistance from various U.S. agencies. The "step-down" in Compact direct
funding occurred at the end of fiscal year 1991. In 1992, the RMI's U.S.
program assistance revenues were $12.3 million. A similar experience
followed the second step-down in Compact assistance at the end of fiscal
year 1996. The RMI received U.S. program assistance of
$15.9 million by 1998, compared to $7.5 million in 1996. Increasing reliance
on program assistance is also evident for particular RMI agencies. For
example, in the operating expenditures of the Ministry of Education in the
RMI, U.S. program assistance increased from 10.1 percent of operating
revenues in 1994 to 42.4 percent in 1998. In the FSM, a similar shift to
program funds did not immediately occur following the scheduled step-downs
in Compact assistance. In fact, in 1992, following the 12 percent cut in
Compact funds, FSM use of U.S. program assistance fell 40 percent.

Not all U.S. program assistance is given through grant assistance to the FSM
and RMI governments. The U.S. Department of Agriculture has provided loans
for both governments' telecommunication and electric power companies. In the
RMI, the loans totaled $22.8 million by fiscal year 1998 for
telecommunications, with an additional $12.5 million for electric power. In
the FSM, the U.S. Department of Agriculture has provided
$40 million in telecommunication loans. Additional U.S. assistance is
provided directly to citizens in each nation. For example, students in the
FSM and the RMI qualify for Pell Grants. These are federal, nonreimbursable
grants awarded to undergraduate students who have not yet earned a degree.
Total awards since the beginning of the Compact came to almost $32 million.
According to the President of the College of Micronesia in the FSM, over 75
percent of the college's students use Pell Grants to attend. The President
also told us that without the availability of Pell Grants, the college would
not be able to survive.

The U.S. Department of the Interior does not have complete data on the type
or amount of U.S. program assistance that is provided to the FSM and the RMI
each year by U.S. agencies, though the financial statements of the FSM and
the RMI contain aggregate data on program assistance. While the legislation
enacting the Compact gave the Department of the Interior the responsibility
for monitoring program assistance, the Secretary of the Interior determined
in 1987 that the most effective method for U.S. federal agencies to provide
continuing federal programs to the Freely Associated States was to create a
direct grant relationship between the agencies and the island governments.
As a result, program assistance is provided independently by each U.S.
agency, and there is no central monitoring agency. The Department of the
Interior has one individual working in the FSM who is the program
coordinator for the FSM, the RMI, and Palau. When we met with him, he
expressed frustration at the difficulties he has faced in trying to compile
a comprehensive listing of all U.S. program assistance that is provided to
the region.

In addition to U.S. aid, both the FSM and the RMI have received assistance
from other donors. For example, Australia provides technical assistance to
the FSM to aid in government budgeting and statistics and has provided
experts in tax and customs issues to the RMI. According to data from the
embassy of Japan in the FSM, the value of Japan's contribution to the FSM
from 1994 to 1998 was $109 million. Japan's contributions have focused on
infrastructure. Based on requests from the FSM government, Japan will
undertake all aspects of a project, including performing a feasibility
study, preparing a design, and then contracting with a Japanese company to
implement the project. In the RMI, we were shown roads and school buildings
similarly constructed by Japan. China provides technical assistance in the
FSM and has supplied a loan for a business venture in the RMI. Recently,
Taiwan has provided loans and built projects in the RMI. Both the FSM and
the RMI have also received loans and technical assistance from the Asian
Development Bank. At the end of fiscal year 1998, the FSM had outstanding
loans from the Asian Development Bank of $10 million, and the RMI had
outstanding loans of $42 million. These loans are interest free but carry a
1-percent annual service charge. Loans are reported in the financial
statements of both countries, but direct, noncash assistance from other
countries, such as the construction of a building, does not appear.

Compact Funds Have Led to Little Improvement in Economic Development

Expenditures of $1.6 billion in Compact funds during 1987-98 in both
countries have contributed little to improving economic development. Three
areas in which Compact expenditures have not led to apparent improvements in
economic development are government operations, physical and social
infrastructure, and business ventures. Compact funds have supported high
levels of public sector employment at high wages, creating a barrier to
private sector growth. Investments in physical and social infrastructure
have not generated significant private sector activity. Finally, investment
of Compact funds in business ventures has been a failure, with many
businesses closed, while others require subsidies. We examined a wide range
of projects funded under the Compact and determined that these projects
experienced problems for many reasons, including poor planning, management,
construction, and misuse.

Discouraged Private Sector Growth

Substantial Compact funds ($616 million in both countries combined) were
used to support general government operations that have, among other things,
maintained high levels of public sector employment and wages and have acted
as a disincentive to private sector growth. Public sector wages are higher
than those in the private sector in both countries. According to a 1996
Asian Development Bank report on the RMI economy, high RMI government
salaries stifle private sector development by raising the threshold of wages
in the private sector.27 Further, in the FSM in 1996-97, public sector wages
were 82 percent higher than private sector wages. Higher public sector wages
attract workers from the private sector and drive up private sector wages.28
These higher wages make the private sector less competitive in international
markets.

However, an official from the Department of the Interior stated that without
substantial financial support from the United States for the status quo
operational expenditures of the FSM and RMI governments, the goals of the
United States to create stable independent governments and secure its
security interests would have failed. Further, a Department of State
official noted the success of the Compact in supporting the development of
public institutions needed to further economic development.

In response to scheduled reductions in Compact funding, the FSM and RMI
governments have recently begun economic reform efforts to, among other
things, decrease their large public sectors through actions such as
government personnel reductions and wage freezes. These efforts have been
supported by the Asian Development Bank with loans to give severance pay to
workers leaving government employment in both countries. The prospects for
further reductions in general government operations are uncertain. For
example, the current position of the FSM is that reform in the economy is
best achieved by private sector growth and not by further large-scale
reductions in government. In fact, the FSM economic strategy does not call
for further cuts in government spending but rather seeks to ensure that
government expenditures do not "grow excessively."29 A recent 1999 internal
evaluation of the Asian Development Bank reform programs concluded that in
the FSM, the reform program "seems to have lost its way." 30 In the case of
the RMI, the evaluation found that momentum for reform had been lost, partly
due to the considerable confidence within the government that external aid
could be increased. The sources for this aid would be Taiwan, which the RMI
recognized in late 1998, and successful renegotiations of Compact funding.
According to the Bank's evaluation, this position had been encouraged by the
U.S. Department of Defense's statement that the U.S. missile range in the
Kwajalein Atoll is a "national asset." However, an official at the U.S.
embassy in the RMI pointed out that the new President of the RMI, who took
office in January 2000, appears to be committed to keeping the RMI's reform
program on track. For example, in June, the RMI complied with the reform
program's government personnel reduction, according to the embassy official.

Have Not Contributed to Significant Economic Growth

The FSM and the RMI have spent at least $256 million in Compact funds for
physical infrastructure improvements and operations. Both nations viewed
this area as critical to improving quality of life and creating an
environment attractive to private businesses. While these improvements have
enhanced the quality of life, they have not contributed to significant
economic growth in the two countries. Both countries have also spent more
than $114 million from a health and education Compact funding provision and
have realized some improvements in these areas, though both rank in the
bottom half in terms of human development among Pacific island nations.31

In the FSM and the RMI, Compact funds of at least $97.6 million and
$24.6 million have been spent to operate and improve energy (including
electrical power) and communications (including telecommunications) systems,
respectively.32 An additional $75 million in loans has been provided by the
U.S. Department of Agriculture to the telecommunications providers in the
FSM and the RMI (see fig. 7) and to an electric utility in the RMI. The
companies view this assistance as critical to their improved performance.

Source: GAO.

Power systems have improved, with increased capacity and dependability and a
higher number of residents served, and have bettered their financial
performance. For example, according to a consultant for the FSM government,
over 50 percent of FSM dwellings had power in 1999, compared to about 29
percent in 1980 (see fig. 8). The Marshalls Energy Company, which serves
Majuro in the RMI, has been operating at a profit since 1994 (except for
1999) and no longer requires annual government assistance, according to the
General Manager. In the FSM state of Kosrae, we visited the electric power
company on a day when electric crews were disconnecting nonpaying customers.
However, financial and service problems persist in the electrical power
sector in some locations, particularly the FSM state of Chuuk and the RMI
island of Ebeye in the Kwajalein Atoll. For example, in Chuuk the power
company is trying to increase revenue through higher rates and better bill
collection, including enforcing its disconnection policy for overdue
accounts. Nevertheless, the utility still depends on a $1 million subsidy
from Compact energy funds and government funding of all capital
expenditures.

Source: GAO.

Telecommunications services have also improved in both countries, with
services provided to more residents and the introduction of enhanced
capabilities such as cellular service and Internet access.

Improvements in telecommunications and energy have not been sufficient to
promote significant private sector growth, though in one instance we did
identify a tuna processing plant in the RMI that recently located to the
country in part as a result of dependable electricity there (see fig. 9). 33

Source: GAO.

Both countries have also spent Compact funds to provide subsidized
transportation systems. These efforts have been targeted at improving
transportation between the main population centers and the outer islands. In
the FSM, ships used to haul cargo between islands have been maintained with
Compact capital account funds of approximately $5.9 million (see
fig. 10).

Source: GAO.

In the RMI, the national airline, Air Marshall Islands, has been in
operation since 1980 in order to move people and cargo between atolls (see
fig. 11). According to the independent auditor for the RMI, the airline has
received close to $27 million in Compact funding for fiscal years 1989
through 1997. This funding has been used primarily for operating transfers
as the airline operates at a loss. Further, we found that for fiscal year
1998, the airline received $500,000 in operating subsidies, as well as debt
forgiveness of
$1.8 million. The airline has received funding for other purposes as well.
For example, in 1995, over $15 million in Compact funding was used to buy
one aircraft. According to an airline official, this aircraft was sold in
1999 for $5 million after a determination that the aircraft was too
technologically advanced for the airline. According to Air Marshall Islands
officials, the previous government had used political influence to override
commercial decisions of the airline and to change management.

Source: House of Representatives Committee on International Relations,
Subcommittee on Asia and the Pacific, Staff Photo.

The two governments have also invested in social institutions, including
schools and hospitals. Both countries have spent over $114 million in a
Compact health and education block grant since 1987. A portion of the FSM's
investment in education has been used to support its college system. The
College of Micronesia has received $2.9 million in Compact funds over the
last few years for designing and supplying facilities (see fig. 12). The
College provides the FSM with a post-high school educational institution. It
consists of facilities in each of the four states of the FSM, as well as a
national campus located in the FSM capital of Palikir, Pohnpei.

Source: GAO.

Both nations show some improvements in social indicators over the life of
the Compact, though both are low ranking in this area among their Pacific
island neighbors. According to United Nations Development Program
indicators, the FSM and the RMI ranked 9th and 10th, respectively, in terms
of their human development level out of 14 Pacific island countries in 1998.
Since the 1980s, both countries have shown increases in school enrollment,
while in the RMI life expectancy at birth also increased from 60 to 65
years. RMI data on infant mortality show that mortality declined from 63
deaths per 1,000 live births in 1988 to 26 deaths per 1,000 live births in
1999. The FSM reports that as of 1997, infant mortality stood at 28 per
1,000 live births. Since the 1980s, life expectancy at birth in the FSM grew
by 1 year, to 66 years.

Compact expenditures have not promoted sufficient economic growth to
compensate for population growth and reductions in U.S. assistance;
consequently, living standards, though artificially higher as a result of
Compact funding, have stagnated. Both economies grew during the Compact
period, but per capita income, adjusted for inflation, showed essentially no
increase during the period in the FSM and fell in the RMI. In 1987, FSM
gross domestic product (GDP) was $130.3 million and by
1997-98 had risen to $213 million. However, the population of the FSM grew
as well, from about 93,000 in 1987 to an estimated population of 116,268 in
1999. The FSM government estimates that per capita income in the FSM, when
adjusted for inflation, grew about a total of 2.4 percent during the
12-year period. In the RMI, the economy grew from a GDP of $70 million in
1987-88 to a peak of $105 million in 1994-95. The RMI's GDP then fell to
$96 million by 1997-98. The RMI population also grew, from 43,380 in 1988 to
50,840 in 1999.34 Estimates from the RMI Office of Planning and Statistics
show that inflation-adjusted per capita income fell 41 percent from 1990
through 1998.35

As noted in chapter 1, the economic growth potential of these countries and
their ability to generate revenue to replace U.S. assistance have been
limited by factors such as geographic isolation and limited natural
resources. Before implementation of the Compact, we reported that the FSM
and the RMI faced serious obstacles to becoming economically
self-sufficient, such as inadequate planning for and maintenance of
infrastructure and low savings levels. Both governments lacked sufficient
managerial and technical expertise and management systems to overcome such
obstacles.

