By Adam Gorajek, Head of the Economics Department at the National Reserve Bank of Tonga (NRBT) during May 2012-May 2014. This article is based on research conducted in the NRBT.

By Adam Gorajek, Head of the Economics Department at the National Reserve Bank of Tonga (NRBT) during May 2012-May 2014. This article is based on research conducted in the NRBT.


Tonga’s recent experience suggests that monetary policy encounters the lower-bound constraint2 more easily than in larger and more developed countries, which limits the effectiveness of monetary policy. What are the current challenges and potential long-term solutions for Tongan monetary policy?


Monetary policy in Tonga has been accommodative over the last few years. Reserves held by commercial banks in excess of required reserves have been increasing since 2009, as reflected in the rise in the Exchange Settlement Account (ESA) balances at the National Reserve Bank of Tonga (NRBT). The rise in ESA balances has been driven by the NRBT’s accumulation of foreign reserves under Tonga’s fixed-exchange-rate regime. Normally, the NRBT would limit the increase in ESA balances, either by issuing short-term securities or raising the reserve requirement. However, given the weak economic outlook in 2009, the NRBT has allowed ESA balances to rise in order to support economic activity through lower interest rates and higher credit growth.

Structural Challenges

Even so, banks’ lending rates have fallen little since early 2010. The level of ESA balances was already high enough in early 2010 to cover even the most extreme levels of banks’ daily cash outflows. This means that the balances, even then, did not actively constrain bank lending and further additions could not motivate banks to lower interest rates. Except for a brief period, the NRBT’s standing facility rate was set at zero percent. The NRBT had already reached the lower bound of monetary policy.

At about 9 percent, the average bank lending rate seems too high to constitute a lower bound. But lending rates in Tonga cannot fall as much as in developed countries because lending is seen to be riskier and banks require compensation in the form of higher interest rates. Several factors contribute to the higher lending risks in Tonga:

  • Tongan law prohibits banks from claiming freehold ownership of a borrower’s property when the borrower defaults. Banks are restricted to leasehold ownership, for a period usually limited to 30 years from the mortgage start date. Mortgage collateral thereby depreciates over time. Banks also have difficulties diversifying assets owing to Tonga’s small and narrow production base. General commercial rates are perceived to be high, with the ONDD, a Belgian public credit insurer, ranking commercial risks in Tonga among the highest, with institutional risks being a contributing factor.

  • Tonga established a collateral registry in November 2011 but the registry data are reportedly questionable. Banks still cannot determine with confidence whether they are lending against genuine collateral. The information in Tonga’s credit bureau is deficient and banks have little access to quality information on credit histories. The World Bank Group’s International Finance Corporation scored Tonga 2 out of 6 for depth of credit information in 2013: the average score among small island states was 4.

  • Resolving insolvencies in Tonga is unusually costly owing to the lack of insolvency-specific laws. The IFC accordingly ranked Tonga at 118 of 189 countries for ease of resolving insolvency.

  • Foreign-owned banks, which account for 85 percent of Tonga’s banking system, need NRBT approval to transfer funds to their head offices. The approvals are constant reminders that if Tonga’s foreign reserves reach low levels again, the banks might be prevented from repatriating lending profits.

Policy Options Going Forward

Further increases in ESA balances would not be helpful. The NRBT could even drain some of the existing balances without lessening the degree of monetary policy stimulus. Draining the balances would also assist Tonga’s financial market development, partly through increasing local familiarity with trading and holding debt securities. It would be critical not to drain balances to the point at which banks become liquidity constrained. The best way to stimulate economic growth now is with longer-term policies aimed at reducing local lending risks. The possibilities include, for example, helping improve the data in Tonga’s collateral registry and credit bureau, supporting the introduction of insolvency laws, and helping enhance Tongans’ personal financial management.



This note reflects the views of the author and does not necessarily represent those of the NRBT or the IMF.


A lower bound constraint is defined as a level of interest rate below which conventional monetary policy ceases to be effective.