Tonga
Recent Economic Developments

This paper reviews economic developments in Tonga during 1990–95. During 1990/91–1991/92, GDP rose by an average of 3.4 percent, fueled by a fourfold increase in squash exports. In 1992/93, GDP growth quickened to 3.7 percent, largely on the basis of a rebound in construction and a rise in domestically oriented manufacturing production—and despite a sharp fall in squash exports. In 1993/94, growth reached 4.7 percent, as squash exports again increased, construction boomed, and commerce accelerated.

Abstract

This paper reviews economic developments in Tonga during 1990–95. During 1990/91–1991/92, GDP rose by an average of 3.4 percent, fueled by a fourfold increase in squash exports. In 1992/93, GDP growth quickened to 3.7 percent, largely on the basis of a rebound in construction and a rise in domestically oriented manufacturing production—and despite a sharp fall in squash exports. In 1993/94, growth reached 4.7 percent, as squash exports again increased, construction boomed, and commerce accelerated.

I. Introduction and Overview

A. Introduction

Tonga is a small island country located northeast of New Zealand, with a population of about 100,000 and a GDP per capita of about US$1,500. In common with other small South Pacific island nations, it faces numerous obstacles to development. Its natural resources are limited, its population dispersed over widely scattered islands, and its location remote, all of which raises production costs and renders most industries uncompetitive. Moreover, while Tonga has a comparative advantage in tourism, the development of this sector has been approached cautiously because of a strong desire to preserve the country’s cultural heritage.

To overcome these obstacles, the country has traditionally relied upon the state. The central government finances myriad retail, manufacturing, and other commercial activities, spending 40 percent of GDP and employing 40 persons per 1,000 population,1 considerably higher than the ratio in other Pacific island developing countries. In addition, there are 13 major nonfinancial public enterprises, including a diversified holding company. Private activities, meanwhile, center around agriculture and fishing, much of a subsistence nature.

This state-led development strategy has been accompanied by cautious macroeconomic management. In general, the authorities have kept the public finances in balance, by maintaining a small surplus in the current budget and tailoring development expenditure to available concessional foreign grants and loans. To provide a cushion against external shocks, they have maintained sizeable foreign exchange reserves, averaging about five months of imports of goods and services2 in recent years. They have also pegged the pa’anga since 1991 to a weighted basket of the currencies of Tonga’s main trading partners.

This approach has enabled Tonga to avoid serious macroeconomic crises. However, it has been less successful in generating growth, which has averaged about 1 1/2 percent per annum over the past decade,3 despite government investment/GDP ratios exceeding 15 percent of GDP. Neither has it enabled the country to overcome its dependence on external transfers. About one third of imports4 is financed by remittances, provided by an estimated 40,000 Tongans who have migrated overseas and by foreign affiliates of local churches.5 A further fifth is financed by official bilateral grants, which also fund nearly all of the development budget. Finally, this approach has not fostered a diverse productive base. Exports have remained concentrated on just a few primary products, rendering the economy vulnerable to exogenous shocks, including large shifts in the terms of trade.

B. Overview

Two severe economic shocks have buffeted Tonga’s economy in recent years. The first one was external: during the 1980s and early 1990s, virtually all of the traditional exports--bananas, melons, and especially copra--declined and eventually disappeared. One reason was the prolonged decline in the international copra price, which rendered this activity unprofitable. Another was the considerable reduction in Australian and New Zealand tariffs, which eroded Tonga’s advantage from its duty-free access to these markets. Finally, the country suffered from disease problems, which led to quarantine restrictions on its agricultural exports.

Meanwhile, the economy was battered by the second macroeconomic shock. This one was self-imposed: in 1989/90,6 the Government departed from its long-standing budgetary principles and simultaneously increased civil servant salaries by 35-50 percent, while increasing development spending by one third, mainly on locally funded projects. Total expenditure rose by 8 percentage points of GDP, only a small portion of which was offset by revenue measures, pushing the previously balanced budget into a deficit of 6 percent of GDP. About half of this deficit was financed by bank borrowing, propelling domestic credit growth to 37 percent.

Consequently, by the early 1990s, Tonga was in a difficult economic situation Real GDP was stagnating; inflation was surging, to 13 percent in 1990/91 from 4 percent in 1988/89; and the trade deficit was widening. Moreover, future prospects looked dim. In response to the decline of traditional products, the Government had adopted a strategy of promoting manufacturing, establishing an industrial park and providing generous tax concessions under the Industrial Development Incentives (IDI) Act. The initial outcome was encouraging, but by the early 1990s, as tax holidays began to expire and tariff preferences continued to erode, production for the domestic market began to level off and exports began to decline.

This situation was saved by three developments. The first was the introduction of squash cultivation. This crop was brought to the country in 1988, by a New Zealand firm, which aimed to supply the Japanese market from early November to early January, between the end of the Japanese growing season and the start of imports from New Zealand, the main established foreign supplier. In the next year, a Tongan entrepreneur established direct contacts with Japanese importers and shipped about 4,000 tonnes. Production proved highly profitable and farmers were quickly able to learn the cultivation and handling standards necessary for export to the demanding Japanese market. As a result, exports grew rapidly if somewhat unevenly, so that by 1993/94 squash amounted to more than 60 percent of merchandise exports and 9 percent of GDP. In that year, the contribution of squash to total output was as large as that made by the entire export sector in 1988/89.

The second development was the decision by the authorities to scale back the size of the public sector and reorient the economy around private enterprise. In line with this policy, since the early 1990s, government commercial activities have been corporatized, export monopolies ended, and virtually all price controls lifted. Most significantly, the Government has brought the public finances back into equilibrium by reducing budgetary expenditure. Since 1989/90, operations and maintenance spending has been severely compressed while the civil service wage scale has been frozen, enabling current expenditure to be reduced by 4 1/2 percentage points to 22 percent of GDP in 1993/94. Spending on locally funded development projects has also been cut, reducing development expenditure to a level consistent with external grants and the current budget surplus. As a result, by 1993/94 the budget balance had swung into a surplus of 1 1/2 percent of GDP--without any increase in the revenue/GDP ratio.

The third development was the introduction of competition into the commercial banking system. Until recently, the country had only one commercial bank, the Bank of Tonga (BOT), which generally maintained a cautious attitude toward expanding its activities. This had the advantage of protecting the country’s foreign exchange reserves, which throughout the past, difficult, decade never fell below 4 1/2 months of imports of goods and services. At the same time, it also led to low levels of financial intermediation, with broad money amounting to only about one quarter of GDP. To remedy this situation, the National Reserve Bank of Tonga (NRBT) licensed two foreign banks to enter the domestic market and challenge the BOT’s monopoly. Competition began in late 1993 and almost immediately financial intermediation improved. The ratio of broad money to GDP increased, as did the share of bank deposits in broad money, while margins between deposit and lending rates declined.

As these three developments took hold, the overall economy began to revive. In 1989/90, real GDP fell by 2 percent, reflecting the continued decline of traditional exports and a reduction in manufacturing output. Subsequently, however, economic activity began to increase. During 1990/91-1991/92, GDP rose by an average of 3.4 percent, fueled by a fourfold increase in squash exports. In 1992/93, GDP growth quickened to 3.7 percent, largely on the basis of a rebound in construction and a rise in domestically oriented manufacturing production--and despite a sharp fall in squash exports. In 1993/94, growth reached 4.7 percent, as squash exports again increased, construction boomed, and commerce accelerated.

Through 1992/93, macroeconomic balances also improved, reflecting the steady reduction in underlying financial pressures. Not only was fiscal equilibrium restored, but as the Government began rebuilding its deposits with the banking system, monetary expansion tapered off. Domestic credit growth even turned negative in 1992/93, as the BOT wrote off a substantial amount of nonperforming private sector debt. As this occurred, the external current account swung into surplus, international reserves swelled to the equivalent of 7 months of imports of goods and services, and inflation receded to 3 percent.

This situation changed in 1993/94. The problem related mainly to the entry of the two new banks: although this promoted a competition to attract deposits, thereby raising financial intermediation, it stimulated an even larger increase in lending to the private sector. At the same time, other bank assets also rose as the NRBT, which was established in 1989, finally constructed its headquarters.7 In all, net domestic assets (NDA) expanded by 20 percent, well above the 11 percent rise in broad money.8 This asset expansion spilled over not into prices, which increased by only 2 1/2 percent, but rather into the balance of payments. The current and capital accounts both shifted into deficit, and reserve coverage shrank to five months of imports from seven months in 1992/93.