Current living standards depend on U.S. assistance. The FSM and the RMI are
among the largest recipients of U.S. assistance worldwide on a per capita
basis and are highly dependent on U.S. assistance. In 1998, total U.S.
assistance equated to about $895 per capita in the FSM, while per capita
income was $1,910. The RMI is more dependent, with 1998 U.S. assistance of
about $1,085 per capita compared to $1,890 in per capita income. The high
level of U.S. funding has maintained artificially higher standards of living
in both countries that could not be sustained in the absence of U.S.
assistance. An Asian Development Bank report describes the two countries as
"looking over the edge of a cliff" as they face the scheduled end of U.S.
Compact assistance.36

Failed

We identified $188 million in Compact funds spent in the FSM and the RMI for
business ventures. Compact funds have been invested in fisheries,
agriculture, aquaculture, livestock, business advisory services,
handicrafts, tourism, and manufacturing. Other Compact funds went to
development banks in both nations for business loans. During our visit, FSM
and RMI officials reported that few Compact-funded business ventures were
operating at a profit, if at all. Government officials from both countries
told us that investing in business ventures has been a bad strategy, and
using Compact funds for this purpose had been a failure. Two FSM state
governors noted that private sector initiatives, in every sector, had in
every instance lost money. An official of the Marshall Islands Development
Bank reported that all but one of the Bank's business investments had
failed.

The few successful business ventures that FSM and RMI officials identified
were the result of Compact funds loaned to businesses by government
development banks. FSM Development Bank officials identified several
successful loans, such as loans to the Yap Community Action Program, a
Kosrae resort, and a car rental agency. However, in general, the Bank's
lending record using Compact funds was weak. FSM Development Bank officials
said they made bad debt provisions of $12 million in likely loan losses
involving Compact funds in 1998, about two-thirds of the value of the
Compact-backed loan portfolio.

In the RMI, a Marshall Islands Development Bank official identified only one
successful business loan; loans using Compact funds generally failed, and
all business lending has currently been suspended. According to the
official, business lending had been directed by the RMI President or by the
Cabinet and was not based on business considerations. A recent audit by the
Department of the Interior Inspector General of bank lending listed
questionable loans, including loans to Air Marshall Islands, for an office
building, for an entertainment complex, and for several fishing ventures.
Because of political direction and influence, loans of about $6 million went
to businesses with family connections to the former RMI President, according
to the Bank's Chairman of the Board and the Managing Director.37 An RMI
official also noted that the only successful business loan was to the Trust
Company of the Marshall Islands. This company provides "off-shore" services
for businesses and individuals, including a ship registry, "off-shore"
incorporation, and financial trusts.38 According to an attorney for the RMI
embassy in Washington, D.C., such an enterprise is one of the few
competitive advantages that an island government has--to leverage off its
sovereignty. In fiscal year 1998, the ship registry returned about $766,000
to the government.39

Examples of failed business ventures are numerous and involve various
business sectors. For example, we identified failed fisheries and pepper
ventures in the FSM, and a closed garment factory, a large resort hotel
operating at a loss, and a dry dock facility in the RMI.

FSM: Fisheries Ventures,
$60 Million in Compact Funding

We identified $60 million in Compact funds that the FSM spent on fisheries
activities (see fig. 13).40 The FSM has undertaken unprofitable fisheries
investments in each of the four states. A 1999 analysis of FSM fisheries
ventures, prepared by a consultant for the FSM government, reported that the
current valuation of the national and state fishing enterprises, on the
basis of expected future cash flows, was zero.41 We visited one storage and
processing facility in each of the four FSM states; none of the facilities
was operating at the time of our visit. Officials from the states of Yap and
Chuuk said that ventures in fisheries were failures due to inexperience and
poor business judgment.

Source: GAO.

FSM: Pohnpei Pepper Industry Development, $870,000 in Compact funding

In Pohnpei, the state government spent $870,000 to develop a pepper
exporting industry (see fig. 14). As part of this effort, the government
started a pepper processing plant to provide farmers with an alternative
buyer to the one successful private sector pepper company already in
operation that purchased pepper from farmers. The intent of the project was
to provide an opportunity to pepper farmers to sell their pepper to the
government enterprise at higher prices than those paid by the private
company. The government enterprise would then process, market, and export
the pepper. As a result of the government effort, the private sector company
went bankrupt. Subsequently, the government enterprise closed. Pepper
exports fell from $95,000 in 1995 to zero in 1997.

Source: GAO.

RMI: Garment Factory,
$2.4 Million in Compact Funding

We identified almost $2.4 million in Compact capital funds that were spent
to establish a garment enterprise that included a factory and a dormitory
for workers (see fig. 15). This business was a 1993 Marshallese-Chinese
joint venture to manufacture and export clothing using Chinese workers. The
government of the People's Republic of China loaned the RMI an additional $2
million for the joint venture. However, management disagreements ensued and
the Chinese workers were returned to China. According to RMI government
officials, the facility never operated and is now closed.

Source: GAO.

RMI: Resort Hotel, $11 Million in Compact Funding

The RMI also used more than $11 million in Compact capital account funds to
build a major resort hotel, according to the independent auditor for the
RMI. This hotel was built so that the RMI could host a meeting of the South
Pacific Forum in 1996. The hotel now operates at a loss and receives
government subsidies. For example, in fiscal year 1998 subsidies amounted to
more than $1 million.

RMI: Dry Dock, $4.5 Million in Compact Funding

The RMI spent $4.5 million in Compact funding to establish a dry dock
facility. According to the RMI Minister for Resources and Development, the
dock is in bad condition due to a lack of maintenance, and the government's
current concern is that the investment will sink in the water.

Management, Construction, Maintenance, and Misuse

After a review of financial records, and project files, or both for over
150 projects undertaken with Compact capital account funds, visits to
80 project sites, and numerous interviews in the FSM and the RMI, we
determined that many Compact-funded projects (infrastructure and business
ventures) experienced problems as a result of poor planning, management,
construction, maintenance, and misuse, or all of these problems. These
problems have reduced the effectiveness of Compact expenditures. According
to Department of the Interior officials, the ineffective use of Compact
funds can be partially explained by the fact that neither the FSM nor the
RMI governments had staff that possessed the skills necessary to plan and
manage expenditures under the Compact.

The standard documents in the FSM used to track capital projects--the
project control document--often contained minimal or very broad descriptions
of project objectives, costs, and expected benefits and are no longer than
two pages for projects that cost hundreds of thousands of dollars.42 In the
RMI, we could find no evidence of any standardized form used to plan or
track capital projects. In some cases, we found very limited files for
sizable RMI ventures such as the airline or the resort hotel. Further, in
both countries, we found that many project files that we reviewed lacked

complete documentation such as economic feasibility studies, competitive
bids, contracts, and inspection reports.43

Poor planning and management were evident for many failed projects we
visited. Examples of poor planning and management that we identified
included a causeway in the RMI and a coconut products company, fishing
venture, and road in the FSM.

RMI: Ebeye Causeway,
$9.2 Million in Compact Funding

The RMI government spent an estimated $9.2 million in Compact capital funds
to build a road, or "causeway," from Ebeye, an extremely crowded island in
the Kwajalein Atoll, to a planned development on the nearby island of
Gugeegue (see fig. 16). This causeway was meant to relieve population
problems on Ebeye by allowing residents to move to additional islands
connected by the road. However, the causeway remains unfinished due to an
inability to budget additional funding for the project. Little development
has occurred on Gugeegue, and few residents have moved from Ebeye to
Gugeegue. Ebeye officials told us that the causeway is covered with water in
places during high tide and is considered an inadequate and unreliable
connection between Ebeye and the other islands. Construction has been
suspended.

Source: GAO.

FSM: Ponape Coconut Products, Inc., $133,000 in Compact Funding

In the FSM state of Pohnpei, a company involved with the production and
distribution of soap and other products made from island-grown coconuts made
significant investments in production expansion based on a contract with one
individual. Relying on a 1996 contract with a foreign national, the soap
company requested and received $133,000 in Compact funding to purchase new
equipment to meet contract production requirements. According to the
company's senior accountant, the foreign national disappeared shortly after
the equipment was installed, and the company is losing money. According to
the company's 1999 financial statement, losses were $45,000. The senior
accountant said that the factory stays in business through government loans
and grants. When we visited, the new machinery was sitting idle and rusting,
while limited production was underway using old equipment (see fig. 17).

Source: GAO.

FSM: Pohnpei Fishing Venture, $21 Million in Compact Funding

Also in Pohnpei, the state government, in conjunction with the national
government, spent about $21 million on fishing boats and processing
facilities that were not compatible. Because of poor management and
planning, the boats never returned a profit, and the processing plant is
currently idle. According to the Pohnpei State Lieutenant Governor, the
government knew nothing about the fishing industry when it made the
investment and was duped into paying too much for three 25-year old boats
that were too small for the Pacific environment.44 In addition, the
processing plant, which cost almost $16 million, was intended to process
high-grade tuna and not the lower-grade tuna caught by the three boats.

FSM: Kosrae Road Construction and Paving, $9.3 Million in Compact Funding

Another example of poor planning that we observed was in the FSM state of
Kosrae. The state used $9.3 million in Compact capital account funding
within the last 12 years to construct and pave a road around the island.
When we visited, the road was in obvious disrepair, and we were told that
the road surface had been largely removed (see fig. 18). In reviewing the
project file for road construction, we found that an inferior, though
cheaper, paving technology had knowingly been employed. Kosrae officials had
been informed, prior to construction, that a $800,000 grant from the U.S.
Department of Commerce's Economic Development Authority would not be
provided if Kosrae chose this inferior method of building a road. Kosrae
chose the cheaper method, never received the Economic Development Authority
grant, and is now preparing to pave its roads again.

Source: GAO.

Inadequate construction was evident during our site visits and could be
considered a result of poor planning. At times during our visit, it was
difficult to distinguish poor construction from inadequate maintenance. The
tropical climate consists of high temperatures, rain, and exposure to
salt-laden air, which requires different material standards than does
construction in more temperate climates. Water leaks were evident in many
buildings, and corrosion was obvious both in Compact-funded buildings as
well as on government vehicles.

RMI: National Capitol,
$8.3 Million in Compact Funding

The capitol building in the RMI, built during the 1990s using $8.3 million
in Compact funding, has visible signs of deterioration (see fig. 19). Stairs
are rusting, elevators are inoperable, and roof leaks are evident throughout
the building. In reviewing the construction file for the capitol project, we
found a letter from the contractor building the capitol to the government's
engineering representative questioning the suitability of the supplied
roofing material for the project. According to the contractor, a warranty on
the roofing material would not be supplied in part because the supplied
material's original purpose was to be used as a "pond liner," not as roofing
material. We were unable to ascertain whether the pond liner material was
subsequently used on the project, but we did observe leaks throughout the
building. RMI embassy officials in Washington, D.C., told us that funds have
been recently appropriated to make repairs.45

Source: GAO.

FSM: Health and Education,
$80 Million in Compact Funding

We found inadequate or nonexistent maintenance in numerous schools and
hospitals we visited, despite the government's spending $80 million in
Compact funding designated for health and education in the FSM. For example,
we visited schools in Pohnpei and Chuuk where sections of ceilings were
missing, bathrooms were in disrepair, and electricity had been disconnected.
In general, many schools appeared poorly maintained (see fig. 20). According
to a 1999 Asian Development Bank assessment of the FSM education system,
salaries consumed 97 percent of the 1999 elementary education budget in
Pohnpei and 100 percent in Chuuk, leaving almost no funds for educational
materials or facility maintenance.

Source: GAO.

At the Pohnpei hospital, the Director told us the hospital lacked adequate
funding, drugs, and supplies (see fig. 21). He said the entire health care
system would collapse without Compact funds, in part because collection fees
covered less than 20 percent of health care costs. As a cost-cutting
measure, the hospital no longer provides sheets to patients. The Director
said patients who cannot afford sheets simply lie on hospital mattresses,
where their infections can contaminate the mattresses and infect future
patients. The U.S. embassy in the FSM reported in January 2000 that, because
the hospital lacked funding for cleaning products, infectious viruses had
been found in 37 locations, including 10 sites in the operating and
emergency rooms.

