This paper describes economic developments in Tonga during the 1990s. From 1993 to 1996, financial policies were quite expansionary. Following the licensing of two new banks, credit growth accelerated in 1994. The National Reserve Bank of Tonga initially adopted an accommodating stance, but in December 1995, tightened monetary policy significantly. Hampered by its poor profitability in the use of indirect monetary instruments, it relied on an increase in reserve requirements. Meanwhile, fiscal policy had added further to demand pressures with the recurrent budget surplus declining, owing to a cost-of-living adjustment to government wages.

Abstract

This paper describes economic developments in Tonga during the 1990s. From 1993 to 1996, financial policies were quite expansionary. Following the licensing of two new banks, credit growth accelerated in 1994. The National Reserve Bank of Tonga initially adopted an accommodating stance, but in December 1995, tightened monetary policy significantly. Hampered by its poor profitability in the use of indirect monetary instruments, it relied on an increase in reserve requirements. Meanwhile, fiscal policy had added further to demand pressures with the recurrent budget surplus declining, owing to a cost-of-living adjustment to government wages.

I. Overview

1. Tonga is an archipelago, located on the dateline 1,500 kilometers south of the equator, counting 36 inhabited islands and stretching over 1,000 kilometers of ocean. Its population of about 100,000 enjoys a middle-income standard of living (with a per capita GDP in 1995/96 of US$1,800). Tonga is a constitutional monarchy in which substantial powers are assigned to the King and the nobility. Key features of the economy are its openness, the dominance of agriculture, the large public sector, and its dependance on grants and remittances (Charts 1 and 2). Like in other Pacific island economies, growth potential has been kept low by constraints such as remote location, small domestic market, narrow resource base, the scarcity of skilled labor, and a vulnerability to shocks.

CHART 1

TONGA: ECONOMIC DEVELOPMENTS, 1984/85-1995/96 1/

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1/ Statistical year ending June.2/ An increase indicates an appreciation of the pa’anga.
CHART 2

TONGA: RECENT ECONOMIC DEVELOPMENTS, 1993–96

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Source: Data provided by the Tongan authorities.

2. In the early 1990s, Tonga enjoyed several years with unusually high growth reflecting the success in exporting squash to Japan. More recently, growth appears to have reverted to its long-term trend on the order of 1½ percent annually; in 1995/96,1 real GDP actually contracted by 2 percent. This reflected the shifting circumstances for squash production which peaked in 1993/94 and has since fallen by half. Production has been adversely affected by diseases, marketing problems, soil depletion, shortage of crop financing, and growing foreign competition.

3. From 1993 to 1996, financial policies were quite expansionary. Following the licensing of two new banks, credit growth accelerated in 1994. The National Reserve Bank of Tonga (NRBT) initially adopted an accommodating stance, but in December 1995, tightened monetary policy significantly. Hampered by its poor profitability (see Annex for details) in the use of indirect monetary instruments, it relied on an increase in reserve requirements. Meanwhile fiscal policy had added further to demand pressures with the recurrent budget surplus declining, due to a cost-of-living adjustment (COLA) to government wages, and the overall deficit actually turning into a deficit, largely on account of foreign-financed development projects.

4. Tonga’s traditionally large trade deficit started to widen appreciably in 1993/94 as squash exports declined, while imports—fueled by the expansionary financial policies—continued to rise. Consequently, the current account deficits widened, and foreign reserves, which had reached 7 months’ import coverage in 1993, declined to 3½ months’ import coverage in 1995/96. The pegged exchange rate system has been maintained, as has Tonga’s open exchange system. The exchange rate of the pa’anga has been reasonably constant in its real effective terms since it was tied to a basket of three currencies in 1991; most recently, it has been appreciating in line with the strengthening of two of those three currencies.

5. The following chapters expand on these developments and also provide some of the institutional background.

II. Output, Prices, and Employment

A. Production by Sectors

Agriculture, forestry, and fisheries

6. The primary sector, comprising mostly subsistence agriculture and fisheries and some forestry, dominates output in the Tongan economy, accounting for 30 percent of output and 40 percent of employment.2 In the early 1990s, rapid agricultural growth, owing mainly to the success with squash, led to overall GDP growth rates well above the historical average (Tables 1, 6, and 7). More recently, squash harvests have been disappointing and contributed to the decline in GDP recorded in 1995/96.

Table 1.

Tonga: Real Sector Developments, 1991/92-1995/96

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Source: Tonga Statistics Department.
Table 2.

Tonga Central Government Operations, 1991/92-1996/97

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Sources: Tonga Ministry of Finance; and Fond staff estimates.