These trends accelerated in early 1994/95. By February 1995, NDA growth had reached 41 percent, as banks continued to run down their holdings of NRBT securities in order to lend to the private sector. Meanwhile, just as NDA growth was fueling a sharp rise in imports, squash export receipts plummeted by 40 percent. The bulk of the difficulty lay in marketing as an export quota was enforced legally for the first time, exporters rushed to ship before the limit was reached, causing quality to deteriorate and unit prices to plummet. As a result, the external situation continued to deteriorate, and reserves to fall further, to 4 months of imports in February 1995--the lowest level in over 10 years.

These recent trends highlight an important aspect of Tonga’s economic transformation: although it has resolved most of the pressing problems, it has also exposed a number of others. First, the advent of banking sector competition has revealed a weakness of monetary policy. The NRBT can no longer rely on the BOT to contain credit growth, yet it has difficulty controlling liquidity in a market-oriented manner, owing to operational considerations that constrain its ability to raise interest rates on its securities beyond certain limits. Second, although the export base has expanded, it has still not been diversified; to the contrary, the economy is now dependent on a single, risky, crop. Third, although the public finances have been brought back into balance, most of the expenditure compression has been achieved by reducing operations and maintenance and freezing the salary scales, neither of which can be sustained indefinitely. These key issues will become increasingly important over the course of the following years.

II. Real Sector

A. Sectoral Production

1. Primary sector

The primary sector is critical to the Tongan economy. Not only does it account for about 40 percent of both output and employment, but it has recently been the economy’s engine of growth. During the past five years, from 1989/90 to 1993/94, production has increased by an average of 4.4 percent per annum, well above the overall growth rate, mainly because of the rapid expansion of squash output (Table 1 and Chart 1). In 1992/93, sectoral growth slowed to 2.7 percent, largely because squash export volumes fell sharply. However, in 1993/94 squash production rebounded to record levels, propelling sectoral growth to 7.1 percent.

Table 1.

Tonga: Gross Domestic Product by Sector of Origin at 1984/85 Prices, 1989/90-1993/94

(Percent change)

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Source: Data provided by the Tongan authorities.
CHART 1
CHART 1

TONGA: GROWTH AND INFLATION, 1989/90–1993/94

Citation: IMF Staff Country Reports 1995, 067; 10.5089/9781451837391.002.A001

Sources: Data provided by the Tongan authorities; and staff estimates.1/ Average of inflation in Australia, New Zealand, and the United States.
a. Squash

Squash production dominates the Tongan economy, accounting for 9 percent of GDP and more than 60 percent of merchandise exports. Yet, as recently as 1988, the crop was unknown in the country. In that year, squash was introduced by a New Zealand firm, which hoped to supply the Japanese market during the November-January months, between the end of the Japanese growing season and the beginning of exports from New Zealand. This experiment was highly successful: climate conditions proved favorable and farmers quickly learned the skills necessary to produce a high-quality product.

Most important, the crop has proved extraordinarily profitable. Estimates for 1993 have shown that by planting squash a farmer could earn a profit per acre of nearly T$ 1,800, on average.9 If the farmer’s family provided the labor needed to plant and harvest, then income from the crop could total T$ 2,700 per acre10--one third more than Tonga’s per capita income. Farm earnings are even more impressive when measured against estimated costs of production: in 1993 gross revenue per acre from squash was, on average, nearly twice as high as total production cost and more than three times as high as nonlabor cost. Even during the 1994 squash season, when prices dropped sharply, gross revenue was still more than twice nonlabor cost.

Additional stimulus to squash cultivation has come from the Government, which has provided tax concessions and financing. To increase the rewards from this activity, in 1990/91 earnings from agriculture were made exempt from income tax for five years and export agriculture was made eligible for development incentives. In particular, imported inputs for agriculture and approved capital equipment were made exempt from duty and the port and services tax, leading to a surge in motor vehicle imports. Moreover, to ensure that farmers and growers would be able to obtain financing for this crop from 1989/90 to 1992/93, the Government channeled T$ 5 million from the Export Diversification Fund to the Tonga Development Bank (TDB), for on-lending as working capital.

As a result of these incentives, Tongan entrepreneurs have entered the business and export volumes have increased rapidly. From about 4,000 tonnes11 in 1989/90, exports rose to nearly 6,000 tonnes in the following year, then soared to 18,500 tonnes in 1991/92. Much of the 1991/92 volume, however, was of poor quality, resulting in high rejection rates, low prices, and considerable damage to Tonga’s reputation. In response, the squash exporters’ association decided to introduce a quota limiting the total volume of exports.12 After this system was introduced, exports initially retreated to under 10,000 tonnes, but they then rebounded to over 18,000 tonnes in 1993/94 and 17,000 tonnes in October-December 1994.13

b. Other crops

This increase in squash cultivation appears to have come partly at the expense of other crops, especially food produced for the domestic market. Initially, this decline seemed to reflect a severe drought, which especially affected production in 1991/92. Even after weather conditions returned to normal, however, production of many crops failed to rebound. Root crop output, for example, fell in both 1992/93 and 1993/94, in the latter year by 31 percent. Pronounced cumulative declines have also been recorded for bananas, watermelon, “other fruits” (those other than traditional export crops) and vegetables. These figures, which measure only output sold in central markets, almost surely overstate the declines in actual production, much of which is consumed on farms. Nevertheless, there has clearly been some shift in land and labor toward more remunerative activities. Revealingly, the one major crop which has not shown any decline has been coconut, which is now harvested mainly on the outlying island, where squash is not grown.

By contrast, fishing output has more than held its own, expanding vigorously in recent years. This was due to liberalization: the Government corporatized and partially privatized the Sea Star Fishing Company in 1990/91, and removed its monopoly on deep-sea fishing in mid-1993. These reforms have prompted new private operators to acquire fishing boats and Sea Star itself has expanded rapidly, purchasing three vessels over the past two years. Much of the catch consists of tuna, which is sent mainly to a cannery in American Samoa, but growing amounts of high-value sea cucumber are being harvested for shipment to Asia.

2. Secondary and tertiary sectors

The two main secondary industries are manufacturing and construction, each of which accounts for about 5 percent of GDP (Appendix Tables 6 and 7). The authorities have been attempting to encourage manufacturing since the late 1970s, through three main instruments. They have built an industrial park, the Small Industries Centre. They have established the TDB, to provide financing for new activities, and they have promulgated the IDI Act, which provides registered firms with income tax holidays (typically of 5 years), as well as duty exemptions and concessional rates of port and service tax on imports.14 Partly as a result of these incentives, manufacturing value added has grown at a steady pace of about 4 percent per annum during the past five years.

This apparent success, however, masks two widely divergent trends. Production for the domestic market has grown rapidly, led initially by food, beverages, and tobacco and more recently by chemical products and furniture (Appendix Table 8). However, manufacturing for export has fallen off sharply: sales of textiles and wearing apparel, for example, halved between 1989/90 and 1991/92. To reverse this trend, in November 1992 the authorities attempted to shift the balance of incentives toward export production. Overall incentives were made less generous by eliminating the carry forward of depreciation allowances and losses beyond the income tax holiday period, while export incentives were improved by granting such firms a full exemption from the port and services tax However, the effort has so far been unsuccessful. By 1993/94, when leather and knitwear production ceased, only one export factory remained in the Small Industries Centre, and overall manufactured exports amounted to less than one third their 1989/90 level (Appendix Table 9).

A number of factors appear to have been responsible for this decline. First, as Australia and New Zealand reduced their tariffs, the value of Tonga’s duty-free access to these markets under the South Pacific Regional Trade and Economic Cooperation Agreement (SPARTECA) was eroded, and its exports were undercut by competition, especially from Asian countries. Second, as profitability in agriculture improved, manufacturing firms found it increasingly difficult to attract and retain labor. Third, isolated from consumer markets, firms proved unable to maintain up-to-date products. Fourth, for the above reasons, many firms did not prove viable after their five-year tax holidays expired.

As for construction, activity has fluctuated widely in recent years. Output fell 16 percent in 1990/91 and continued to stagnate in 1991/92, following the completion of two large public sector projects. The sector recovered somewhat in 1992/93, growing by 7 percent, but really rebounded during 1993/94, when output expanded by 13 percent. This renewed activity had three components. First, in the banking sector, the two new commercial banks constructed their offices, the BOT renovated its main building, and--most important--the NRBT built its headquarters, at a cost amounting to 3 1/2 percent of GDP. Second, residential housing construction accelerated, stimulated by high squash incomes and a sharp rise in bank credit. Third, government development expenditure picked up, on projects such as the ‘Eua High School and the Vava’u airport.

Little information is available on the tertiary (services) sector, although it comprises over 40 percent of real GDP. According to official estimates, the sector has grown by 2 1/2 percent on average over the past five years. In large part, this reflects the slow development of tourism: although arrivals have grown at a robust rate, most of these have been Tongans resident overseas, and expenditure per visitor has remained low ( Appendix Table 10). In 1993/94, growth in services accelerated to 4 1/2 percent, commercial activity was fed by the successful squash season, tourist arrivals increased significantly, and government employment rose.