Source: GAO.

RMI: Health and Education,
$34 million in Compact Funding

During our visit to the Ebeye hospital in the RMI, water leaks were evident
in the surgery ward, and supporting roof beams were crumbling from rust (see
fig. 22). The Ebeye City Manager told us that the Compact provided for
capital investment but did not supply any funds for maintenance. For
example, the municipal government takes funds away from other key areas such
as schools in order to maintain capital projects but still cannot adequately
maintain these projects. He advocated that capital improvements only be
undertaken after the costs and funds for maintenance have been
determined--it would be better to have fewer, well-maintained, investments
than the current larger, but unsustainable, number of projects.

Problems in construction were not unique to Compact-funded projects. The new
Ebeye hospital, which is more than a year away from opening, will need to
have foundation support beams replaced before construction can continue. The
support beams were not adequately protected from the corrosive environment
and are already rusting away. According to an official from the Kwajalein
Atoll Development Authority, this project received a non-Compact U.S. grant
totaling $4.5 million.

Source: GAO.

Finally, we identified Compact expenditures that appeared to be a misuse of
funds. The prospect that these projects will promote widespread economic
advancement is questionable. For example, in the FSM state of Chuuk, the
Udot road and dock project was intended to upgrade basic social and economic
infrastructure in Udot. According to government officials, it will not meet
this goal. The project cost $188,000 in Compact funding. When we visited the
site, we noted that the dock was built directly in front of the Mayor's
house (see fig. 23). Chuuk state officials said that the crane used to build
the dock would be left to rust after the dock was completed. The road led
from the Mayor's house through the jungle to a small village, with few other
houses along the road. In contrast, at the end of the Mayor's road was a
junior high school that received $2,800 in Compact funding to repair the
one-room schoolhouse. There were no desks or chairs for students. Further,
we were told that students did not have their own textbooks and were read to
by the teacher, who used the one set of available textbooks.

Source: GAO.

Also in the FSM state of Chuuk, the Fanapanges ice plant was to be built to
increase income, employment, and nutrition by providing ice to fishermen on
the island of Fanapanges and other nearby islands so they could store their
catch for later sale in Weno, the capital of Chuuk, about an hour's boat
ride away. We identified almost $100,000 in Compact funding that was used
for this project. When we visited the site, we discovered that the plant had
never been built. Chuuk State officials told us that, after site preparation
had begun, the Mayor of Fanapanges had decided to move the ice machine to
his home in Weno on a different island, about 11 miles away by boat. When we
visited the Mayor's house in the state capital, we found the ice machine
sitting by the side of the house, not in use (see fig. 24).

Source: GAO.

As another example of what appeared to be a misuse of funds, the FSM used
funds in what the U.S. embassy in the FSM described as "cars and boats for
votes." The FSM Public Auditor reported that $1.5 million was spent on cars
and boats that were simply given away to individuals for their personal
use.46 Although the procurement documents for purchasing boats stated that
they were to be used for economic purposes, we learned in interviews with
two different recipients that they received the boats from the Mayor without
any restrictions placed on their use (see fig. 25). Furthermore, the embassy
reported that another 187 cars had arrived in May 1999 and were used for
"re-election assistance."

Source: GAO.

We also found examples of possible misuse of Compact funds in our
examination of records relating to two RMI government entities that executed
capital and business development projects. These were the Marshall Islands
Development Authority and the Kwajalein Atoll Development Authority.

The Kwajalein Atoll Development Authority received certain Compact capital
fund transfers for use in the Kwajalein Atoll. We found instances in which
the independent auditor reported that the Authority had spent more than the
amount authorized in the Compact for administrative expenses. The Compact
states that 1.5 percent of capital account funds can be spent for
administrative purposes. While the independent auditor determined that,
based upon capital account funds available, the Authority was only
authorized to spend about $60,000 for administrative expenses in 1992, it
instead used $1.1 million for the Board of Directors and other costs of
operation (28 percent of its capital funds for the year). In another
instance in fiscal year 1992, the independent auditor identified more than
$9,000 that the Authority had spent to host a party in Hawaii, as a
questioned cost in its annual audit.

In addition, the Authority lent five personnel to the RMI President to
assist in completing his residence in Majuro in 1997. The Authority also
spent funds on overseas travel. For example, in 1991, about $108,000 was
spent to send a delegation to the United Nations to witness the RMI's
official entry into that body. In another instance, the Authority sent five
members as part of the RMI delegation to the United Nations' "Rio Earth
Summit" in 1992.

The Marshall Islands Development Authority served as the agent for
implementing capital investment decisions made by the government's Cabinet.
Officials from this agency reported that they did not have a feasibility
study for any project but implemented decisions of the Cabinet. We found
several cases in which the RMI Cabinet would reprogram development funds for
nondevelopment purposes such as to pay for medical referrals, to finance
foreign travel of an Ambassador, and to pay salaries for the council of
Traditional Leaders.

In commenting on the RMI record of Compact expenditures, the Minister of
Finance characterized the RMI's past expenditures for various projects as
lacking due diligence on the part of the government. He recommended that any
future Compact contain better accountability. The RMI Foreign Minister
reported that financial management of RMI funds responded to politicians'
goals and had not been for the benefit of the RMI.

The Two Compact Nations and the United States Have Provided Limited
Accountability Over Compact Expenditures

The FSM, the RMI, and the United States have provided limited accountability
over the use of Compact funds. Although the Compact established
accountability requirements for all three countries, they have not fully
complied with the requirements. The FSM and the RMI have usually submitted
the required development plans and reports, but these documents fell short
of meeting their intended purposes. In addition, the FSM and the RMI have
not demonstrated adequate control over the use of Compact funds. Finally,
limited Interior staff devoted to oversight, interagency disagreements in
the United States on the level of and responsibility for oversight, and a
Compact provision guaranteeing payment of Compact funds, have limited the
U.S. government's ability to oversee the use of Compact funds and ensure
that they are used effectively.

States of Micronesia, the Republic of the Marshall Islands, and the United
States

The Compact required the FSM, the RMI, and United States to account for the
use of Compact funds by filing development plans, annual reports, and
financial audits and by conducting bilateral consultations. The FSM and the
RMI were responsible for preparing overall economic development plans at
least every 5 years. Among other things, the plans were required to serve as
a program for annual development by identifying specific economic goals and
also by determining specific projects and linking them to development goals.
The FSM and the RMI were also responsible for preparing annual reports on
the implementation of the development plans and the use of Compact funds and
for having annual financial and compliance audits conducted. The Compact
required the United States to review the development plans for compliance
and consistency with the Compact and to assist in identifying appropriate
development goals. The United States was also required to meet annually with
the FSM and the RMI to review the annual reports and discuss the use of
Compact funds. The Department of the Interior is designated to provide and
monitor Compact funds. In addition, a 1986 executive order established an
interagency group, chaired by the Department of State, to provide policy
guidance on the Compact.

Micronesia and the Republic of the Marshall Islands Were Generally
Incomplete and Insufficient

While the FSM and the RMI generally met the Compact requirements to submit
national economic development plans and annual reports to the United States,
our analysis of these documents, confirmed by officials from the Departments
of State and the Interior, concluded that both types of documents have been
insufficient to meet the Compact requirements.

The FSM and the RMI submitted economic development plans for the first and
second 5-year periods, covering the period from 1987 to 1997. Our analysis
of the economic development plans, confirmed by a Department of the Interior
official and an FSM government document, found that the plans gave
inadequate attention to broad development goals and plan implementation, as
required by the Compact. The Interior official said the plans focused on
spending funds in specific sectors without tying projects to development
needs. The Department of State Special Negotiator for the Compact of Free
Association told us that the FSM's most recent planning document, the FSM
Planning Framework for 1999-2001, has been accepted as that country's third
economic development plan.

For fiscal years 1987 through 1999, the FSM submitted annual reports each
year except for 1999, while the RMI has submitted 7 of the 13 annual
reports. Department of the Interior officials told us that the annual
reports, which are required by the Compact as a means of assessing economic
progress, were also inadequate at describing how Compact funds were used to
achieve development goals. Additionally, the reports were submitted too late
to be relevant for timely U.S. oversight, according to U.S. officials.47
Although State and Interior were generally critical of the quality of the
reports, a State Department official noted that the quality of FSM annual
reports has improved over time, while the quality of RMI reports has
deteriorated.

In addition to requiring the submission of reports on the overall use of
Compact funds, a Compact-related agreement requires that each nation submit
annual plans regarding the use of targeted annual assistance of
$10 million for health and education. Based on our review of documents held
by the Department of the Interior, it appears that few of these required
annual plans have been submitted. For the FSM, four plans were on file, and
two were available for the RMI. (See app. II for a listing of accountability
requirements that the FSM, the RMI, and the United States did and did not
meet.)

In addition, the FSM and the RMI have failed to adequately control and
account for Compact expenditures. According to their annual financial
audits, the FSM and the RMI did not maintain or provide sufficient financial
records to effectively audit Compact funds. Of the 60 financial reports of
the FSM national government and its four states from which we obtained
financial statement data, Deloitte Touche Tohmatsu (the independent auditor
for the FSM and the RMI) was unable to issue an audit opinion on the
financial statements in 7 reports, and issued a qualified opinion on the
financial statements in the other 53 reports.48 Of the seven audits with no
opinion, the auditor cited accounting deficiencies and a lack of financial
data from the government entity or one of its component units. The auditor
cited similar reasons for the qualified opinions in its remaining audits.
For example, in fiscal year 1998, the Yap Fishing Corporation, in which the
government has a majority interest, did not provide financial statements.
Similarly, none of the 12 independent audits we read for the RMI were issued
without qualification. A frequent reason for the qualification was the lack
of financial statements provided by government entities. For example, in
fiscal year 1998, eight entities were not able to produce financial
statements, including the Marshall Islands Social Security Administration,
the Marshall Islands Development Bank, the Marshall Islands Drydock, and the
College of the Marshall Islands.

Further, the independent audits showed that the two countries, as well as
the United States, have taken little action to address management weaknesses
and resolve questioned uses of Compact funds. The annual audit reports list
questionable uses and accounting of U.S. assistance, including direct
Compact payments and U.S. program assistance. The United States expects the
FSM and the RMI to develop and implement corrective action plans to resolve
these questioned costs. 49 However, under current guidelines, if the FSM and
the RMI do not take corrective action, and if the U.S. agencies providing
the assistance do not notify the FSM and the RMI within 2 years that the
issues are unresolved, then the FSM and the RMI can remove all questioned
costs that fall outside this 2-year window from the summary audit schedule
of questioned costs. As a result, by fiscal year 1998, the two countries
wrote off about $57 million in questioned uses of Compact and other program
assistance that had been unresolved since the 1980s ($46.3 million for the
RMI and $10.8 million for the FSM). The FSM created a special committee in
1998 to address questioned costs directly and work with the government
agencies to implement corrective action on open recommendations.

Finally, program audits by the FSM Public Auditor found inappropriate use of
Compact funds and extensive management weaknesses in accounting for Compact
funds. For example, an audit of Compact-funded projects for fiscal years
1997 and 1998 found that 37 of 42 projects examined were not properly
managed and had deficiencies such as improperly documented payments. An
audit of Compact-funded projects for fiscal years 1992-96 found problems
related to misuse of funds. For example, the audit found that nearly
$600,000 of heavy equipment purchased for a $1.3-million road improvement
project in Tolensome, Chuuk, was being used at a former mayor's personal
dock for activities not related to road improvement. According to the
auditor, funding for the road project continued even after inspections
identified this instance of inappropriate use of funds. We could not
identify any similar program audits involving the use of Compact funds
conducted by the RMI Auditor General.

The U.S. government has not met many of the Compact's accountability
requirements to review and consult on Compact expenditures. We found that
the U.S. government concurred with and praised the initial development plans
of both countries, although Interior officials informed us that U.S.
concerns over the plans remained. Despite this concurrence, the Department
of the Interior was unable to provide us with the reviews of the first plan
of both countries, and we found no evidence that required reviews of, and
concurrence with, the second plans took place. Although the Compact requires
the U.S. government to review each FSM and RMI overall economic development
plan to, among other things, assess whether they include appropriate
development goals, we did not find any assessments. We found no evidence
that Interior consulted with the Agency for International Development or
other agencies regarding the plans, as required in the Compact.