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

Budget statement figures have not been adjusted for the estimated implementation rate.

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

Revenue less current expenditure.

Table 3.

Tonga: Monetary Survey, 1991/92-1995/96

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Source: National Reserve Bank of Tonga.
Table 4.

Tonga: Banking Survey, 1991/92-1995/96 1/

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Source: National Reserve Bank of Tonga.

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

Table 5.

Tonga: Balance of Payments Summary, 1991/92-1995/96

(In millions of U.S. dollars)

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Sources: Data provided by the Tongan authorities; and Fund staff estimates.
Table 6.

Tonga: Gross Domestic Product by Sector of Origin at 1984/85 Prices, 1991/92-1995/96

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Source: Tonga Statistics Department.
Table 7.

Tonga: Gross Domestic Product by Sector of Origin at Current Prices, 1991/92-1995/96

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Source: Tonga Statistics Department.
Squash

7. Squash production has become very important to the Tongan economy, accounting for half of merchandise exports in 1995/96, all of it to Japan. Butternut squash was introduced in 1988 by a New Zealand firm, which hoped to supply the Japanese market during the November-January period, between the end of the Japanese growing season and the beginning of exports from New Zealand. This experiment was highly successful: climatic conditions proved favorable and farmers quickly learned the necessary skills.

8. The crop proved very profitable, even after prices dropped sharply in 1994. Additional stimulus came from the government In 1990/91, earnings from agriculture were made exempt from income tax for five years; this exemption was extended for noncorporate growers in 1995/96. Moreover, 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. Furthermore, the government facilitated crop financing by channeling funds to the Tonga Development Bank (TDB) for on-lending.

9. As a result of these incentives, Tongans entered the squash growing business in great numbers, often without much previous agricultural experience (there were an estimated 2,000 independent growers in 1994/95), and export volumes increased rapidly. From about 4,000 tonnes3 in 1989/90, exports rose to nearly 6,000 tonnes in the following year, then soared to 18,500 tonnes in 1991/92 (see Table 23 listing exports by commodity). 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.4 After this system was introduced, exports initially retreated to under 10,000 tonnes, but they rebounded to over 18,000 tonnes in 1993/94, far in excess of the quota.

10. From then on, squash production gradually declined. In 1994/95, production was 17,000 tonnes but the prices obtained dropped due to quality problems. The accompanying drop in incomes caused a shake-out among growers, and plantings for the 1995/96 season were halved. The 1995/96 crop was further adversely affected by a drought and the fact that the export quota was announced late in the planting season. As a result, exports in 1995/96 fell to merely 9,000 tonnes but because the scarcity pushed up prices in Japan, export receipts fell by only 6 percent and the income effect was limited. The export quota, which had been unpopular with the growers, was dropped in advance of the 1996/97 planting season. Nonetheless, affected by diseases, the 1996/97 harvest was only about 10,000 tonnes, while prices were about half the 1995/96 level.

11. Reduced prices and increasing production costs, especially of fertilizer, have apparently changed the economics of squash production, prompting the exit of many small growers.5 A contributory factor is that banks are less willing to provide crop financing, except to well-established growers, following large scale defaults on their loans to squash growers. Finally, the future of squash production in Tonga will also depend on how successful competitors are in shifting their harvests into Tonga’s production period.

Other crops

12. Vanilla, cultivated mainly in the northern island group of Vava’u, has also been a generally profitable export crop. However, harvests in recent years have been disappointing, in particular in 1995/96 when high rainfall prevented pollination. Average world market prices have come down, even though growers specializing in organically grown vanilla obtained high prices. Also reasonably successful has been root crop production, especially yams, exported to Tongan expatriate communities in Australia, New Zealand, and the United States.

13. Exports of fish have been growing slowly, concentrated in long-line fisheries offshore. Production remains far below potential, with the catch in 1995/96 only about half the peak achieved in 1987/88. Problems afflicting fisheries are in meeting the quality standards that gain access to the Japanese market, and high transportation costs. The largest domestic fishing operation is the state-owned company Sea Star. The government does not allow foreign fishing, nor majority foreign-owned companies operating out of Tonga. Near-shore fishing, most of which goes to the subsistence sector, has reacted a level where concerns for the overfishing of certain varieties are growing. A separate Ministry for Fisheries was established in 1991 to develop policies and regulations.