3. Environmental issues

There is some concern that the increase in agricultural exports may be damaging the environment. Traditionally, soil fertility has been preserved by mixing subsistence and commercial crops, rotating crops, and allowing long fallow periods. With the advent of squash production, however, these practices are changing. Land is being cleared of trees and dedicated to squash production, fallow periods are being shortened, and the use of chemical fertilizers and pesticides is increasing. This more intensive agriculture will require careful practices and monitoring to ensure it does not cause environmental damage, including a reduction in soil fertility or damage to ground water. As a first step, the Government has introduced a licensing system for agrochemicals and is now developing guidelines to control the use of these and other hazardous materials. Moreover, greater attention is now being paid to land use management. In particular, the authorities are considering ways to prevent chemicals from being used near sensitive areas, such as schools and water reservoirs.

Another problem is the potential depletion of fish stocks near coastal waters. As the number of fishing boats has increased, the size of the catch from inshore areas has grown rapidly, while breeding grounds (sea-grass beds, mangroves, and coastal reefs) have been damaged by excessive siltation from dredging and filling for waterfront development. To redress this problem, efforts are being made to improve the quality of coastal and lagoon waters and fish sanctuaries have been established, although enforcement is an ongoing problem.

B. Prices and Wages

1. Prices

Movements of the Consumer Price Index (CPI) in this highly open economy are strongly influenced by imported inflation and domestic supply shocks. Over the past five years, the foreign component of the CPI, which constitutes 60 percent of the index, has increased on average by about 4 percent per annum, reflecting moderate inflation in trading partners (Appendix Table 11). However, there have been two sizeable domestic shocks--the government wage increase in 1989/90 and a severe drought in 1991/92--which have caused the local component to increase by 10 percent per annum. Accordingly, the overall index has increased at an average annual rate of 6 1/2 percent.

Inflation peaked in 1990/91 at 13 percent, as the previous year’s government wage increase spread to other sectors, tax and duty rates increased, and world oil prices rose. The CPI rose by another 9 percent in 1991/92, because the drought caused a sharp rise in domestic food prices. As these supply shocks dissipated, however, inflation began to retreat. It fell to 3 percent in 1992/93 and eased further to 2 1/2 percent in 1993/94, despite rapid money supply growth. In the first quarter of 1994/95, the year-on-year price increase amounted to only 1 1/2 percent.

In the early 1990s, price controls were lifted on a broad range of products, and now remain only on a few essential items. The most significant controls are on petroleum products, for which prices are adjusted monthly using a formula based on spot oil prices in Singapore. A further 16 items are subject to maximum price margins: typically, wholesalers are allowed a 12 1/2 percent mark-up over landed costs, while retailers are allowed a 15 percent mark-up over wholesale prices. Also, most motor vehicle spare parts are subject to wholesale margins of 25 percent and retail margins of 20 percent. In practice, however, little attempt is made to enforce margin controls.

2. Wages

The limited data available suggests that wage growth has remained moderate since 1989/90, when government wage scales were increased by 35-50 percent, with a similar rise in the private sector. Subsequently, the government salary structure has been frozen, but most civil servants have been able to receive annual increments of about 5 percent by climbing well-defined rungs on the pay ladder for their grade. In the manufacturing sector, average earnings increased by about 20 percent in 1989/90, stabilized in 1990/91, then rose by a further 14 percent in 1991/92. These increases were mainly in the protected food and beverage sector; in export-oriented industries, wages were stable. In the agricultural sector, tentative data indicates that wages have gradually increased from T$ 2.00 per hour in 1990 to T$ 2.50 per hour in recent years.

III. Public Finance

A. Government Finances15

1. Overview

In recent years, fiscal policy has been directed toward restoring budgetary balance through a determined compression of expenditure.16 From 1989/90 to 1993/94, current expenditure was reduced by 4 1/2 percentage points, mainly by cutting spending on goods and services and freezing the salary scales (Table 2 and Chart 2). Development expenditure was also reduced, by 2 percentage points, as the authorities returned to their traditional practice of limiting projects to those that can be financed through foreign aid and the current budget surplus. As a result of these efforts, the overall fiscal balance was shifted from a deficit of 6 percent of GDP in 1989/90 to a surplus of 1 1/2 percent of GDP in 1993/94--all without any increase in the revenue/GDP ratio.17

Table 2.

Tonga: Central Government Operations, 1989/90-1994/95

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Sources: Data provided by the Tongan authorities; and staff estimates and projections.

Beginning in 1992/93, item includes interest income from the Tonga Trust Fund.

Budget statement figures have been adjusted for the estimated implementation rate.

Calculated as a residual and includes financing from nonbanks and a discrepancy.

Revenue less current expenditure.

Foreign grants plus net disbursements of foreign loans.

CHART 2
CHART 2

TONGA: CENTRAL GOVERNMENT BUDGET, 1989/90–1993/94

(In percent of GDP)

Citation: IMF Staff Country Reports 1995, 067; 10.5089/9781451837391.002.A001

Sources: Data provided by the Tongan authorities; and staff estimates.

The 1994/95 budget basically follows the trend of the last few years, with further current expenditure restraint and few new revenue measures. However, development expenditure is projected to increase by 40 percent, reflecting the initiation of a number of new projects, including a large power development scheme funded by an Asian Development Bank(AsDB) loan. Should this spending materialize, the budget deficit would widen to 8 percent of GDP, but the more likely outcome is that both spending and the overall balance will be considerably smaller.

In early 1994/95, the Legislative Assembly approved a balanced T$ 1.5 million supplementary budget, to cover unforeseen expenses such as the peace-keeping operation in Papua New Guinea and losses incurred by squash growers who tried to develop a May squash crop.

2. Revenue

In recent years, total revenue has remained around 26 percent of GDP Nearly half of this amount has been provided by taxes on international transactions, comprising import duties and the port and services tax (Appendix Table 12). As imports have stagnated in nominal terms during the past five years, however, the authorities have been forced to increase duty rates in order to maintain trade tax revenue as a share of GDP. In 1990/91, as part of a major tax package, the port and services tax was increased to 20 percent from 17 1/2 percent, while import duties on alcoholic beverages, tobacco, and fuel were raised substantially, and the import duty exemption on fuel for electricity generation was revoked.

Although this step increased import taxation to a ratio of 14 percent of GDP, by 1991/92 the ratio had fallen back to 11 1/2 percent of GDP--partly because sporting clubs were given the right to import cigarettes and other items free of import duties and other taxes Consequently, in 1992/93, rates were again adjusted: specific import duties on beer and cigarettes were increased, and minimum duties were established for meats, eggs, soft drinks, and motor vehicles. In 1993/94, as imports accelerated again, trade taxes rebounded to 12 1/2 percent of GDP, without any new tax measures. Consequently, in the 1994/95 budget, only the import duty rate on cigarettes was adjusted, by about 6 percent.18

One notable development in 1993/94 was the poor performance of import duties, which increased by only 5 percent,19 compared to a 15 percent increase in dutiable imports One reason was the growing amount of goods imported under the exemption for personal effects, which applies to imports on an accompanied or unaccompanied basis Although there is a value limit on goods eligible for this exemption, customs officials have generally accepted the importers’ low valuation of such goods, which are often unpackaged and declared as secondhand. Much of these goods are subsequently sold in informal markets. In addition, this exemption has been used to import shipping container full of materials needed for residential housing construction which boomed in 1993/94. Finally, there continues to be considerable undervaluation of imports of secondhand Japanese motor vehicles, despite the introduction of minimum duties.

Income taxes have accounted for just under 3 percent of GDP in recent years To a certain extent, this relatively small figure reflects the low and stable tax structure, with a single 10 percent tax rate for individuals, 15 percent rate for small local businesses, and somewhat higher rates for other businesses. However, it also reflects a number of exemptions and administrative difficulties. First, in 1990/91, income from agriculture and fishing was exempted from tax for a period of five years. Although this decision was taken partly because there were difficulties in assessing and collecting taxes on such incomes, it has also excluded the fastest growing sector from the tax base. Second, income tax holidays are provided to firms that register under the IDI Act.20 Third, deductions are available on a number of items, including life insurance, fixed asset loan repayments, and education. Fourth, enforcement is limited, leading to considerable under declaration of incomes, as well as to tax arrears.

Goods and service tax jumped by 1/2 of 1 percentage point to 3 percent of GDP in 1992/93 and remained at that level in 1993/94. The sudden rise in 1992/93 was due to the introduction of a foreign exchange levy; however, as this encouraged a shift of transactions away from the banking system, it was terminated after five months. In 1993/94, a more permanent increase was obtained by shifting the collection point for sales tax from the retail level to the wholesale level, where compliance was easier to obtain. A further increase in sales tax is likely this year, since the fuel tax was increased by one-half to 3 seniti per liter in the 1994/95 budget.