With respect to the annual reports prepared by the FSM and the RMI, we were
unable to identify documentation demonstrating that the Department of the
Interior reviewed these reports. A Department of the Interior official
stated that the reports are not assessed to determine if they provide
adequate information on development plan implementation and the role of
Compact expenditures in achieving development goals.

In addition, the United States did not initiate the required annual
consultations with the two countries until 1994--7 years after the Compact
went into effect. The United States has held four additional consultations
with the FSM and three consultations with the RMI since 1994. As a result of
missed meetings, the FSM and the RMI were not required to demonstrate their
progress in economic development and justify their Compact expenditures on a
regular basis. Further, according to a Department of the Interior official,
the talks that were held have been cordial diplomatic meetings but have not
included serious discussions of economic growth or compliance with Compact
spending requirements. A Department of State official disagreed with this
statement.

The Compact requires that audits of FSM and RMI Compact expenditures be
conducted. A Compact-related agreement requires that annual audits be
conducted within the meaning of the Single Audit Act of 1984. These audits,
discussed in the previous section, were contracted to an independent auditor
and have been conducted for both the FSM and the RMI for every year since
the Compact was enacted. The Department of the Interior pays for the annual
audits. According to an Interior official, the audits cost over $1 million
for both countries in fiscal year 1999. Our review of independent audit
information has demonstrated that U.S. government reliance on the financial
statements of the FSM and the RMI as a complete accounting of Compact
expenditures is questionable. The independent auditor has routinely stated
that it has been unable to audit the financial statements of various
recipient government subcomponents--entities that may have received Compact
funding. Further, a large portion of U.S. direct Compact payments were
placed in a general government fund and commingled with other revenues and
therefore cannot be further tracked. In addition, due to transfers between
different types of funds, some Compact assistance is only traced at a high
level with few details readily available regarding final usage. In addition,
the Department of the Interior's Inspector General has done few audits of
its own in either country. Since 1987, the Interior Inspector General has
issued four reports for the FSM and four for the RMI. Most of these audits
occurred in the first few years of the Compact. When asked to summarize how
Compact funds were spent, one Department of the Interior official replied
that "they were spent."

As noted in the previous section, U.S. agencies took little action to
address questioned costs identified in the annual independent audits of the
FSM and the RMI. However, we did identify documentation demonstrating that,
in the last few years, the U.S. Ambassador to the RMI raised the issue of
questioned costs and fiscal mismanagement with the Department of the
Interior and requested increased attention to audit compliance by the
Department of the Interior's Inspector General. The Ambassador informed us
that Interior has not taken any action.

Finally, Interior resources devoted to Compact oversight are minimal.
Currently, Interior has one person in Washington, D.C., who works with the
two Compact nations, as well as one person in the FSM,50 and no one is
posted in the RMI.51 In 1987, the Department of the Interior reported that
it would need 15 staff positions to implement the Compact, including 7 field
positions, but few of these positions were filled. Interior has speculated
that a larger U.S. presence in the FSM and the RMI might have produced
better results through moral suasion and encouragement.

Belief That Compact Provisions Restricted U.S. Actions

An executive order issued in 1986 shared Compact responsibilities between
the Departments of State and the Interior. The Department of State was to
conduct government-to-government relations, while the Department of the
Interior was responsible for providing the assistance, coordinating and
monitoring all federal programs in both nations, and monitoring economic
planning.52 However, disagreements between the Departments of State and the
Interior regarding the level of and responsibility for Compact oversight
have led to limited monitoring. These disagreements, discussed in the
following paragraphs, have not engendered U.S. government action,
specifically by these two Departments, to assess expenditures and review
them with both countries. As a result, the United States did not use its
influence to promote greater progress toward self-sufficiency and more
effective financial management on the part of the FSM and the RMI.

Accountability. The Department of State counseled Interior to be lenient in
reviewing the use of Compact funds in the early years of the Compact because
State placed a high priority on maintaining friendly relations with the FSM
and the RMI. State viewed positive relations as key because, for example,
both countries had a tendency to vote with the United States in the United
Nations General Assembly. According to a Department of State official, the
Department did not place greater priority on oversight of Compact funds
until the early to mid-1990s, after the Cold War had ended. As a result,
Interior did not aggressively monitor Compact expenditures, according to
Interior officials.

Staffing. The Departments disagree regarding authority over Interior staff
selected to work in the RMI, as well as where Interior staff would be
located within the country. Specifically, while the Department of State
reports that U.S. government staff working in the RMI are under the direct
authority of the Ambassador, who is a State Department official, the
Department of the Interior disagrees. Further, a Department of State
official reported that the two departments have disagreed regarding whether
Interior staff posted in the RMI should be located in the capital, Majuro,
or in the Kwajalein Atoll. These disagreements partially explain why there
are currently no Interior staff working in the RMI. Finally, the Departments
differ on whether Interior is the appropriate agency to be responsible for
administering a foreign assistance program.

Roles and Responsibilities. Disagreements over agency responsibilities help
to explain the lack of consultations with the FSM and the RMI from 1987 to
1993. Department of the Interior officials told us that the Department of
State is supposed to initiate discussions regarding Compact issues with the
FSM and the RMI as part of its responsibility for "government-to-government
relations" with the two countries and as chair of the interagency group that
establishes policy regarding the two countries. However, Department of State
officials maintain that the Department of the Interior, as the agency
responsible for providing Compact funding, should have requested meetings
with the FSM or the RMI regarding Compact expenditure issues. Consultations
began in 1994 and are now supported by both Departments.

In addition, Department of the Interior officials believe that certain
Compact provisions limit the Department's ability to require accountability.
They told us that while the Compact and a related agreement refer to direct
payments for economic assistance as "grant assistance," these payments are
not the same as discretionary grant assistance as commonly understood in
domestic U.S. programs. For discretionary grant assistance, requirements
such as performance measures can be applied to control the use of funds.
According to Department of the Interior officials, Interior voiced concerns
to Compact negotiators, prior to implementation of the Compact, regarding
the lack of enforceable standards in a Compact-related agreement.

Further, Interior officials told us that one Compact provision states that
payments are expressly backed by the "full faith and credit" of the U.S.
government and are intended to be an enforceable obligation. If the United
States withholds funds or otherwise fails to make a payment, the FSM and the
RMI can seek redress in court. As a result, Department of the Interior
officials told us that they are unable to withhold funding from the FSM and
the RMI and essentially have no mechanism to ensure that funds are not
misused. We and the Department of State officials agree that withholding
funds is impracticable. Interior felt it became simply a "pass-through" for
the money. Interior officials told us that the guarantee of funding provided
by the "full faith and credit" provision explains why the agency has not
pursued questioned costs identified in the independent audits involving
direct Compact payments.

While the "full faith and credit" provision may make withholding most funds
impracticable, the legislation enacting the Compact did identify certain
funds that could be withheld for noncompliance with Compact requirements. We
identified one instance in which Interior withheld funds from the FSM. In
late 1994, Interior withheld a portion of these funds (targeted for health
and education) from the FSM state of Chuuk due to unpaid bills outstanding
at a hospital in Guam. Interior reported that this action was effective, and
Chuuk took quick action to resolve the problem. The funding was then
provided to Chuuk.

Conclusions and Recommendations

Our work reviewing the Compact with the FSM and the RMI has led us to
conclusions in three specific areas. First, Compact assistance spent on
economic development has been largely ineffective in promoting significant
economic growth, with many unsuccessful development efforts. Second, the
structure of the Compact provided insufficient guidance regarding the
expenditure and accounting of Compact funds. Third, the accountability
requirements contained in the Compact were not met by the FSM, the RMI, or
by the United States. Lastly, our work raises several broad issues that need
to be resolved as Compact assistance nears its scheduled end and as the
United States negotiates with both nations regarding possible future
assistance.

Compact funds spent on economic development have been largely ineffective in
promoting economic growth. Neither the FSM nor the RMI can boast a strong
track record in economic development, despite some improvements in social
and living conditions. Although the countries have had sporadic success in
using Compact funds, many development efforts have been unsuccessful because
the funds were spent without planning or were misused, such as the bad
investments in business ventures or the maintenance of a large public
sector. Many projects have failed, and the money has been wasted, because
the countries did not conduct
cost-benefit or feasibility analyses or plan for local environmental
conditions or maintenance needs and were not held accountable for the
effective use of funds. The persistent problems we found in project
planning, implementation, and monitoring demonstrate a lack of adequate
local skills and experience in managing projects and large budgets. Both
countries remain highly dependent on U.S. assistance and, thus, economic
self-sufficiency at current living standards remains a distant goal for the
FSM and the RMI.

The Compact of Free Association with the FSM and the RMI provides
insufficient guidance regarding how Compact funds are to be spent and
accounted for by the FSM, the RMI, and the United States. By issuing Compact
revenue-backed bonds, both countries took a risk in concentrating spending
in the early years of the Compact when they had little experience in
planning and managing economic development investments. Further, the listing
of eligible capital account expenditures in an agreement related to the
Compact includes a broad range of expenditures that are not traditionally
viewed as capital investment. As a result, the determination that both
countries spent 40 percent of certain Compact funds on capital investment as
required by the Compact provides little assurance that infrastructure has
actually received this level of investment. Also, expenditures were not
subject to performance measures or evaluations. Finally, our review of
financial statements and audits revealed that it is often not possible to
track specific uses of Compact funds. Transfers between funds and
commingling of Compact and local revenues seriously limit the ability to
track Compact funds to their final usage.

The Compact contains some accountability requirements, but they were never
followed with any degree of rigor. Further, the financial data on Compact
expenditures provided in the audits are not linked to the performance and
effectiveness of Compact-funded projects. The limited U.S. oversight of
Compact expenditures, particularly in the early years of the Compact,
reduced a potentially effective means for the United States to influence
Compact spending. For example, by not holding the required annual
consultations with the FSM and the RMI during the first half of the Compact,
the United States forfeited the chance to review how the countries used
Compact assistance and to provide input into future spending decisions.
Further, disagreements between the U.S. Departments of State and the
Interior on the level of and responsibility for Compact oversight have
contributed to minimal monitoring efforts. Moreover, the "full faith and
credit" provision of the Compact, which guarantees most funding to the FSM
and the RMI, has had the effect of restricting the ability of the United
States to take actions necessary to ensure Compact funds are spent
efficiently and effectively. Partly as a result of this provision, the
Department of the Interior provided limited oversight.

Our work raises several issues that need to be resolved as Compact
assistance nears its scheduled end and as U.S., RMI, and FSM negotiators
discuss the possibility of future assistance. First, unless U.S. policy
objectives are reassessed and consensus is reached on the appropriate
objective for U.S. assistance, the United States may continue to provide aid
without adequate assurance that it will be targeted to high-priority areas
with a potential for achieving lasting impact. Second, in conjunction with
determining appropriate policy objectives, consideration should be given to
the level and the duration of future assistance and mechanisms to ensure
performance. Policy goals should be consistent with judgments about how much
funding the United States should spend on aid to Micronesian countries
versus other competing programs. Third, U.S. policymakers need to determine
the appropriate composition of U.S. assistance, including support for
general government operations, targeted assistance for priority areas and
projects, and whether U.S. domestic programs should continue for the FSM and
the RMI and be administered separately from the Compact. Finally,
negotiations on future assistance provide an opportunity to assess and
clarify or redefine the respective roles of U.S. agencies responsible for
providing and monitoring U.S. assistance to avoid a continuation of
oversight problems stemming from disagreements.

As negotiations to determine the extent and nature of future assistance to
the FSM and the RMI continue, we recommend that the Secretary of State, in
consultation with Congress, develop guidelines regarding U.S. policy
objectives for assistance; the level, duration, and composition of U.S.
assistance; and the agency responsible for U.S. oversight.