Manufacturing and construction

14. Starting in the late 1970s, the government made significant efforts to develop manufacturing. The principal one was the enactment, in 1978, of the Industrial Development Incentives (IDI) Act (Box 2, Chapter III). In 1980, the Small Industries Center (SIC) was created to assist with providing buildings, utilities, and infrastructure facilities. The TDB was set up in 1977 to assist export-oriented businesses by providing loans at below-market interest rates. Despite these efforts, the share of manufacturing in GDP has not grown significantly over the past 15 years. The boost to manufacturing provided by the IDI Act proved temporary. A number of companies disappeared after their tax holidays ran out. Another factor was the erosion of trade preferences vis-à-vis Australia and New Zealand under the South Pacific Regional Trade and Economic Cooperation Agreement (SPARTECA) as these countries lowered their tariffs for clothing and footwear.

15. With the sector as a whole on the decline—manufacturing shrank by 4 percent in 1994/95 and by 1 percent in 1995/96—enterprises that were able to redirect production to import substitution recorded an increase, notably food, beverages, and tobacco (Table 8). Although the number of companies at the SIC has remained stable, the number of employees has been halved since 1990/91, partly because of a shift to more capital intensive activities. International competitiveness of manufacturing suffers from high operating costs, especially for utilities6 and transportation, delays in obtaining approvals, high duty rates, and shortages of skilled labor. Moreover, labor costs are high in comparison to Southeast Asian economies.

16. Construction activity is heavily influenced by externally financed development projects. The decline in 1994/95 followed two years of high growth as a number of projects were completed. In 1995/96, housing and nonresidential building declined but construction activity still increased, owing to the Japanese-funded road rehabilitation project. The sector of mining and quarrying (sand and coral) also benefited from this road project.

Tertiary sector

17. The tertiary sector recorded an average growth rate of 3 percent from 1990/91 to 1994/95 spread over all categories. The decline in 1995/96 was led by the commerce, restaurants, and hotels subsector, which was, at least in part, the result of depressed tourism activity. The number of tourist arrivals decreased by 4 percent in 1995/96 (Table 9).7 A major constraint on the tourism sector is the lack of good quality hotels: Tonga has currently 540 salable rooms, of which 90 are at the three-star level and the rest below.

B. Prices and Wages

Prices

18. The Reserve Bank compiles an underlying CPI in addition to the regular, “headline” index. The underlying CPI excludes some 20 percent of the items of the headline CPI basket, namely, items with volatile prices such as domestic fruits and vegetables. The CPI was rebased to November 1995, starting with the December quarter of 1995, and at the same time the composition of the basket was changed to reflect the 1992/93 Household Income and Expenditure Survey. The weights for the transportation and miscellaneous items categories were increased by 170 percent and 30 percent, respectively, while the largest decreases were recorded for the housing and food groups.

19. In 1990 and 1991, Tonga experienced inflation of around 10 percent, the result of a large wage increase in 1989/90 combined with the large fiscal deficits, high import prices, and a drought in 1992 (Table 10). In the following years, fiscal restraint helped subdue inflationary pressures and the CPI trended downward. Inflation remained low in 1994/95, despite the acceleration in credit which was felt mainly in the balance of payments, but picked up in 1995/96, and by the June quarter of 1996 had readied a 12-month rate of 3.8 percent (4.8 percent underlying).

Labor market

Labor force and employment

20. The labor force in Tonga was last estimated in 1993/94 at 37,000 or 38 percent of the total population (Table 11). A steady emigration has kept the growth rate of the labor force down to between 1 and 1.4 percent.8 The selective nature of emigration has caused shortages of certain types of skilled workers. The average unemployment rate was estimated at 12 percent, with youth unemployment reaching almost 20 percent. Of the labor force, 40 percent was employed in the agriculture and fisheries sectors, 26 percent in the community, social, and personal services sectors, and 22 percent in manufacturing.

Wages

21. Statistical information on wages, other than for the central government, does not exist. In the government sector, COLA have tended to take place about every five years. One such adjustment took place in 1995/96 when government salaries and wages were increased by 10 percent in three installments. This sparked a wage adjustment in the public enterprise sector, reportedly of a much larger magnitude, further widening the already considerable wage gap with the central government. Manufacturing wages are among the lowest in the economy.