After an increase in government fees in 1992/93, nontax revenue has regained its earlier level of about 8 percent of GDP. The bulk of this revenue comes from three sources: dividends from the BOT and NRBT, and royalties from the international telecommunications operator, which are scheduled to rise gradually from 35 percent of revenue in 1993/94 to 45 percent in 1998/99. By comparison, user charges remain quite low, especially for health and education. In 1993/94, health service revenue covered less than 1 percent of expenditure, mainly because most services are free, while charges for laboratory tests are set at just T$ 1.00 apiece. Similarly, in education, revenue covered only 6 1/2 percent of expenditure, partly because tuition in the most prestigious public high school was only one third that charged by private schools.

3. Expenditure

Over the past five years, expenditure has been reduced by 6 percentage points of GDP to about 40 percent of GDP. Most of this reduction has occurred in current spending, which has been curtailed by 4 ½ percentage points to 22 percent of GDP--mainly by holding current spending nearly constant in nominal terms since 1990/91 (Appendix Table 13).

The burden of this current spending squeeze has fallen mainly on goods and services expenditure, which has been reduced by more than 3 ½ percentage points to under 9 percent of GDP. Inevitably, this has led to a deterioration in the government capital stock, especially buildings. Goods and services spending has also fallen sharply relative to the size of the civil service, by one third in real terms, resulting in a shortage of supplies for government workers.

Meanwhile, expenditure on the wage bill has been reduced by a much smaller amount--by 1 percentage point to 11 1/2 percent of GDP--even though the salary scales have been frozen since 1989/90 (Appendix Table 14). A key reason is that the size of the civil service has increased. Employment did decline initially, but subsequently it expanded again, so that by 1993/94 it had reached 4,000 workers, a full 18 percent above the 1989/90 trough and even 8 percent above the 1988/89 previous peak. At this level, the civil service employed about 40 persons per 1,000 of Tonga’s population, a ratio that is high even by comparison to other Pacific island developing countries. Moreover, the government also employed another 2,000 casual workers, equivalent to another 20 persons per 1,000 population.

A second reason for the limited decline in the wage bill is that most workers (except those at the highest levels) have been able to obtain annual increments of about 5 percent as they climbed well-defined rungs on their salary scales. Partly as a consequence, salaries at the lower levels still appear to be competitive with those in the private sector, even after five years of salary scale freeze. For example, the median salary of senior clerks is T$ 5,300, which compares well to the median salary of T$ 5,500 for their counterparts in the private sector, as determined in a 1994 wage survey. Moreover, in many cases benefits--such as the noncontributory pension--are superior in the public sector.

As nominal spending on goods and services has been kept constant, while that on wages has increased, the composition of the current budget has shifted radically. The share of goods and services in recurrent expenditure has declined by 10 percentage points since 1988/89 to 40 percent in 1993/94, while the share of wages has increased by 7 percentage points to 53 percent--a ratio that is exceeded in the South Pacific only by Vanuatu.

At the same time, spending on pensions has doubled its share of the current budget. Although this item still represented only 3 1/2 percent of current expenditure in 1993/94, its share will continue to expand rapidly over the medium term as the number of retirees starts to swell. The main problem is the exceptional generosity of the pension scheme. According to actuarial calculations,21 to obtain similar benefits from a commercially funded scheme, annual payments would need to be about 24 percent of salaries. Yet under the Tonga scheme, workers do not pay anything at all.

Development expenditure and net lending has not been exempt from the expenditure restraint. Such spending has been reduced by 2 percentage points of GDP over the past five years to 17 ½ percent of GDP in 1993/94, mainly by cutting back on locally funded projects.22 Most of the projects implemented in recent years have focussed on infrastructure--such as electricity, water, roads, and school buildings--but there has also been a considerable amount of on-lending to the TDB so that it could finance private sector activity, especially in the squash sector In 1993/94, major projects included the Queen Salote Memorial Hall, which will be used for public functions;23 airport upgrading; and two new high schools.

The 1994/95 budget envisages that development spending will surge to 26 percent of GDP, swelled by a wave of large new projects. These include on-lending to the Electric Power Board to add two new generators to the main island of Tongatapu and extend electricity supplies in the outer island of Vava’u; the purchase of a tugboat; and construction of a building for the capital’s central food market, the Talamahu. Actual implementation, however, is likely to fall considerably short of target.

4. Financing

Financing of the budget comprises three distinct components: foreign financing, drawings from the Tonga Trust Fund, and domestic financing. Foreign financing has increased gradually in recent years, rising from about ½ percent of GDP in 1990/91 to 1 ½ percent of GDP in 1993/94--and a planned (though optimistic) 4 percent of GDP in the 1994/95 budget. In large part, this increasing trend reflects the stagnation of grants from traditional donors; although grants from newer sources, such as Japan, have increased rapidly, these tend to be focussed on specific construction projects, rather than on general infrastructure needs.

The Tonga Trust Fund is an official account, held mainly offshore, separate from the budget and the foreign exchange reserves. It became operational in July 1989, when it received the first deposit of proceeds from the sales of Tongan passports to nonnationals (Appendix Table 15). Since 1992/93, a portion of the accrued interest has been transferred as revenue to the government budget and used to finance amortization payments on external debt. Drawdowns of capital have been limited to special circumstances, such as occurred in 1992/93, when the capital of Royal Tongan Airlines needed to be replenished urgently. In 1994/95, T$ 1.4 million was withdrawn to finance the construction of the Queen Salote Memorial Hall.

Trends in domestic financing have reflected the swings in the overall deficit. As fiscal imbalances emerged in 1989/90-1990/91, such financing amounted to about 3 percent of GDP, largely in the form of large issues of development bonds, which were taken up by the banking system, and of ways and means advances, provided by the central bank. More recently, as the fiscal position has improved, the Government has gradually rebuilt its deposits and is once again a creditor to the banking system. Its term deposits have been maintained with commercial banks rather than the NRBT in order to maximize its interest income and to provide resources for lending to the private sector. Meanwhile, the advance from the NRBT has been refinanced, by issuing T$ 6 million in bonds at the end of 1993/94.

B. Public Sector Commercial Activities

1. Nonfinancial public enterprises and privatization

There are 13 major nonfinancial public enterprises, spanning areas from transportation to utilities to manufacturing (Appendix Table 16). Although recent data is not available, their financial performance appears to have improved recently, so that now only one company requires budgetary transfers. Still, most only manage to cover current costs with their revenue, and their provisions for capital replacement and loan amortization are usually inadequate. Moreover, despite a Government policy of privatization, almost no firms have been sold in recent years.

The one enterprise that requires budgetary subvention is the Shipping Corporation of Polynesia. The company has been making small operating losses in recent years, as revenues from passenger and cargo traffic have stagnated, while maintenance costs on its aging vessels have been exceptionally high. Consequently, when the grace period on two large foreign loans expired in 1992/93 and 1993/94, it was unable to make the amortization payments, and the obligations had to be paid out of the government budget. In 1992/93, 40 percent of the company’s shares, which had been owned by a German shipping corporation, were sold to the TDB.

In the past, the main public enterprise in financial difficulty has been Royal Tongan Airlines (RTA). In 1991/92, the company started an international service using chartered jets This proved to be quite costly: large losses were incurred and shareholder’s funds turned negative, forcing the authorities to provide a capital injection of T$ 2.5 million in early 1992/93. Since then, however, the company has scaled back and reorganized its activities, reducing losses to minimal levels that can be financed by loans from the TDB. In early 1995, RTA re-entered the international market using a large-capacity aircraft, jointly leased with Air Pacific of Fiji, which it is using to re-establish service to New Zealand and open new links with Australia. RTA also provides a domestic service, which operates at a small loss.

Progress to date in privatization has been relatively limited In January 1992, the Tongan Commodities Board was transformed into a holding company, Tonga Investment Limited, with the declared purpose of privatizing its subsidiaries. In 1992/93, it sold one of its assets, a shipping arcade, to a Tonga-based church. Since then, however, no further assets have been privatized, owing to the lack of appropriate Tongan buyers. Two of the six remaining subsidiaries, the hardware store and the monopoly LPG distributor, are consistently profitable; two others, the export marketing subsidiary (which sells squash and vanilla) and the quarry, have had fluctuating fortunes; and the soap manufacturer and coconut oil mill are candidates for liquidation.

2. Government commercial activities and corporatization

In contrast to the limited progress in privatization, the Government has made considerable headway in corporatizing its numerous commercial activities. In 1990/91, the Sea Star Fishing Company was corporatized, and subsequently a 20 percent share was sold to private investors In the 1994/95 budget, both Duty Free Shops Tonga Limited and the International Dateline Hotel were corporatized, as well.