Further, we recommend that the Secretary of State direct the Special
Negotiator for the Compact of Free Association to negotiate Compact
provisions that provide greater control and effectiveness of expenditures
and that include

ï¿½ requiring that funds be provided primarily through specific grants that
facilitate the ability of the United States to (a) direct the money to
mutually agreed-upon priority areas and projects; (b) control and monitor
expenditures through grant requirements such as performance indicators,
technical and financial planning, incremental funding, and evaluation; and
(c) provide technical assistance for planning and implementing the use of
funds;

ï¿½ more specifically defining the eligible uses of capital account funds;

ï¿½ requiring that funds, either Compact or from local revenues, be set aside
for maintenance of capital projects; and

ï¿½ requiring that consultations that lead to a consensus take place between
the U.S. and the FSM or RMI governments before either the FSM or the RMI
issue any Compact revenue-backed bonds.

To achieve greater oversight over expenditures, we recommend that the
Secretary of State direct the Special Negotiator for the Compact of Free
Association to negotiate Compact provisions

ï¿½ requiring, in addition to annual financial statement data, expanded annual
reporting requirements for the FSM and the RMI, including a requirement to
provide data and information on specific expenditures in mutually determined
priority areas on an annual and historic basis presented in a format that is
easily understandable to U.S. policymakers and officials responsible for
providing and monitoring Compact assistance and

ï¿½ ensuring an expanded agenda for the annual consultations that will include
discussions of (a) progress toward mutually agreed-upon objectives, (b)
questioned costs and management weaknesses identified in financial and
program audits, and (c) the role of U.S. program assistance in furthering
development.

Finally, to secure an improved U.S. ability to enforce compliance with
Compact spending and oversight requirements, we recommend that the Secretary
of State direct the Special Negotiator for the Compact of Free Association
to exclude a "full faith and credit" provision from any future economic
assistance agreement and to include provisions that will provide that funds
can be withheld from the FSM or the RMI for noncompliance with spending and
oversight requirements.

In order to strengthen accountability and ensure the effective use of the
remaining FSM and RMI Compact funds, we recommend that the Secretary of the
Interior direct the Director of the Office of Insular Affairs to make
increased use of existing Compact oversight provisions. The Secretary of the
Interior needs to reassess the level of resources being directed to this
area and ensure that appropriate agency resources be used to monitor Compact
assistance. In particular, the Department of the Interior should review
annual independent audits as well as the annual reports prepared by the FSM
and the RMI in order to identify, for example, questioned costs, management
weaknesses, or spending that does not support development goals. The
Director should ensure that required annual meetings are held with both
countries and include the participation of other U.S. agencies, as
appropriate, in order to resolve the issues identified previously.

Further, in the event Interior retains the responsibility for providing and
monitoring any additional Compact assistance as a result of the current
negotiations, in order to strengthen accountability over expenditures, we
recommend that the Secretary of the Interior direct the Director of the
Office of Insular Affairs to implement a system to centrally monitor program
assistance. Further, the Secretary of the Interior should report annually to
Congress on Compact and program expenditures and how they are specifically
advancing economic progress in the FSM and the RMI, as well as on compliance
with oversight responsibilities for all three countries. The Secretary of
the Interior should also ensure that appropriate resources, including the
number and skills of staff, are dedicated to monitoring U.S. assistance to
both nations.

We received comments on this report from the Departments of State and the
Interior as well as from the governments of the Federated States of
Micronesia and the Republic of the Marshall Islands. The Department of State
agreed with three of our recommendations. It agreed that the Department
should consult with Congress to determine U.S. policy objectives for future
Compact assistance; the level, duration, and composition of U.S. assistance;
and the agency responsible for U.S. oversight. The Department also agreed
with our two recommendations that it negotiate Compact provisions that
establish greater control and effectiveness of, and oversight over, future
U.S. assistance. While the Department of State agreed with us that any
future Compact provisions should allow for the withholding of funds, the
Department reserved judgment on our recommendation that any future funding
exclude a "full faith and credit" provision until the Department better
understands the ramifications of this action on budget procedures. The
Department of the Interior did not respond to our recommendations.

Neither the Department of State nor the Department of the Interior disagreed
with our conclusion that Compact expenditures have led to little economic
development. Both departments noted that the circumstances of both countries
merit further discussion in our report. Both departments stressed that it is
important to acknowledge the challenges faced by Pacific island nations,
such as geographic isolation and a lack of natural resources, in achieving
economic advancement. We further emphasized this point in the report. State
and Interior also stated that our report downplays successes under the
Compact. We added information summarizing Interior and State views that
Compact expenditures to support general government operations were necessary
to build stable governments, and funding to develop public institutions has
been important. State and Interior also emphasized the importance of
investing in infrastructure, including utilities, as being necessary for
further economic development.

The governments of the Federated States of Micronesia and the Republic of
Marshall Islands also expressed some of the views of the Departments of
State and the Interior previously noted regarding development challenges,
the limited recognition of successes under the Compact in our report, and
the importance of infrastructure investment. They further cited their
experience under the Trust Territory Administration, specifically the
failure of the United States to promote economic development during this
period, as a contributing factor to their difficulties in realizing economic
growth under the Compact. In addition, they cited concern over our view that
Compact expenditures have led to little economic development in either
country and provided examples of economic advancement under the Compact. For
example, the Republic of the Marshall Islands government noted the growth of
private business under the Compact, while the Federated States of Micronesia
government reported that the country had experienced respectable economic
growth during the Compact years. We have responded to such comments by
noting that increasing private sector activity is dependent upon government
support and does not reflect sustainable growth, and economic performance
has been limited. We maintain that our assessment of economic development is
accurate. Finally, both countries raised several issues that were outside
the scope of our review. The comments of the Department of the Interior, the
Department of State, the government of the Republic of the Marshall Islands,
and the government of the Federated States of Micronesia appear in full,
along with our specific responses, in appendixes III-VI.

Compact of Free Association Capital Expenditures, Fiscal Years 1987-98

(Continued From Previous Page)

     Dollars in
     thousands
                       Federated States of Micronesia
      Capital         National
   expenditures     government    Chuuk   Kosrae  Pohnpei   Yap   FSM total
 Economic
 development        $37,843      $38,399  $17,205 $51,434 $10,758 $155,639
 Infrastructure
 development        6,426        40,875   21,651  36,106  27,967  133,027
 Social services
 development        2,985        14,863   3,723   6,519   2,154   30,244
 Other              3,218        14,312   2,110   2,031   3,003   24,674
 Totala             $50,472      $108,451 $44,690 $96,090 $43,882 $343,583
 Economic
 development
 Marine resources   $7,061       $17,820  $9,953  $18,317 $6,623  $59,774
 Agriculture &
 forestry           974          7,389    814     1,672   2,499   13,348
 Commerce &
 industry           84           8,159    1,980   269     1,038   11,530
 Tourism            55           379      173     512     212     1,331
 Development loans  22,506       2,303    350     1,749   200     27,108
 Other/unspecified  7,163        2,350    3,935   28,913  186     42,548
 Subtotal a         $37,843      $38,399  $17,205 $51,434 $10,758 $155,639
 Infrastructure
 development
 Energy/power       0            $6,201   $4,780  $12,090 $7,689  $30,761
 Water/sewer        $402         11,443   2,569   2,259   844     17,517
 Air/sea
 transportation     2,923        9,448    998     6,194   6,466   26,030
 Roads/bridges      127          7,199    9,258   13,167  11,819  41,571
 Communications     16           399      99      0       495     1,008
 Government
 infrastructure     2,518        6,185    494     871     133     10,202
 Other              439          0        3,452   1,525   521     5,937
 Subtotala          $6,426       $40,875  $21,651 $36,106 $27,967 $133,027
 Social services
 development
 Health             $178         $1,099   $491    $469    $229    $2,467
 Education          1,933        4,843    1,536   2,033   1,212   11,556
 Manpower training  872          46       994     1,094   235     3,241
 Social/community
 services           2            3,159    51      62      278     3,552
 Housing            0            5,716    651     2,860   200     9,427
 Other              0            0        0       0       0       0
 Subtotala          $2,985       $14,863  $3,723  $6,519  $2,154  $30,244
 Other
 Land lease &
 acquisition        0            $3,095   $1,097  $50     $1,491  $5,732
 Resource
 management         $227         429      176     500     373     1,706
 Other/unspecified  2,991        10,789   837     1,480   1,139   17,236
 Subtotala          $3,218       $14,312  $2,110  $2,031  $3,003  $24,674

(Continued From Previous Page)

    Dollars in thousands
   Republic of the Marshall Islands
    Capital expenditures       Total
 Economic development        $32,518
 Infrastructure development  35,274
 Social services development 7,950
 Other                       64,653
 Totala                      $140,395
 Economic development
 Marine resources            $9,137
 Agriculture & forestry      862
 Commerce & industry         6,864
 Tourism                     3,257
 Development loans           0
 Other/unspecified           12,398
 Subtotala                   $32,518
 Infrastructure development
 Energy/power                $1,429
 Water/sewer                 490
 Air/sea transportation      19,667
 Roads/bridges               809
 Communications              384
 Government infrastructure   11,133
 Other                       1,362
 Subtotala                   $35,274
 Social services development
 Health                      $4,161
 Education                   3,789
 Manpower training           0
 Social/community services   0
 Housing                     0
 Other                       0
 Subtotala                   $7,950
 Other
 Land lease & acquisition    $100
 Resource management         0
 Other/unspecified           64,553
 Subtotala                   $64,653

Note: These figures include only expenditures listed for projects or
recipients in country financial statements. Transfers and capital
expenditures made from bond proceeds are not included.

aNumbers may not sum due to rounding.

Source: GAO analysis of FSM data, compiled by the Joint Committee on Compact
Economic Negotiations, and of RMI financial statements.

Record of Accountability for the Federated States of Micronesia, the
Republic of the Marshall Islands, and the United States

 Time period Submitted by the    Submitted by the   The United States
             FSM                 RMI                concurred
 1987-91     Yes                 Yes                Yesa
 1992-96     Yes                 Yes                No
 1997-01     Yesb                No                 Yes (for the FSM)b

a While the U.S. government officially concurred with the initial
development plans submitted by both countries, the Department of the
Interior was unable to provide us with analyses or reviews of the plans.

b The Federated States of Micronesia (FSM) submitted a 3-year (1999-2001)
planning framework document to the U.S. government. The Department of State
Special Negotiator for the Compact of Free Association informed us on August
22, 2000, that he has accepted this document as the country's third economic
development plan.

Source: GAO analysis of FSM, Republic of the Marshall Islands (RMI), and
U.S. government documents.

                                                                  Annual
                                                               meeting held
           Submitted by the FSM       Submitted by the RMI      between the
                                                                  United
                                                               States and:
 Fiscal Annual   Health/education  Annual    Health/education  The   The
 year   report   report            report    report            FSM   RMI
 1987   Yes      No                No        No                No    No
 1988   Yes      No                No        No                No    No
 1989   Yes      No                Yes       No                No    No
 1990   Yes      No                No        No                No    No
 1991   Yes      No                Yes       No                No    No
 1992   Yes      No                Yes       No                No    No
 1993   Yes      No                No        No                No    No
 1994   Yes      No                Yes       No                Yes   Yes
 1995   Yes      No                Yes       No                Yes   Yes
 1996   Yes      Yes               No        Yes               No    No

 1997   Yes      Yes               Yes       Yes               Yes   Yes
                                   (draft)
 1998   Yes      Yes               No        No                Yes   Yes

 1999   No       Yes               Yes       No                Yes   No
                                   (draft)

Source: GAO analysis of FSM and RMI government documents and U.S. government
documents, and discussions with U.S. government officials.

Comments From the Department of the Interior

The following are GAO's comments on the Department of the Interior's letter
dated September 5, 2000.

1. We have added a paragraph to the report on pp. 40-41 quoting the
Departments of the Interior and State regarding the importance of Compact
funding in building independent nations through supporting government
operations and developing public institutions.

2. Our report does not establish expectations regarding the level of
economic development and self-sufficiency that should have been reached by
the FSM and the RMI during the term of Compact assistance. In chapter 4 of
our report, on p. 50, we have added information reiterating some of the
challenges, such as geographic isolation and limited natural resources,
faced by these two Pacific island nations in realizing economic growth. We
report on the economic performance of the two countries over the term of
Compact assistance. Both countries remain highly dependent on U.S.
assistance to maintain current standards of living that are higher than
could be sustained without U.S. funding. In our report conclusions, we note
that U.S. policy objectives regarding the two countries should be
reassessed.

3. We have added a footnote at the beginning of chapter 3 of our report
(p. 34) reflecting the views of the Department of the Interior regarding
standards of living in the two countries.