III Public Finance

A. Central Government

Structure and overview

22. The central government budget, which includes allocations to the island councils, is normally approved by the Legislative Assembly in late June or early July for the fiscal year beginning July 1. Additional current and development expenditures, not included in the budget, require a supplementary appropriations. The government’s basic budget strategy is to balance recurrent expenditures with revalues,9 and finance development expenditures mainly from foreign grants and loans on concessional terms. The Treasury Department in the Ministry of Finance oversees the formulation of both recurrent and development budgets; the development budget is drawn up in cooperation with the Central Planning Department and the sectoral ministries, in line with the priorities set out in the five-yearly Development Plan.10

23. The 1996/97 Budget Statement contained a number of innovations. It imparted a medium-term orientation to the fiscal policy framework by adopting four fiscal limits, namely:

  • recurrent expenditure shall be kept below 30 percent of GDP;

  • disbursed outstanding debt shall be kept below 60 percent of GDP;

  • the debt-service ratio shall be kept below 50% of the proceeds from the export of merchandise; and

  • foreign reserves shall be kept at an adequate level of around 3 to 4 months’ import coverage.

24. A second innovation was that the budget formulation involved a dialogue between the Ministry of Finance and the sector ministries, and was based on Cabinet approved guidelines. Thirdly, government pensions, which used to be the balancing item, inevitably requiring supplementary appropriations, for the first time were realistically budgeted for, at 7 percent of payroll. The Ministry is working toward the introduction of Program Performance Budgeting (PPB), starting with the 1997/98 budget, and in tandem the fiscal accounts are being computerized.

25. Having recovered from a period of large deficits, fiscal policy again turned expansionary in 1993/94 (Table 2). The recurrent surplus, which had reached 4 percent of GDP in 1993/94, declined to 2.5 percent in 1995/96, largely the result of the 10 percent COLA of government wages which occurred in 1995/96. The overall balance on a Government Finance Statistics (GFS) basis (consolidating recurrent and development expenditures) swung from a surplus of close to 5 percent of GDP in 1993/94 to a deficit of 1 percent of GDP in 1995/96 on account of large aid-financed projects (power development and road upgrading). The 1996/97 budget constrained recurrent expenditures to the 1995/96 outcome but envisaged an increase in development expenditures.

Revenue

26. The most important revenue source in Tonga is foreign trade taxation, at around 12 percent of GDP in 1995/96, or 40 percent of total revenue, split almost evenly between Customs Duties and Port and Services Tax (PST). Income and sales taxes make up the bulk of the remainder (Box 1). Total revenue as a share of GDP has remained stable in recent years at around 26-27 percent (Table 12).

27. The tax system is characterized by large exemptions and deductions, notably the tax and duty exemptions under the IDI Act (Box 2), and the duty, PST, and sales-tax exemption for the whole of the public sector.11 The government has recognized the problems associated with the heavy reliance on trade taxation and the narrow tax base. It announced in the 1996/97 Budget Statement its intention to revise the existing taxation system including both the form and rate of trade taxes, income taxes, and sales taxes to become more progressive, equitable, simple, efficient, and market oriented.

Tonga: Tonga Tax System

Personal income tax:

  • On worldwide income; tax-free threshold T$2,500; single tax rate of 10 percent.

Corporate income tax:

  • Multiple rates; companies not incorporated in Tonga, 37.5 percent on the first T$50,000 and 42.5 percent on the balance; designated export companies, 17 percent; other resident companies, 15 percent on the first T$100,000 and 30 percent on the balance.

Sales tax:

  • Single ad valorem rate (5 percent) on retail sales of imported and domestically manufactured goods and some services.

Customs duties:

  • Levied at ad valorem rates on the c.i.f. value of imports; specific duties for a few items, including tobacco products and alcoholic beverages; rates range from zero to 45 percent.

Port and services tax:

  • Single rate (20 percent) ad valorem tax levied on the c.i.f. value of all imports.

Stamp duties:

  • Levied on a specified list of documents; specific rates apply, although in such a way that they come close to ad valorem rates.

28. Income tax revenue benefitted in 1995/96 from the collection of substantial tax arrears: from T$9.2 million (4 percent of GDP) in June 1995, arrears were brought down to T$5 million in June 1996. Also, by raising taxable income, the 10 percent COLA for government workers boosted income taxes. With a one-year lag in the collection of income tax, other than from government employees, the economic recession of 1995/96 did not affect income tax revenue that year. The income tax exemption for the agricultural sector was lifted in 1995/96 but only for corporate growers.

Tonga: Industrial Development Incentives (IDI) Act

The IDI Act was enacted in 1978 to actively encourage entrepreneurship for the establishment and growth of industries and tourism; its scope was later expanded to include export agriculture. In addition to the ordinary business license, an investment license under the IDI Act is required for an enterprise wishing to invest in processing; manufacturing; assembly, including packaging; export farming; export fishing; and provision of prime facilities for the tourism industry (accommodation, vessels, and tourist attractions).