Potentially most significant, however, has been the establishment of “revolving funds” in the development budget.24 Traditionally, activities such as a store, local markets, machinery pools, fishing boat building, and sawmills have all been funded out of the government recurrent budget. However, in 1993/94, the Government gave 17 of these commercial activities a fixed amount of working capital, to be used as a revolving fund, and required them to meet any additional expenses out of their own earnings.25 As a transitory measure, wages for some of these activities will continue to be paid by the general administrative budget, but as they learn to operate on a self-sustaining basis this subsidy will be phased out, and the activities will then be corporatized and privatized. This reform has already proved successful: in 1993/94, the revolving fund activities recorded a surplus of T$ 1 1/2 million, prompting another nine activities to be added in the 1994/95 budget.

IV. Financial Sector

A. Institutional Structure

The financial system in Tonga comprises the central bank, three deposit money banks, and the TDB. Tonga’s central bank, the NRBT, was created in July 1989, when it took over the management of the international reserves, currency issue, and the operation of monetary policy.

For many years, the sole commercial bank was the BOT, which is 40 percent owned by the Government and 60 percent by two foreign banks, the Bank of Hawaii and Westpac Banking Corporation of Australia. In late 1993, this bank was joined by two new entrants, one Malaysian (MBf Bank) and one Australian (Australia and New Zealand Banking Group Limited).26

The TDB, which is 95.7 percent owned by the Government and 4.3 percent by the BOT, was established in 1977. Its aim is to foster private sector development using resources obtained mainly from concessional external borrowing; it does not accept deposits.

B. Recent Developments

1. Monetary policy and instruments

In recent years, the NRBT has gradually shifted the operation of monetary policy from reliance on direct controls to the use of market-oriented instruments. Interest rate ceilings have been progressively phased out, with the last one removed in July 1991. Credit controls--which operated mainly through a maximum loans-to-deposits ratio, reinforced by direct lending limits in case reserves fell through a specified floor--were eliminated in early 1993.

At that time, the NRBT introduced two new market-oriented policy instruments. First, in March 1993, the maximum loans-to-deposits ratio was replaced by a requirement that commercial banks hold 5 percent of their deposits as noninterest-bearing statutory reserves at the central bank. This reserve requirement was designed to serve both prudential and monetary policy functions, although it was envisaged that the ratio would not be changed frequently unless monetary conditions preclude the use of other instruments that may have a more delayed and less certain effect.

Second, in April 1993, the NRBT started to issue central bank securities on a weekly basis to pave the way for future open market operations and a more flexible control over credit growth (Appendix Table 17). The amount issued varies in light of the NRBT’s target for credit to the private sector, which in turn is based on the objectives for international reserves and inflation, and the expected levels of growth and bank credit to the Government. Although these securities can be purchased by any entity in Tonga, more than 90 percent have been acquired by commercial banks, with the balance being obtained by the TDB. Initially, only one type of note was offered, with a 56-day maturity and a 4.5 percent interest rate. Since February 1994, however, the range of securities has been broadened to include maturities between 28 days and 5 years. At the same time, interest rates were reduced, to a minimum of 1.3 percent on 28-day notes and a maximum of 4.4 percent on 5-year notes.

Following the introduction of NRBT securities, the central bank also opened a rediscount facility, which currently operates on a limited case-by-case basis, with interest rates determined at the NRBT’s discretion.

2. Recent monetary developments

For most of the past five years, there has been little increase in financial intermediation. Broad money has tended to increase in line with nominal GDP, growing by an average of about 8 1/2 percent per year from 1989/90 to 1992/93 (Tables 3 and 4; and Chart 3). Consequently, the ratio of broad money to GDP in Tonga has remained about 26 percent, while in Vanuatu, for example, it has increased to 38 percent in 1993 from 32 percent in 1989.27

Table 3.

Tonga: Monetary Survey, 1989/90-1993/94 1/

article image
Source: Data provided by the Tongan authorities.

Components may not add to totals because of rounding.

Deposits of the Tonga Trust Fund with the Bank of Tonga.

Table 4.

Tonga: Banking Survey, 1989/90-1993/94 1/, 2/

article image
Source: Data provided by the Tongan authorities.

Components may not add to totals because of rounding.

Includes the National Reserve Bank of Tonga, commercial banks, and the Tonga Development Bank.

Deposits of the Tonga Trust Fund at the Bank of Tonga.

CHART 3
CHART 3

TONGA: MONEY AND CREDIT, 1989/90–1993/94

Citation: IMF Staff Country Reports 1995, 067; 10.5089/9781451837391.002.A001

Sources: Data provided by the Tongan authorities; and staff estimates.

Other monetary indicators have shown similar trends. From 1989/90 to 1992/93, the ratio of quasi-money to broad money (a measure of the shift in transactions away from currency and toward the banking system) increased by only 3 percentage points, to 62 percent. Most strikingly, credit to the private sector actually declined, by 13 percent over this period, as the BOT responded to a bout of problem loans in the late 1980s by tightening its lending policies and writing off significant amounts of outstanding debt (Appendix Table 18).28

This situation changed radically following the entry of two new banks in late 1993. As banks started to compete to attract savings, quasi-money (time and savings deposits) climbed by 13 percent in 1993/94, pushing up broad money by 11 percent--more than double the increase in nominal GDP.

At the same time, NDA increased even more strongly, by 31 percent of broad money.29 One reason was that competition sparked a revival of lending to the private sector. Such credit increased by 25 percent, virtually all of which was channeled into just three sectors: housing, which jumped by 10 percent; commerce and trade, which leapt by 25 percent; and personal lending, which soared by 67 percent (Appendix Table 19). Demand for these loans was fueled by a doubling of squash incomes, which induced a sharp rise in demand for durable goods. On the supply side, banks funded these activities not just by mobilizing private deposits, but also by running down their holdings of NRBT securities, and utilizing government deposits, which had been placed with them, rather than with the NRBT.

The other reason for the strong NDA growth was the sharp increase in other items (net), equivalent to 12 percent of broad money. Traditionally, this category had tended to decline, reflecting the BOT’s policy of using much of its profits to augment its capital liabilities, rather than to distribute dividends to shareholders. In 1993/94, however, this effect was more than outweighed by an increase in central bank fixed assets, as the NRBT finally built its heaquarters, at a cost of about 3 1/2 percent of GDP.

As NDA expanded more rapidly than broad money, the inevitable result was a decline in net foreign assets. These shrank by 10 percent, causing gross reserves to contract to the equivalent of 5 months of imports of goods and services30 at end-1993/94 from 7 months’ worth at end 1992/93. This trend continued into 1994/95: net domestic asset growth accelerated to 41 percent, well above the broad money growth of 22 percent,31 causing reserve coverage to fall further to just over 4 months, the lowest level in over 10 years.

3. Tonga Development Bank

The TDB has concentrated on providing development financing in the agriculture, fishery, industry, and tourism sectors. Its lending activity is financed mainly through direct and on-lent (via the Government) foreign concessional loans; at end-1993/94 these accounted for about half of liabilities, with most of the remainder consisting of capital (Appendix Table 20). In July 1993, the TDB began to issue promissory notes and bonds, in order to reduce its reliance on external sources and to better match its funding to the seasonal nature of its lending. Although these amounted to only T$ 4 million at end-1993/94, by end-December 1994 they had reached T$ 21 1/2 million, with maturities ranging from one month to five years. Interest rates on these securities varied from 3 percent 30-day note to 6.5 percent for the 5-year bond--well above the rates offered by the NRBT on its securities.

In constrast to the BOT, the TDB has consistently expanded its credit to the private sector, by an average rate of 11 percent per annum over the past five years, so that by 1992/93 its outstanding stock had surpassed that of commercial banks.32 In 1993/94, nearly half of this loan portfolio was placed in the agriculture sector, of which the bulk was lent for squash exports,33 vanilla exports, and root crop production. The other half of the portfolio was extended to industry and trade, of which most was lent for tourism, transport, and construction.

Arrears problems have continued to bedevil the TDB, reflecting the risky nature of the bank’s lending. However, the problems have normally been resolved by restructuring loans, and actual write-offs thus far have been minimal. Owing to the unsuccessful squash season in late 1994, accounts in arrears34 reached 17 ½ percent of TDB’s loan portfolio in December 1994, compared with 11 percent in December 1994.

4. Interest rates

Following the elimination of the interest rate ceiling in 1991, the NRBT has influenced commercial banks’ deposit rates by controlling interest rates on its own notes In general, the policy has been to keep deposit rates in Tonga positive in real terms based on the underlying inflation rate,35 while also maintaining their competitiveness with interest rates in neighboring industrial countries. Although the sharp increase in prices during 1990/91-1991/92 resulted in a negative real deposit rate, this subsequently turned positive as inflation was once again brought under control (Appendix Table 21). Nominal deposit rate differentials between Tonga and Australia and New Zealand, however, have been negative for many years--although the gap widened considerably in 1993/94, as rates in the latter two countries increased sharply.