4. A reduction in reliance on U.S. funding does not necessarily signal an
increasingly productive economy. For example, in the FSM, the reduction in
reliance on U.S. funding reflects changes in accounting of revenues and
increased local revenues in the form of fishing license fees and import
taxes. Regarding investments in infrastructure, our report notes the
importance of such investment in improving the quality of life and creating
an environment attractive to private business.

5. We have added text on p. 83 of the report noting that Interior expressed
concerns to negotiators over the inability to withhold Compact funds prior
to implementation of the Compact.

6. We have no audit responsibilities set forth in the Compact or its
implementing legislation. However, We are granted authority to conduct
audits regarding Compact assistance in the FSM and the RMI. As noted in our
report, required annual audits have been conducted each year in the FSM and
the RMI by a private accounting firm. The Department of the Interior pays
for these audits.

Comments From the Department of State

The following are GAO's comments on the Department of State's letter dated
August 18, 2000.

1. In chapter 4 of our report, on p. 50, we have added information
reiterating some of the challenges, such as geographic isolation and limited
natural resources, faced by these two Pacific island nations in realizing
economic growth.

2. We do not state or imply in our report that the living standards in the
FSM and the RMI are "high." Rather, we note that living standards in both
countries are artificially higher than could be achieved in the absence of
Compact funding.

3. We have added a paragraph in chapter 4 on pp. 40-41 quoting the
Departments of State and the Interior regarding the importance of Compact
funding in building independent nations through supporting government
operations and developing public institutions. Our report notes improvements
in energy, communications, transportation, and education and acknowledges
that investments in infrastructure have led to improved quality of life and
are necessary to create an environment attractive to private business.

Comments From the Republic of the Marshall Islands

The following are GAO's comments on the letter from the government of the
Republic of the Marshall Islands dated August 30, 2000.

1. Compact assistance to the RMI and the FSM is not provided through the
budgets of the Department of State or the Agency for International
Development. Compact assistance is provided through the Department of the
Interior--the agency that has been responsible for providing funding to the
region since before the RMI and the FSM became sovereign nations. Our past
analysis of the U.S. government budget has found numerous examples of
foreign affairs spending not contained in the budgets of the Department of
State or the Agency for International Development. Our May 2000 report
included funding associated with U.S. nuclear testing in the region. We
agree that such funding does not constitute foreign assistance. This report,
however, emphasizes direct Compact payments intended to further economic
advancement. Such assistance to sovereign nations would commonly be viewed
as foreign assistance. We note in our report in footnote 8 of chapter 1, the
RMI's objection to the use of this term, but we maintain that it is an
accurate characterization of U.S. Compact assistance to the RMI and the FSM.

2. Our review concerns the Compact as agreed to between the three sovereign
nations and does not consider any hypothetical alternative arrangements. At
the request of Congress, we have recently initiated a review of U.S.
programs extended to the FSM and the RMI. Programs that are extended include
weather service, childhood programs, grants for college students, and health
grants.

3. The dependence of the private sector on Compact expenditures demonstrates
the lack of a viable economy. Irrespective of the growth in the number of
businesses operating, the Asian Development Bank has reported that the
overwhelming reliance on U.S. assistance has damaged the RMI's ability to
develop income-generating activities.53 The existing economy could not be
sustained in the absence of further Compact assistance.

4. We have added text on p. 41 of our report noting recognition by the U.S.
embassy in the RMI that reforms, including government personnel reduction,
appear to be back on track under the new administration that took office in
January 2000.

5. We have modified our language in this section of the report to state that
targeted Compact funds spent on physical and social infrastructure have not
contributed to significant economic growth. We state that RMI investment in
infrastructure has not led to "significant" economic growth, rather than our
prior statement that investment in infrastructure did not directly
contribute to economic growth.

6. We have deleted our statement that the dry dock is inoperable based on
the comments of the RMI government as well as a statement from a private
businessman in the RMI. We are uncertain as to the dry dock's actual status,
as a senior RMI government official continues to maintain that the dry dock
is inoperable.

7. We did not conduct a comprehensive assessment of government subsidies to
public enterprises. In 1998, financial statements were not available for
various public enterprises such as the Marshall Islands Drydock Inc., and
the Marshall Islands Port Authority. Such information is necessary in order
to calculate total RMI subsidization to public enterprises. We do note,
however, that because of scheduled step-downs in Compact funding and
required payments of bond debt, the RMI government lacks sufficient Compact
funds to subsidize public enterprises at past levels.

8. The RMI government was given 45 days to review and comment on our draft
report, per the terms of a Compact-related agreement.

Comments From the Federated States of Micronesia

The following are GAO's comments on the letter from the government of the
Federated States of Micronesia dated September 1, 2000.

1. Our report states that U.S. interests have been met in two key areas:
(1) securing self-government for the FSM and the RMI and (2) assuring
certain national security rights. However, with respect to the Compact goal
of advancing economic growth in both countries, we have concluded that
Compact funds have been spent in a manner that has not furthered such
progress. Many FSM officials agreed with this conclusion. Further, a Bank of
Hawaii assessment found that there has "been very little change in the FSM's
basic economic structure since the Compact went into effect."54 As a result,
we are recommending that if future Compact assistance is provided, it should
in fact be more tightly controlled, with a greater emphasis placed on
accountability. Of note, two FSM state governors and a former FSM president
told us that future U.S. assistance should be more tightly controlled.

2. For the sake of consistency and fairness, we evaluated both countries
using criteria, such as progress toward economic self-sufficiency, listed in
the Compact. As a result, our discussions of the FSM and the RMI are often
integrated. However, we clearly distinguish between the two countries in our
discussion of specific expenditure and project data.

3. Our review assessed actual progress made by both countries in furthering
economic self-sufficiency and development as a result of Compact
expenditures. Our review did not establish or imply levels of economic
growth that should have been achieved, nor did it suggest the degree to
which economic self-sufficiency was attainable within the
15-year term of Compact assistance.

4. As cited in our report, we conducted a review in 1983 regarding
Micronesian self-sufficiency.55 This review found that both countries lacked
sufficient managerial and technical expertise and management systems to
overcome significant obstacles to growth. This finding may in part explain
the performance of both nations under the current Compact. The impact of
U.S. Trust Territory Administration on both countries, whether negative or
positive, was not part of our current review.

5. Our analysis began with the first year of the Compact, fiscal year
1987--a logical point to begin assessing economic progress under the
Compact. This approach is consistent with that used by the FSM government in
its response to our report.

6. In order to identify the principal economic goals of Compact assistance,
we relied upon the Compact itself. These goals of promoting economic
advancement and self-sufficiency in the region, as stated in the Compact,
were reiterated by officials from the Departments of the Interior and State.
The objectives of maintaining social peace and political stability are not
contained in the Compact.

7. In chapter 4 of our report, on p. 50, we have added information
reiterating some of the challenges, such as geographic isolation and limited
natural resources, faced by these two Pacific island nations in realizing
economic growth. Our review focused on identifying the current state of
economic self-sufficiency and development resulting from Compact
expenditures and was not intended to encompass a comprehensive comparative
analysis regarding Pacific islands or other nations. Such analyses are
available from the Asian Development Bank.

8. We report on the growth of the FSM economy between 1987 and 1997/98, from
a gross domestic product (GDP) of $130.3 million to
$213 million. However, as the FSM government noted on page 7 of its
comments, economic growth has barely been sufficient to overcome the effects
of population growth and decreased U.S. assistance. Real per capita GDP
reached a peak in 1993 of $2,261 and has since fallen to $1,927 in 1999.

9. While the private sector and private sector employment have grown overall
during the entire Compact period, this growth was realized only during the
early years of the Compact. According to the March 2000 FSM Planning
Framework document (hereafter referred to as the "Framework" in our
comments),56 real private sector GDP has fallen since 1993, and private
sector employment has decreased from its 1994 peak.

10. The question regarding the length of time required to achieve economic
self-sufficiency was outside the scope of our review.

11. While our report does not address the issue of the amount of time needed
for the FSM to achieve economic self-sufficiency, we note that the FSM
government has not provided an analysis that its current level of government
services is appropriate or sustainable. An Asian Development Bank assessment
found that the FSM's public service is both large and unproductive and has
in part played a welfare function. As a result, this hypothetical projection
aimed at maintaining government services on a constant per capita basis may
not be appropriate.

12. The FSM has cut public sector employment and wage levels in recent
years. However, inconsistent data make a precise analysis of public and
private sector wages difficult. For example, the FSM Framework document
notes that public sector wages are 82 percent higher than private sector
wages (1996-97). FSM Social Security Administration data, as reported in a
Bank of Hawaii report,57 show that public sector wages are 147 percent
higher than private sector wages (1996-97). Similar average data
inconsistencies also exist regarding the size of public employment. The FSM
Framework reports 5,862 public sector employees in 1997, while the FSM
Social Security Administration data show 9,917.

13. While the FSM has substantially improved its self-sufficiency, with
dependence on U.S. funding as a percentage of total FSM government revenue
falling from 83 percent to 54 percent, this situation cannot all be
attributed to economic growth resulting from the use of Compact funds.
Social Security Administration revenues were not included in the FSM
government financial statements until 1991. As a result, since 1991, local
revenue shows growth due to this change in how government revenues are
reported. In addition, in 1998 fishing license fees constituted the largest
single source of local revenue in the FSM (except for Social Security
revenues). While such fees represent an important means for raising local
revenue, they do not represent local productivity. Finally, reductions in
Compact assistance have by definition increased FSM self-sufficiency.

14. According to the FSM Framework document, "The extensive and expensive
traveling done by public servants must be reigned-in [sic]…" Further,
a former President of the FSM told us that travel was not undertaken on the
basis of government need.

15. We have added text to our report on pp. 10, 34, and 50 that notes that
standards of living are higher than could be achieved in the absence of
Compact funding. The Asian Development Bank report referred to in this
comment was not the basis for our conclusion that Compact funding has
maintained artificially higher standards of living in the FSM and the RMI.
Rather, this conclusion was drawn independently following our assessment of
the continued dependency of both countries on U.S. assistance. In our view,
it is clear that current living standards are far higher than can be
sustained through local resources, given that both countries rely on the
United States for at least half of total government revenues.

16. We agree with the comment that the decline in dependency in the FSM on
U.S. funding equates to substantial progress toward enhanced
self-reliance--as long as U.S. assistance is not being replaced with other
external donor assistance.

17. Officials in all four FSM states told us that fisheries ventures had
failed due to inexperience and poor judgment. For example, we were told by a
government official in Pohnpei that FSM officials were novices in their
knowledge of fisheries, and a Kosraean official told us that fishing
ventures failed due to a lack of knowledge and foreign partners who took
advantage of FSM investments.

18. We agree with this comment. One of our recommendations is to expand
annual reporting requirements.

19. In addition to financial management weaknesses identified by Deloitte
Touche Tohmatsu, the Public Auditor for the FSM has found numerous instances
of inadequate financial and program controls. Based on these two sources, we
believe that there has been a general lack of control over the use of funds.

20. In providing comments on a GAO report published in May 2000 identifying
the amount of assistance provided to the FSM and the RMI from various U.S.
agencies,58 the FSM government did not dispute the FSM population figure of
131,500. Therefore, we were comfortable using this estimate in our draft
report. However, we have changed the report to reflect the lower population
estimate. This change does not affect our message in any way.

21. We have recomputed the U.S. assistance per capita figure based on a
revised population estimate for 1998 of 111,536. This figure is now
$895. We added footnote 4 in chapter 3 to our report that identifies our
data sources for our discussion of U.S. assistance per capita and FSM gross
domestic product.

22. A review of the success of the public sector reforms currently underway
was outside the scope of our work. Our report does note that the FSM is a
member of international organizations such as the United Nations and that
infrastructure in the areas of electricity and communications has improved.
In addition, we added a paragraph to the report quoting the Departments of
the Interior and State regarding the importance of Compact funding in
building independent nations through supporting government operations and
developing public institutions.

23. In the FSM Framework document, "large public sector employment
opportunities and higher relative wages" are listed as one of the "specific
factors limiting private sector growth." This characterization is in line
with the statement in our report that "[S]ubstantial Compact funds were used
to support general government operations that have, among other things,
maintained high levels of public sector employment and wages and have acted
as a disincentive to private sector growth."

24. The "unattributed quote from someone saying that in the FSM the reform
program `seems to have lost its way'" is from an Asian Development Bank
evaluation of its reform programs in the region,59 and is properly footnoted
in the paragraph.

25. Our report now states that investment in infrastructure, which has
improved the quality of life in the FSM and the RMI and is necessary to
create an environment attractive to private business, has not contributed to
"significant" economic growth to date, rather than our prior statement that
investment in infrastructure did not directly contribute to economic growth.
For example, the FSM government points out in its comments that growth in
the tourism industry during the last 13 years would not have been possible
without improvements in infrastructure. While we agree that improved
infrastructure may have benefited the tourism industry, we dispute that this
improvement represents significant economic growth. Over the past 13 years,
tourism has grown to represent only 2 percent of the FSM economy. The FSM
Framework document notes that the annual number of visitors to the FSM has
decreased during the 1990s and points out that "…average hotel
occupancy rates in FSM are low--less than 30 percent in 1996…"

26. As the FSM states that it needs additional funding for infrastructure,
we note that the current level of existing infrastructure in the FSM is not
sustainable without additional external donor assistance. For example, an
official from the Pohnpei Utilities Corporation told us that 80 percent of
the utility's revenues come directly from the government or government
employees, and thus the Pohnpei Utilities Corporation is very dependent upon
Compact funding. Further, an official from the FSM telecommunications
company told us that without Compact payments, consumer demand would
collapse and the company could not repay its outstanding loans to the U.S.
government.

27. As noted previously, we have changed the FSM population estimate for
1999 from 131,500 to 116,268 to reflect the estimate provided to us by the
FSM government in its comments. This does not, however, change our reported
estimate of per capita income growth in the FSM. According to the FSM
Framework document, real GDP per capita in fiscal year 1987 was $1,881. In
fiscal year 1999 it had grown to
$1,927. This represents a growth in real GDP per capita of 2.4 percent over
a 12-year period. All figures reflect 1998 U.S. dollars.

28. We agree that there are numerous businesses in operation in the FSM.
However, according to a Bank of Hawaii report,60 "U.S. funds are the only
primary income source" in the FSM economy. The report further states that
"[T]hese funds are used mainly to pay government wages, salaries and
benefits, and a portion goes towards adding to public
infrastructure…" The report concludes that "[T]hus, the economy's
engine is the public sector which, in turn, supports a private sector that
is made up largely of services and distribution activities. There is very
little indigenous commercial production economy other than subsistence
production that has stagnated in the last 10 years."

29. Improvements in economic management and a shift in policy direction that
emphasizes private sector growth with the government's role being to improve
the business environment and provide necessary infrastructure and social
services are in an early stage. According to the FSM Framework document in
its discussion of future actions for accelerating private sector
development, "The initiatives embarked upon within the FSM to restrain
government employment and wages, improve training, reform public
enterprises, encourage foreign investment, liberalize banking regulations,
improve leaseholds, and improve business support indicate that progress is
being made. But there is still a long way to go to have these initiatives
fully developed, refined, publicly understood and accepted, passed into law,
and implemented effectively." The government faces significant challenges in
implementing reforms that will foster private sector development. For
example, regarding reforming public enterprises, the Framework points out
that "[N]o complete inventory of public enterprises is currently available."

30. We changed the title of this section to reflect the FSM government's
comment.

31. During our visit to the FSM, no government fish storage and processing
facilities were in operation in any of the four states. For example, in
Pohnpei, officials from the Pohnpei Fisheries Corporation told us that the
plant had completely shut down as of October 1999, and the refrigeration
system was inoperable, awaiting parts, at the time of our visit. In Kosrae,
we were told that the cold storage facility had been closed since January
2000. In addition, officials in Yap and Chuuk told us that the facilities in
those states had never been profitable or had not been profitable for years.

32. We have modified our discussion of the pepper industry to reflect FSM
government comments. We have also eliminated our statement that there is no
longer a pepper industry in the FSM. It is our understanding, based on a
discussion with an official from the Pohnpei Office of Agriculture and
Forestry, that there is currently one Japanese pepper farmer in Pohnpei with
10 acres. According to data published in the 1999 FSM Statistical Yearbook
(the most recent data available), black pepper exports in 1996 and 1997 were
$0. The Yearbook also shows no purchases of black pepper in major local
markets in 1998.

33. In data provided to us by the FSM government detailing Compact capital
fund expenditures, we were unable to find any Compact funds that went to the
garment factory in Yap. Regarding the Pohnpei garment factory, we were told
by the Governor of Pohnpei that the facility received a development bank
loan (U.S. funds) and had employed foreign workers, but did not receive any
direct government assistance. The development loan to the company was almost
$1.8 million. A Department of State official informed us that the facility
is now closed. The Kosrae slipway is operating but does so at a loss.
Kosrae's investment in the ship repair facility is almost $1.5 million.

34. In choosing capital projects for our review, we used the following
criteria: (1) the largest areas of investment by the governments,
(2) project expenditures covering a wide range of sectors, and
(3) project expenditures made at different points in the Compact. Regarding
the projects listed in the FSM government comment letter as examples of
well-planned and implemented Compact-funded projects, we questioned FSM
officials as to the data sources for these projects and were told that this
information is incorrect. The FSM Capitol and the College of Micronesia were
not funded using Compact funds but were instead built using funds provided
outside of the Compact.

35. At every government location (national and state), we requested access
to complete project documentation for all projects we reviewed and mentioned
specifically that we were interested in reviewing documents such as
feasibility studies, competitive bids, and inspection reports. We believe
that the burden was on government officials to provide us with access to all
relevant documentation. Officials from the state of Kosrae mailed us
documentation after we had returned to the United States.

36. The Governor of Kosrae told us that the chip-seal roads in the state
were an example of a project that was not properly designed or built.
Further, an official from the Kosrae Department of Public Works informed us
that the chip-seal roads lasted only 4 years but with patches were usable
for 10 years. He also noted that chip-seal paving is a high-maintenance type
of pavement and Kosrae did not budget for maintenance.

37. We reviewed the road and dock project because it was identified by Chuuk
State officials as an example of a questionable use of Compact funds that
would not upgrade basic social and economic infrastructure. After visiting
the site, we concluded that the Mayor would be the chief beneficiary of the
dock and road since there were few other houses between the Mayor's house
and the seaside village at the end of the road.

38. The U.S. embassy in the FSM, the FSM Public Auditor, and we all
independently concluded that the "boats for votes" had no demonstrable
economic impact or accountability. The U.S. embassy, in numerous cables,
reported that the boats were given away to support reelection efforts. The
FSM Public Auditor concluded that the boats were given away with no
requirement or evidence that they were used for economic advancement. When
we spoke with the recipients of these boats, they told us that the mayor
simply gave them the boats. There is no requirement that they demonstrate
how the boats would be used for economic advancement and no reporting
requirements.

39. Our report notes that the FSM, the RMI, and the U.S. governments all had
a role to play in ensuring that 5-year economic development plans were
sufficient. We noted that while the plans had deficiencies, it was the
responsibility of the U.S. government to discuss and correct these
deficiencies with the FSM and the RMI. The U.S. Department of State's
Special Negotiator for the Compact of Free Association informed us that the
FSM Planning Framework for 1999-2001 has been accepted by the U.S.
government as the FSM's third economic development plan, thus allowing the
FSM to meet its Compact obligations in this area.

GAO Contact and Staff Acknowledgments

Emil Friberg, Jr., (202) 512-8990

In addition to the person named above, Leslie Holen, Dennis Richards, and
Edward George, Jr. made key contributions to this report.

(711470)

Table 1: Compact Section 211(a) Annual and Total Funding
Levels for the Federated States of Micronesia and the
Republic of the Marshall Islands, Fiscal Years 1987-2001 19

Table 2: Compact Revenue-backed Bonds Issued by the
Federated States of Micronesia and the Republic of the
Marshall Islands, Fiscal Years 1987-98 31

Table 3: Five-Year Economic Development Plans 95

Table 4: Annual Reports and Meetings 95

Figure 1: Location and Map of the Federated States of
Micronesia and the Republic of the Marshall Islands 15

Figure 2: FSM and RMI Compact Expenditures by Fund Type as a Percentage of
Total Compact Expenditures, Fiscal
Years 1987-98 27

Figure 3: FSM and RMI Compact Capital Account Expenditures,
Fiscal Years 1987-98 29

Figure 4: RMI Debt Service as a Percentage of Annual Compact Expenditures,
Fiscal Years 1987-98 33

Figure 5: FSM Dependence on U.S. Assistance, Fiscal Years 1987-98 35

Figure 6: RMI Dependence on U.S. Assistance, Fiscal Years 1987-98 37

Figure 7: Compact Investment in Communications 43

Figure 8: Compact Investment in Energy 44

Figure 9: Electric Power and Tuna Processing Plant, Majuro, RMI 45

Figure 10: Investment in Interisland Cargo Transportation, FSM 46

Figure 11: Investment in Air Transportation, RMI 47

Figure 12: FSM Investment in College Facilities 48

Figure 13: FSM Fish Processing and Cold Storage Facilities 53

Figure 14: Pohnpei Pepper Industry Development, FSM 54

Figure 15: RMI Investment in Garment Factory 55

Figure 16: Causeway From Ebeye to Gugeegue, Kwajalein Atoll,
RMI 58

Figure 17: Ponape Coconut Products, Inc., FSM 59

Figure 18: Kosrae Road Pavement, FSM 61

Figure 19: RMI National Capitol Building, Majuro 63

Figure 20: Ohmine Elementary School, Pohnpei, FSM 64

Figure 21: Pohnpei State Hospital, FSM 66

Figure 22: Old and New Ebeye Hospitals Suffer From Corrosion,
RMI 68

Figure 23: Udot Dock Project and Junior High School, Chuuk, FSM 70

Figure 24: Fanapanges Ice Plant: Planned and Actual Locations,
Chuuk, FSM 72

Figure 25: "Boats for Votes," Chuuk, FSM 73
  

1. The negotiating delegation for the U.S. government is led by the Special
Negotiator for the Compact of Free Association, a Department of State
official.

2. See Foreign Relations: Better Accountability Needed Over U.S. Assistance
to Micronesia and the Marshall Islands (GAO/RCED-00-67 , May 31, 2000).

3. For GAO's assessment of economic self-sufficiency, GAO used total U.S.
funds, which consist of all direct payments under the Compact as well as
U.S. program assistance.

4. The FSM 1999 population estimate is based on the figure provided to GAO
in the FSM government's comments on our draft report. The RMI figure is from
the 1999 RMI population census. These figures differ from those used in
Foreign Relations: Better Accountability Needed Over U.S. Assistance to
Micronesia and the Marshall Islands (GAO/RCED-00-67, May 31, 2000).

5. For a history of U.S. assistance, see David Hanlon, Remaking Micronesia:
Discourses Over Development in a Pacific Territory, 1944-1982 (Honolulu,
Hawaii: University of Hawaii Press, 1998).

6. See The Challenge of Enhancing Micronesian Self-Sufficiency (GAO/ID-83-1,
Jan. 25, 1983).

7. Francis X. Hezel, S. J., "A Brief Economic History of Micronesia," in
Past Achievements and Future Possibilities: A Conference on Economic
Development in Micronesia (Conference held in Kolonia, Ponape, May 22-25,
1984; published by The Micronesian Seminar, Majuro, RMI, July 1984).

8. The Compact makes available the services and related programs of the U.S.
Weather Service, the U.S. Federal Emergency Management Agency, the U.S.
Federal Aviation Administration, the U.S. Civil Aeronautics Board or its
successor agencies, and provided pursuant to the 1970 Postal Reorganization
Act.

9. Such services and programs include Head Start, Pell Grants, and
immunization grants.

10. See Foreign Relations: Better Accountability Needed Over U.S. Assistance
to Micronesia and the Marshall Islands.

11. In the title of this report, we refer to Compact economic assistance as
"foreign assistance" in recognition that the FSM and the RMI are foreign
nations. Compact funds do not, however, come from the foreign operations
appropriations act, which includes the budgets of the Department of State
and the Agency for International Development. Instead, Compact funds are
provided as a domestic spending program administered by the Department of
the Interior. The RMI believes that designating Compact funds as "foreign
assistance" is both confusing and misleading.