On some measures, spreads between deposit and lending rates have been increasing in recent years. The average deposit rate has gradually fallen as inflation has receded, but average rates on all loans outstanding has actually increased marginally, so that the spread has climbed to 6.4 percent in 1993/94 from 3.5 percent in 1989/90. In part, this reflects higher lending risk premia following the BOT’s bad loan experiences in the late 1980s. Also, especially in 1993/94, it reflects a shift in the composition of lending toward higher-risk, higher-interest rate, personal and housing loans. Most recently, however, as competition has intensified, the spread has begun to narrow: by end-1994 it had reached 5.0 percent, 140 basis points lower than at end-1993.

V. External Sector

A. Overview

External performance in recent years can be characterized as generally favorable. Still, three distinct periods should be distinguished (Table 5 and Chart 4). First, in 1989/90, the external accounts were dominated by a single set of transactions, the large sale of passports to non-nationals. These receipts propelled the current account into a large surplus and, since most of the funds were deposited abroad, they also pushed the capital account into a nearly offsetting deficit. Second, from 1990/91 to 1992/93, the balance of payments mirrored the loosening and subsequent tightening of the fiscal stance. In 1990/91, the current account and overall balance turned negative, and reserve coverage slipped to about 4 1/2 months of imports of goods and services.36 But as policy was tightened, both balances gradually swung back into surplus, allowing reserves to be rebuilt to nearly 7 months of imports by 1992/93.

Table 5.

Tonga: Balance of Payments Summary, 1989/90-1993/94 1/

(In millions of U.S. dollars)

article image
Sources: Data provided by the Tongan authorities; and staff estimates.

Components may not add to totals because of rounding.

Including foreign grants.

Including Tonga Trust Fund investments and private capital.

Excluding foreign grants.

In months of non-aid imports of goods and services.

In percent of private current account receipts.

CHART 4
CHART 4

TONGA: BALANCE OF PAYMENTS, 1989/90–1993/94

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 1995, 067; 10.5089/9781451837391.002.A001

Sources: Data provided by the Tongan authorities; and staff estimates.1/ In months of non-aid imports of foods and services.

Third, in 1993/94, as the monetary stance turned expansionary, the balance of payments deteriorated again. Rapid net domestic asset growth fueled a 14 percent increase in imports, causing the current account to shift into deficit despite a near-doubling of merchandise exports. It also stimulated private capital outflows, causing the capital account to turn negative as well. Consequently, a large overall deficit was incurred, and reserves shrank to about five months of imports.

B. Exports

Over the past five years, the export base has expanded by 5 percentage points of GDP to reach 13 percent of GDP in 1993/94. This increase has occurred for one reason--squash shipments--which grew by 7 ½ percentage points of GDP to reach 9 percent of GDP by 1993/94. In comparison, other exports have contracted as a share of GDP.

1. Squash

Although squash exports have expanded rapidly, this growth has not been without problems, especially on the marketing side. Difficulties were first encountered in 1991/92, when volumes more than tripled over their previous year level, to 18,500 tonnes (Appendix Table 22 and Chart 5). Much of these exports were of poor quality, resulting in a high rejection rate by Japanese importers and low per unit prices. As a result, some exporters were unable to pay their growers and they, in turn, found it difficult to repay the loans they had obtained--mainly from the TDB.

CHART 5
CHART 5

TONGA: EXTERNAL TRADE, 1989/90–1993/94

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 1995, 067; 10.5089/9781451837391.002.A001

Sources: Data provided by the Tongan authorities; and staff estimates.

To prevent further such problems, exporters decided to subject squash to an informal quota and to organize the industry around a system of “registered” growers. Under these arrangements, an aggregate shipment limit was established by the industry association, the Squash Council, which was allocated among established exporters. Each exporter subsequently subdivided its quota among a number of growers, based on their available land and an assumed productivity of 3.5 tonnes per acre. Each “registered” grower was then provided with seeds, chemicals, and other inputs, which were financed by loans (typically T$ 800 per acre) from the TDB. In return, the grower agreed to plant, harvest, and supply the squash to the exporter according to a specified timetable, timed to coincide with one of the three shipments to Japan. Then, once the squash reached its destination and final prices had been agreed, squash exporters took a fixed margin and paid out the remainder to their growers, coursing the money through the TDB so as to ensure that the loans would be repaid.

For exporters and the TDB, this system had a number of advantages--at least, in principle. First, it allowed them to reassure overseas customers that they could rely on Tonga to provide a stable supply of squash. Second, since Tonga was the dominant supplier to Japan during the short exporting season, export restraint also helped stabilize prices. Third, stable quantities and prices, in turn, minimized risks for exporters, and for the bank that financed them. Fourth, the quota helped promote the standard of squash exports, since faced with assigned volumes growers could improve their incomes only by raising the quality of their production.

It was not long, however, before this attempt to regulate the market ran into trouble. In 1993/94, Japanese demand increased sharply as poor weather caused a shortage of local production, while in Tonga there were concerns by exporters about meeting their quotas. This started a bidding war by exporters for additional squash that resulted in exports of over 18,000 tones, far in excess of the 13,000 tonne quota. As quantity surged and prices improved by 16 percent, squash receipts improved to US$13 1/2 million--more than double the previous year’s level. Nevertheless, the authorities were concerned about the breakdown of the system, and so decided to give the Ministry of Labor, Commerce, and Industries the authority to impose a quota that would be legally binding.

Accordingly, during the October-December 1994 season, exports were limited to the quota level of 17,000 tonnes. This restraint, however, did not succeed in stabilizing the market; to the contrary, receipts plummeted by about 40 percent. The main problem was that it proved difficult to enforce production controls on such a highly profitable crop.37 Even though the quota was announced well before the season, actual production amounted to a much higher 20,000 tonnes, as nonregistered farmers tried to produce and sell to exporters, registered farmers produced more than allotted, and both tried to harvest as early as possible, to ensure that they could sell before the quota was filled. As farmers rushed to harvest and exporters raced to ship, storage houses at the wharf filled to capacity, causing much of the crop to spoil--and unit prices to collapse.

2. Other exports

Fish exports have increased rapidly since the sector was deregulated in 1993, and now amount to about US$ 2 1/2 million, or 13 percent of total exports. This expansion has been led by a growing catch of low-priced tuna and high-priced sea cucumber. Tuna shipments more than doubled in 1993/94 to US$1 1/2 million, reflecting the increased output of the Sea Star Fishing Company, which purchased two additional fishing vessels in 1993; virtually all of this was shipped to a cannery in American Samoa. Sea cucumber exports increased by about one fifth to nearly US$1 million, most of which was exported to Asia.

Vanilla exports, which now comprise about 8 percent of the total, have been declining since 1990/91, owing to poor profitability--and despite the introduction of a new technology that significantly reduces the cost of production. Previously, only mature vanilla beans could be harvested, and then they needed to be dried and cured, a process which created a high-quality high-vanilla content product (exported mainly to Europe), but which involved considerable time and labor. Under the new system, however, immature beans are turned directly into liquid and exported, mainly to the United States, for use as flavoring in products such as ice cream. This technology, together with an upswing of the biannual crop cycle, sparked a modest rebound in exports during 1993/94, to about US$ 1 1/2 million--although this remained well below the US$2 1/2 million earned in 1990/91.

Other agricultural exports are about 13 percent of the total, and have shown little growth in recent years. Recorded exports of root crops amount to only about US$0.5 million a year, but significant amounts are also exported informally to Tongan communities abroad in exchange for cash remittances or goods that are imported as personal effects. The authorities are currently trying to develop other crops, hoping to identify niche markets similar to that found for squash. Manufactured exports have been in a continual decline since 1989/90, falling by two thirds to US$0.8 million in 1993/94. Currently, the only items exported are handbags, spectacle cases, shoes, and T-shirts.

C. Imports and Direction of Trade

The interpretation of movements in imports is clouded by statistical problems. According to official data, imports have grown much more slowly than GDP in recent years, causing the ratio between the two to fall to 35 percent in 1992/93 from 43 1/2 percent in 1989/90. One possible explanation for this trend is the progressive tightening of financial policies over this period, which reduced excess demand pressures. This hypothesis is not fully convincing, however, since development spending and export incomes--which tend to be closely related to imports in other small island economies--have not declined as a ratio to GDP. This suggests that there may be a growing problem of under recording, possibly arising from the increasing volume of goods, including shipping containers of construction material, being brought into the country as duty-free “personal effects”.

These statistical problems emerged to the fore in 1993/94, when a conflict arose between customs figures used by the Statistics Department, and banking system data, processed by the NRBT. For the first time, the former were lower than the latter, a phenomenon which was not only difficult to explain in view of the considerable amount of imports not financed by bank payments, but which also led to a large statistical discrepancy in the balance of payments. An analysis of this situation suggested to the NRBT that under recording may have increased by about US$4.8 million, mainly owing to the boom in construction. Accordingly, they have adjusted imports upward by this amount, implying a 1993/94 growth rate of 14 percent, rather than 7 percent. The figures reported here are based on these adjustments.

Data on import composition, which are on a c.i.f. basis, indicate that 1993/94 import growth was led by a 20 percent surge in consumer goods, reflecting the doubling of squash incomes (Appendix Table 23). Imports of intermediate goods also increased strongly, by 17 1/2 percent, owing to the sharp acceleration of construction activity. In 1993/94, nearly one half of imports consisted of intermediate goods, mainly agricultural inputs, fuel, and construction materials, while another third was consumer goods, including food. By comparison, imports of capital goods are minor. Imports of petroleum products have grown slowly in recent years, increasing by a cumulative 12 percent in volume terms since 1989/90 to reach 32 million liters in 1993/94 (Appendix Table 24).

As traditional exports have fallen and squash shipments have grown, the direction of trade has shifted significantly. Australia and New Zealand have become minor destinations, while Japan has become the country’s largest export market, taking 59 percent of total shipments in 1993/94 (Appendix Table 25). Australia and New Zealand remain, however, Tonga’s predominant suppliers, furnishing more than half of the country’s import needs. Fiji is a important source of petroleum products and Japan is a growing supplier of motor vehicles.

D. Services

The services deficit38 has widened steadily in recent years, as travel receipts have failed to keep pace with the rise in aid-funded payments (Appendix Table 26). From 1989/90 to 1993/94, travel receipts increased by about 6 percent per annum to reach US$9 million, reflecting a steady increase in the number of air arrivals. Expenditure per visitor, meanwhile, has remained relatively low, at US$350 in 1993/94, essentially because most “tourists” are actually Tongans resident abroad who are returning to visit--and stay with--their families; there is also some evidence that Tongans have been visiting during the squash season to work in family fields. Travel receipts remained unchanged in 1993/94 despite a 9 percent increase in arrivals. Other service credits have fallen precipitously since 1989/90, as sales of passports have plummeted to low levels.

Service debits are dominated by payments for transportation and aid-funded services. The former remained essentially flat until imports surged in 1993/94. The latter, however, is estimated to have jumped to US$14 million in 1993/94 from US$4 million in 1989/90, as a rising level of grants has financed a growing amount of technical assistance and scholarships for study abroad. Reflecting the modest level of Tonga’s external debt and its concessional nature, interest payments are small.

E. Transfers

Transfers are Tonga’s major source of foreign exchange, providing US$48 million per year on average over the past five years, about two thirds of which comes from private transfers About half of the latter, in turn, consists of remittances from Tongans living abroad. Data show that these have not increased in recent years, but this trend may be more apparent than real, since there has been a growing tendency for returning Tongans to bring in goods, rather than cash, as they can be sold in informal markets at large mark-ups. The other half of private transfers consists of inflows from nonprofit organizations, mainly foreign affiliates of local church denominations, to be used for church (and church school) construction and renovation These, too, have shown little trend in recent years.

In 1992/93, private transfers were unusually high, stimulated by special events, including the King’s birthday and the 25th anniversary of the coronation. In 1993/94, inflows declined slightly, but outflows increased sharply for the second consecutive year, causing the net balance to fall by 8 percent39 The reasons for this remain unclear, but may be related to the good squash season: higher incomes may have allowed households to transfer more money to overseas Tongans, especially relatives studying abroad.

Official grant receipts have increased by more than 50 percent during the past five years to US$22 1/2 million in 1993/94 (Appendix Table 27). This growth has been fueled by the commencement of aid from Japan, increasing support from the European Union, and by a one-time grant from Taiwan Province of China to finance the Queen Salote Memorial Hall.40 More recently, however, aid from Japan and Europe has leveled off, while the traditional bilateral donors--Australia and New Zealand--have maintained their assistance at a steady US$11 million per year.

F. Capital Account

During the past five years, the capital account has oscillated between surplus and deficit. The balance on official loans has nearly always been positive, as disbursements--almost exclusively concessional loans from multilaterals--have averaged about US$2 1/2 million per year, while amortization has averaged US$1 million, mainly for concessional bilateral debt. Meanwhile, the balance on nonofficial capital has swung widely, but has almost always remained negative. Identified flows have generally been positive,41 but these have been more than offset by consistently negative errors and omissions, perhaps reflecting unrecorded acquisitions of overseas financial assets. Foreign direct investment has been minor, although significant inflows were received in 1991/92 when the international telecommunications operator began service, and in 1993/94 when two new commercial banks commenced operations.

In 1993/94, the capital account plunged into a deficit of US$5 1/2 million. This reflected squash proceeds that were not repatriated, as well as a net repayment of forward exchange cover, which more than offset the US$3 million brought in by the new commercial banks. Meanwhile, net official capital remained stable: gross official disbursements increased to US$3 1/2 million, mainly from the AsDB, while amortization rose to US$1 1/2 million.

G. External Debt and Debt Service

The stock of external debt has grown moderately, and has declined as a percentage of GDP to 32 percent in 1993/94 from 40 percent in 1989/90 (Appendix Table 28). Its composition, however, has shifted considerably. In 1989/90, the largest component was bilateral, but this balance has now fallen to only one third of the total, because the 1977 loans owed to Germany by the Shipping Corporation of Polynesia--which constitute the bulk of this debt--are being repaid.42 By contrast, debt owed to multilateral institutions has grown briskly, by an average of 10 percent per year, and now accounts for more than half of the total stock. Most of this has been borrowed from the AsDB, by the Government for infrastructure projects and by the TDB for on-lending to the private sector. The small amount of commercial loans are suppliers’ credits that financed the country’s telephone satellite links. Because most external borrowing has been on concessional terms, total debt service has remained low, ranging between US$2-US$3 million per year. The effective interest rate in 1993/94 was 2 percent, and the amortization rate 3 percent.

H. Exchange Rate Developments

In February 1991, the pa’anga was delinked from the Australian dollar and pegged to a currency basket comprising the Australian, New Zealand, and U.S. dollars, with the last as the intervention currency. Initially, each currency’s weight in the basket corresponded closely to its share in current account transactions, but now that trade with Japan has increased this is no longer true. Nonetheless, the NRBT has so far decided not to include the yen in the basket, largely because historical data indicates that such a link would have damaged Tonga’s competitiveness vis-à-vis third-country squash competitors, such as Mexico, Vanuatu, and New Caledonia. Had the pa’anga followed the yen from 1990/91 to 1993/94, for example, it would have appreciated by 22 percent against the Mexican peso, 25 percent against the Vanuatu vatu, and 22 percent against the French Pacific franc (used in New Caledonia).

Effective exchange rates--as measured by the IMF Information Notice System and based on 1980-82 trade and competitor weights--have remained remarkably stable during the past three years since the basket was introduced (Appendix Table 29 and Chart 6). The nominal effective exchange rate has remained essentially flat, as has the real effective exchange rate, now that inflation has declined to partner country levels. Movements in cross-rates among basket currencies have also been relatively small, although since 1991/92 the pa’anga has tended to depreciate against the New Zealand dollar and appreciate against the U.S. dollar. Against the yen, however, the pa’anga has depreciated significantly--by 22 percent since 1991/92.

CHART 6
CHART 6

TONGA: EXCHANGE RATE INDICES, 1991–95

(1980=100)

Citation: IMF Staff Country Reports 1995, 067; 10.5089/9781451837391.002.A001

Sources: IMF, Information Notice System and International Financial Statistics; and staff estimates.1/ Through January 1095.2/ Through March1995.

VI. Exchange, Trade, and Foreign Investment Regulations

Tonga accepted the obligations of Article VIII, Sections 2, 3, and 4 of the Fund’s Articles of Agreement as of March 22, 1991 and maintains an exchange system that is free of restrictions on payments and transfers for current international transactions.

Regulations on trade-related transactions are few in number and straightforward in application. There are three minor ones: (i) all shipments except exports of less than 10 kilograms require licences; (ii) export proceeds are to be repatriated and surrendered to the banking system within 12 months; and (iii) fresh egg imports are subject to quota. Of these, only the first is enforced, and even then licences are granted freely.