12. Single Audit Act of 1984, P.L. 98-502, and the Single Audit Act
Amendments of 1996,
P.L. 104-156. The single audit is meant to advise officials whether
financial statements are fairly presented and to provide reasonable
assurance that federal financial assistance programs are managed in
accordance with applicable laws and regulations. The audit must be conducted
by an independent auditor on an annual basis, except under specific
circumstances. Single audit reports contain meaningful information on
entities' financial status and management of federal funds and can indicate
where entities have additional problems that need further audit or
investigation.

13. Funding for 2002-03 is at a higher level than what the countries
currently receive, per the terms of the Compact. For example, the Department
of the Interior estimates that for fiscal years 2002-03, the FSM would
receive $50.3 million annually and the RMI would receive $22.4 million
annually under section 211(a). This base section 211(a) funding, as well as
other Compact assistance, would be further increased to account for
inflation.

14. To the extent that assistance from other nations can be used as a
substitute for U.S. assistance, dependence on all external donor assistance
(which we did not measure) in the FSM and the RMI is unchanged. We were
unable to address the size or importance of assistance from other nations as
this information is not fully identified in the financial statements of
either country.

15. When Compact expenditures are converted to constant 1999 fiscal year
dollars (using the U.S. gross domestic product [GDP] deflator), the FSM
spent about $1.2 billion, while the RMI spent about $585 million. This
report uses current dollars throughout.

16. Figure 2 shows how all funds--general fund, special revenue fund,
capital fund, and expendable trust fund--were used. The graphic does not
address the 40-percent capital spending requirement, which is computed based
on the allocation of section 211(a) funding between the capital and general
funds.

17. The Attorney General of Kosrae provided a legal opinion to the Governor
of Kosrae stating that sending athletes to the games served to promote
tourism, a permitted use of Compact capital funds for an economic
development project. The FSM Department of Justice concluded it was a
qualified manpower training and development project.

18. We were able to identify specific capital fund expenditures for 6 years
(fiscal years 1987-91, 1993) in Kwajalein Atoll Development Authority
financial statements that totaled over
$34 million. In those years, projects that received large amounts of
Kwajalein Atoll Development Authority capital funds included the Kwajalein
(Ebeye) power plant and generators (over $5 million), dock construction
(over $9 million), and road paving (over
$2 million).

19. According to data provided by the Department of the Interior, in fiscal
year 1998 the United States provided the RMI with $19.1 million in Compact
section 211(a) payments, an inflation adjustment payment of $11.3 million,
and other non-nuclear compensation payments of
$8.9 million.

20. The legislation enacting the Compact recognizes that there is a lease
agreement between the government of the RMI and Kwajalein landowners. The
United States provides funding to the RMI, which is then used to compensate
landowners, per the lease agreement, for the land used by the U.S. military
on Kwajalein Atoll. These payments go to approximately
80 RMI landowners. According to an official at the U.S. embassy in the RMI,
use of these funds, which are distributed based on acreage owned by each
landowner, is at the discretion of each landowner. The official reported
that four landowners receive one-third of the annual payment based on
acreage owned, with one landowner receiving half of this amount.

21. The Kwajalein Atoll Development Authority issued bonds on its own. In a
1989 discussion of gaining access early to Compact funds, the Authority's
Board of Directors was briefed by the Kwajalein Atoll Development
Authority's former Comptroller that for every $1 million borrowed via a bond
issue, the Kwajalein Atoll Development Authority would be forfeiting $1
million in future projects. Ultimately, the Kwajalein Atoll Development
Authority issued Compact revenue-backed bonds of $22 million in 1991.

22. According to a Department of the Interior official, these higher
standards of living were created by policies of the United States Trust
Territory. The official went on to note that the idea of establishing
stable, newly independent nations concurrently with a gross decline in "high
standards of living" is politically inconceivable.

23. Total U.S. program assistance outside of the Compact for fiscal years
1987-98 for both countries was $368 million. This was about 19 percent of
total U.S. funding provided to both nations, with the remaining 81 percent
of U.S. funding provided as direct Compact payments.

24. These data understate the value of U.S. government contributions to the
governments of the Compact nations. U.S. government services provided
in-kind, such as weather service, disaster relief, development loans, and
national defense, do not appear as revenue in the FSM and the RMI government
financial accounts.

25. U.S. assistance per capita was calculated using a FSM Statistical
Yearbook population estimate for 1998 of 111,536. We used an International
Monetary Fund estimate of FSM gross domestic product of $213 million for
fiscal year 1998. The FSM reports that its gross domestic product in 1998
was $227 million.

26. In both countries, changes in how Social Security revenues are
incorporated into the government's budget have affected reported government
revenue. In the FSM, Social Security Administration revenues have been
included in the FSM financial statements since 1991. In that year, these
revenues were almost $5 million. In the RMI, Social Security System revenues
have been excluded from the RMI financial statements since 1996. RMI Social
Security System revenues in 1995, the last year they were reported, were
more than
$13 million, or 13 percent of total revenue in that year.

27. See Marshall Islands: 1996 Economic Report (Manila, Philippines: Asian
Development Bank, June 1997).

28. According to an official at the U.S. embassy in the RMI, other factors
are more important than public sector wages in restricting private sector
growth. These include a remote location, a lack of land registration and
liens, limited comparative advantages, and small economies of scale.

29. Federated States of Micronesia, The FSM Planning Framework, 1999-2001
(Pohnpei, FSM: March 17, 2000) (draft).

30. Bruce Knapman and Cedric Saldanha, Reforms in the Pacific: An Assessment
of the Asian Development Bank's Assistance for Reform Programs in the
Pacific (Manila, Philippines: Asian Development Bank, 1999).

31. The $114 million figure represents FSM and RMI expenditures of general
health and education funding provided under section 221(b) of the Compact.
Through additional Compact provisions, sections 216(a)(2) and 216(a)(3), the
countries spent an additional $56.6 million for purposes such as medical
referrals and scholarships.

32. The figures stated for Compact expenditures in energy and communications
include funds used from the capital account and funds earmarked for use in
these areas in the Compact. Additional expenditures were possibly made in
these areas out of the FSM and RMI general funds, which include some Compact
assistance. We cannot specifically identify the amount of Compact
expenditures from this fund in any area because Compact funding is
commingled with local revenues in the FSM and RMI general funds.

33. The tuna processing venture also was granted certain tax breaks for 10
years and the right to pay less than the RMI minimum wage. In addition, the
RMI government deposited
$2 million in a private bank as a guarantee for a bank loan for the company.

34. The 1999 RMI statistic is from the 1999 Census of Population and Housing
for the Republic of the Marshall Islands. This census reflects a
considerable revision from the population estimates that were most recently
available. For example, the Central Intelligence Agency's World Factbook
1999 reported a 1999 RMI population of 65,507. According to the RMI Director
of Planning and Statistics, the lower population found in the census
reflects migration to the United States since 1996, when job opportunities
in the RMI's private and public sector declined.

35. This estimate is reported in Knapman and Saldanha, Reforms in the
Pacific. If the revised population data for 1999 are used and the inflation
adjusted per capita income is recomputed, we estimate that the decrease in
per capita income has been 27-29 percent since 1990.

36. A Different Kind of Voyage: Development and Dependence in the Pacific
Islands (Manila, Philippines: Asian Development Bank, Feb. 1998).

37. This finding was reported in a U.S. Department of the Interior, Office
of Inspector General, Audit Report: Marshall Islands Development Bank,
Republic of the Marshall Islands (Report No. 99-I-952; Sept. 1999) and was
confirmed during our interview with a bank official.

38. On June 26, 2000, the RMI, along with 34 other offshore financial
centers, was listed by the Organization for Economic Cooperation and
Development (an organization with 29 member countries that conducts analyses
of economic and social policy issues), as a "harmful" tax haven. RMI
officials told us that they have initiated steps to meet the organization's
objections.

39. The RMI has undertaken other efforts to leverage its sovereignty to
raise revenue. For example, the RMI has had coin and stamp sales programs.
Further, over a recent 5-year period, the government reported passport sales
revenue of about $10 million.

40. While we were able to identify $60 million in FSM expenditures in
fisheries from the FSM national and state financial statements, officials in
that country told us on more than one occasion that losses were more than
$100 million.

41. Analysis of the National Fisheries Corporation and its Subsidiaries
(W.H.G. Burslem, May 1999) (draft). The study explains that the National
Fisheries Corporation, an entity created to promote the development of the
fisheries industry in the FSM, is a public corporation with five current
subsidiaries incorporated under normal FSM company law: Yap Fresh Tuna,
Chuuk Fresh Tuna, Kosrae Sea Ventures, the Micronesia Longline Fishing
Company in Pohnpei, and the Yap Fishing Corporation (which is in
receivership). The National Fisheries Corporation no longer has an interest
in Pohnpei state's Caroline Fisheries Corporation. All ventures are involved
in longline tuna fishing for the fresh tuna markets.

42. Concerns over project control documents were raised by the FSM Office of
the Public Auditor in its Report on the Audit of Compact CIP [Capital
Improvement Project] Funds, Fiscal Years 1992-1996. This report noted that
project control documents were " … too brief to be relied upon to
make informed decisions. In essence, the documents state that the project
objective is to receive funds, while the expected benefit is to spend
funds."

43. We requested and examined files for the period from 1987 to the present.
In some cases, files were incomplete or had not been retained. In the RMI,
the General Manager for the Marshall Islands Development Authority said that
some files had been lost between office moves. At the Kwajalein Atoll
Development Authority, we were told that its policy was to retain files for
a 3-year period.

44. In the RMI, a similar investment mistake took place. According to
officials of the Kwajalein Atoll Development Authority, they had undertaken
an Asian Development Bank fisheries project and bought boats that were too
small.

45. We also observed problems with roof leaks in the FSM. We observed
similar roof leaks in a Kosrae courthouse, completed in 1998, using $560,000
in Compact funding. In both courtrooms, leaks were apparent along the wall
that contained a roofing connection.

46. We were unable to determine the portion of this $1.5 million that was
comprised of Compact funding.

47. The annual reports are to be submitted by the first day of the third
quarter of each fiscal year or as soon as practicable thereafter.

48. Typically, a qualified opinion results when an auditor identifies one or
more significant matters that prevent the auditor from issuing an
unqualified ("clean") opinion on an entity's financial statements.

49. Audits of States, Local Governments, and Non-Profit Organizations
(Washington, D.C.: Office of Management and Budget, Circular No. A-133,
Revised June 24, 1997). This Circular was issued pursuant to the Single
Audit Act and sets forth standards for obtaining consistency and uniformity
among federal agencies for the audit of states, local governments, and
non-profit organizations expending federal awards.

50. The Interior staff in the FSM monitors federal program assistance, not
direct Compact funding.

51. There are three to four additional Interior staff in Washington, D.C.,
who work with the Compact nations as needed.

52. Executive Order 12569 issued in 1986 establishes the responsibilities of
the heads of both Departments with respect to the Compact and notes that the
Secretary of State shall conduct the government-to-government relations of
the United States, the FSM, and the RMI, and shall chair the InterAgency
Group, while the Secretary of the Interior shall be responsible for making
economic and financial assistance available to the two countries,
coordinating and monitoring any program or any activity by any department or
agency of the United States provided to the FSM and RMI, and monitoring
economic development planning.

53. Marshall Islands: 1996 Economic Report (Manila, Philippines: Asian
Development Bank, June 1997).

54. Bank of Hawaii, Federated States of Micronesia Economic Report
(Honolulu, Hawaii: July 2000).

55. See The Challenge of Enhancing Micronesian Self-Sufficiency
(GAO/ID-83-1, Jan. 25, 1983).

56. Federated States of Micronesia, The FSM Planning Framework, 1999-2001
(Pohnpei, FSM: March 17, 2000) (draft). The United States and the FSM
recently agreed that the Framework represents the FSM's third economic plan
required under the Compact.

57. Bank of Hawaii, Federated States of Micronesia Economic Report
(Honolulu, Hawaii: July 2000).

58. See Foreign Relations: Better Accountability Needed Over U.S. Assistance
to Micronesia and the Marshall Islands (GAO/RCED-00-67, May 31, 2000).

59. Bruce Knapman and Cedric Saldanha, Reforms in the Pacific: An Assessment
of the Asian Development Bank's Assistance for Reform Programs in the
Pacific (Manila, Philippines: Asian Development Bank, 1999).

60. Bank of Hawaii, Federated States of Micronesia Economic Report
(Honolulu, Hawaii: July 2000).
*** End of document. ***