The only significant restriction is the quota on squash exports, which was introduced in July 1992. For the first two years, it, too, was implemented flexibly, by the exporters themselves. In late 1993, however, after actual exports far exceeded the season’s quota, the authorities decided to establish limits that could be legally enforced. Accordingly, the Ministry of Labor, Commerce, and Industries was empowered to set and administer an official quota, which was fixed for the October-December 1994 squash season at 17,000 tonnes.43

For outward invisible transactions, individuals may freely obtain up to T$ 1,000 per year in foreign exchange from commercial banks. Larger amounts require the prior approval of the Ministry of Finance, although this is generally given upon submission of evidence that a bona fide current international transaction is involved.

Foreign direct investment is subject to approval by the Ministry of Labor, Commerce, and Industries. Although no fixed criteria have been established, project proposals are normally assessed on the basis of their likely contribution to value added and employment, as well as on their level of technology. In general, high technology projects are readily approved; intermediate ones are accepted if a local partner is involved; and simple ones, entailing activities that can be performed by locals, tend to be rejected. The IDI Act prohibits foreign investment in certain sectors: these are agricultural activities; wholesaling and retailing; transportation; some tourism related services; and all resource based activities, such as fishing. However, joint ventures may be allowed in these sectors if the project is deemed beneficial to the country. No time period has been specified for the approval process, which can be quite lengthy, but once licensed, foreign projects (in manufacturing and tourism) are fully eligible for incentives under the IDI Act.

In principle, outward investment is restricted. Direct investment requires the approval of the Ministry of Finance, which is usually given if the level of international reserves is considered adequate and the transaction is considered beneficial to Tongan exports. The acquisition of foreign financial assets is prohibited, but this restriction is not effective because there is a large volume of informal trade and because the repatriation requirement is not monitored.

Finally, there are regulations on commercial banks’ foreign asset positions. Banks are permitted to hold only working balances in foreign currencies, up to a limit of T$ 1 million. No explicit limit exists on foreign exchange liabilities, but provision of forward exchange cover for squash exporters requires the approval of the Ministry of Finance; cover is currently not permitted for imports.

ANNEX I Export Diversification and Import Taxation

Although Tonga’s export base has expanded in recent years, it has also become much more concentrated. Whereas in 1989/90 the predominant product, manufactures, provided less than 30 percent of merchandise earnings, in 1993/94 squash accounted for more than 60 percent of exports. This heavy reliance on squash is not without considerable risk, prompting the authorities to once again consider ways to encourage export diversification. One possible strategy would be to alleviate the burden on exporters posed by the current system of import taxation.

The risks from squash are at least three. First, there is a risk that export prices could collapse. Already, prices have proved to be quite volatile, rising by 16 percent in 1993/94, then falling by over 40 percent in the October-December 1994 season. Second, there is a danger that the market could disappear. The exporting period is quite short, and any extension of the Japanese or New Zealand growing season could close the door on Tongan production. Alternatively, new competitors could enter this profitable market and erode Tonga’s share. Mexico already supplies squash during the same period, and Vanuatu and New Caledonia have been attempting to develop their production. Third, there is a risk that virus infections could reduce or even ruin domestic production.44 There was, in fact, some evidence of virus-inflicted damage to the small May 1995 crop, although the problem was generally considered to be minor, and not likely to affect the larger output in December 1995.

For all these reasons, the authorities have been placing renewed emphasis on diversifying the export base. One of the ways in which this could be done would be to reform the system of import taxation, which is characterized by high tax rates and numerous exemptions, both of which hinder production of traded goods. To begin with, imports are subject to two types of tax in Tonga, customs duty and a port and services tax Standard duty rates range from 0-45 percent, while protective rates of as much as 350 percent are levied on a number of products, including cigarettes, beer, paint, and wire fencing. The port and services tax is levied at a flat 20 percent of the c.i.f. value of imports.

The system is further complicated by a profusion of exemptions. Certain goods are exempt from both taxes. Others are free from only one: fertilizers, for example, are exempt from port and services tax but not customs duty, while the reverse is true for aircraft fuel. In addition, numerous entities are entitled to exemptions, including the reigning monarch, the public sector, diplomatic missions under certain technical assistance agreements, and returning Tongans bringing their personal effects. Moreover, firms registered under the IDI Act--mainly manufacturing and tourism firms, but also including farmers and fishermen producing for export--may import capital goods, including motor vehicles, and raw materials duty-free for a period of up to two years. If the firms are export oriented, their imports are fully exempt from port and services tax, as well.

Despite these exemptions, import taxes provide substantial funds to the government budget. In 1993/94, trade taxes accounted for 48 percent of budgetary revenue--a high ratio even by the standards of the South Pacific, where countries normally rely on import taxation (see below).

Import Duties--A Comparison

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Sources: Staff and authorities’ estimates; IFS Yearbook 1994 and GFS Yearbook 1994, C. Browne with D. Scott, Economic Development in Seven Pacific Island Countries, IMF, 1989. All countries except for Tonga and Western Samoa are on a calendar year basis. In 1991, Western Samoa shifted to a financial year running from July 1 to June 30.

At the same time, the taxes impose a heavy burden on the private sector. Trade taxes amounted to 33 ½ percent of total import value in 1993/94--once again, a high ratio even by comparison to neighboring countries. Most relevant, trade taxes amounted to 57 percent of private dutiable imports in 1993/94. Since these are imposed on top of freight and insurance costs of about 21 percent of the f.o.b. value, they push up the landed cost of imports to about 90 percent more than the export price in supplier countries, such as New Zealand.

This situation has hindered export expansion and diversification in a number of ways. First, high import taxes have made it difficult for firms to compete in world markets directly, by raising the cost of imported inputs. Second, they have hampered firms indirectly, by increasing the cost of local inputs. This has occurred because the high tariff wall has sheltered import-competing firms (and nontradeable services), allowing them not only to charge more, but to pay more for labor and land. Since skilled labor is generally fully employed in Tonga,45 exporting firms have had to match these higher wages in order to attract and retain workers--as export-oriented manufacturing firms have already found. Third, the complex system of rates and exemptions has subsidized certain activities at the expense of other, potentially more efficient ones. In particular, the exemption provided to government departments, corporations, and agencies has given them a significant advantage over private sector firms across the wide range of commercial activities in which the two compete.

These problems are all well-recognized by the authorities. In recent years, they have attempted to address them by offering import tax exemptions to export-oriented firms. However, while this has helped alleviate the first problem, it has not addressed the second--and has only aggravated the third. For these reasons, consideration is being given to a different approach. Under this plan, rates would be brought down sharply for all goods, and rationalized so that similar goods are subject to similar rates. For example, a low rate would be reserved for capital goods, intermediate goods, and raw materials; a standard rate established for most consumer goods; and a higher rate introduced for certain luxury products.

The key problem is financing these reductions, since the budget is dependent on import taxation for the bulk of its revenues. One way to do this would be to scale back exemptions sharply as rates are brought down. Even if this were done, however, it would also be necessary to develop other forms of taxation--especially consumption and income taxes--in order to ensure that the burden is shifted away from the export sector (which is disproportionately affected by import taxes) and spread more generally throughout the economy.

ANNEX II Tonga: Summary of Tax System as of March 1995

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Source: Data provided by the Tongan authorities.

APPENDIX

Table 6.

Tonga: Gross Domestic Product by Sector of Origin at 1984/85 Prices, 1989/90-1993/94

(In millions of pa’anga)

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Source: Data provided by the Tongan authorities.
Table 7.

Tonga: Gross Domestic Product by Sector of Origin at Current Prices, 1989/90-1993/94

(In millions of pa’anga)

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Source: Data provided by the Tongan authorities.
Table 8.

Tonga: Production of Manufactured Goods, 1989-93

(In thousands of pa’anga)

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Source: Data provided by the Tongan authorities.
Table 9.

Tonga: Output of Small Industries Center, 1989/90-1993/94

(In thousands of pa’anga unless otherwise indicated)

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Source: Data provided by the Tongan authorities.

Data refer to January-December 1994.

Table 10.

Tonga: Tourism Statistics, 1989/90-1993/94

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Source: Data provided by the Tongan authorities.

Based on surveys of the Tonga Visitors’ Bureau; figures differ from the balance of payments data. These series relate to calendar years ending in the respective fiscal year (1993 = 1993/94).

Including cruise ship passengers and crew members.

Data from foreign exchange records that are used in the balance of payments.

Table 11.

Tonga: Consumer Price Index, 1989/90-1993/94

(Annual average percent change)

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Source: Data provided by the Tongan authorities.
Table 12.

Tonga: Central Government Revenue, 1989/90-1994/95 1/

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Sources: Data provided by the Tongan authorities; and staff estimates.

Components may not add to totals because of rounding.

Income from the post office and government store has been netted against their expenditures.

Includes transfers from duty-free shops, and changes in the account balances of self-financing commercial activities referred to as “underline funds” and “revolving funds”.