Under the IDI Act, tax incentives are available as well as tax holidays and special depreciation allowances to approved enterprises. Generally, tax holidays are for up to 15 years for new projects and for 5 years for expansions. During the holiday period, enterprises are exempt from the payment of income and withholding tax and their shareholders are also exempt from taxation of dividends.

An enterprise awarded a development licence may import capital goods free of customs duty for up to two years from the date of issuance of the licence. Semi-finished products and raw materials used in export production can be imported free of duty for the duration of the licence. Only 50 percent of the port and service tax is owed on imports of capital goods, and the PST is waived or fully refundablë on semi-finished goods and raw materials eligible for duty-free entry.

Expenditure

29. Following a period of fiscal consolidation with emphasis on recurrent spending (reduced to 22 percent of GDP in 1993/94), both recurrent and development spending increased in 1994/95 and 1995/96 and the fiscal balance deteriorated. The increase in current expenditures in 1995/96 owed much to the 10 percent COLA paid that year to government workers (Table 13). Recurrent expenditures are dominated by wages and salaries which made up 54 percent of total in 1995/96. Their large share has crowded out expenditures on maintenance and operations (down to 7 percent of total) and purchases of goods and services (down to 13 percent).12

30. Comprehensive information on development expenditures has to be compiled from the sources of funding (both cash and in-kind), using donors’ coverage and valuation of grants (Tables 14 and 15).13 A large increase occurred in 1994/95 on account of a major road upgrading project funded with grants from Japan. In 1995/96, the road upgrading continued and additionally there was a power development project financed by the Asian Development Bank.14 The 1996/97 budget envisaged a large increase in development spending, to 40 percent of GDP, on account of, inter alia, airport and water supply development projects, but the experience is that actual implementation is usually only half the amount budgeted.

Financing and debt

31. Financing of the budget comprises three distinct components: domestic financing, foreign financing, and drawings from the Tonga Trust Fund (Table 16). Recourse to domestic financing was heavy in 1989/90 and 1990/91, largely in the form of development bonds, and of ways and means advances by the NRBT. Subsequently, the fiscal position has improved, and the government has gradually rebuilt its deposits and is once again a creditor to the banking system (the government accounts are with commercial banks).

32. Foreign financing has increased gradually in recent years, rising from less than ½ percent of GDP in 1990/91 to 3½ percent of GDP in 1994/95. While grants from traditional donors have stagnated, Japan has become a new major source of grant aid, spent on specific construction projects.

33. 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 proceeds from the issuance of Tonga Protected Persons passports. Since 1992/93, accrued interest has been transferred to the budget for making payments on external debt. Additionally, a number of drawdowns have taken place, such as in 1992/93 to recapitalize Royal Tongan Airlines, and in 1995/96, to finance the construction of a new court house in Vava’u and upgrade the Tonga High Commission in London.

34. Public debt outstanding at end 1995/96 was estimated to be 42 percent of GDP, with domestic debt 7 percent and external debt (mostly concessional) 35 percent. Additionally, the government has a large unfunded legal liability on account of its noncontributory pension scheme for government workers. As of June 1995, the liability was actuarially calculated at between T$78 and T$140 million, equivalent to 10 to 20 percent of payroll for the next 30 years, or 36 to 64 percent of 1995/96 GDP.15

B. Public Enterprises

35. Tonga’s public enterprise sector is large and diverse. It comprises 13 major nonfinancial enterprises (or statutory bodies), including a holding company with seven subsidiaries; two financial institutions; plus substantial shareholdings in five enterprises (Table 17). The activities of the nonfinancial enterprises include utilities, tourism, and transportation, and the shareholdings are in banking, brewery, and airlines. Total employment of all public enterprises combined is around 1,650.

36. Available information on the performance of the public enterprises is sketchy. It appears that most public enterprises have been performing poorly: they did not require any explicit subsidies, but neither did they pay taxes nor a return on invested funds. In 1994/95, the government earned a return of only 3.5 percent on its total portfolio of equity and loans. As at June 30, 1995, the government had invested a total of T$26.5 million by way of equity in corporatized public enterprises, representing mostly contributions from aid donors. This sum does not include the value of shareholders’ funds in former departmental activities now operating in the form of Boards (such as the Water Board) or Commissions (such as the Electricity Commission, the Telecommunications Commission, and the Broadcasting Commission); shareholder equity in those four establishments totaled at least T$13.7 million. The government had further advanced funds totaling T$31.5 million to various public enterprises, of which T$27.2 million was still outstanding at end-June 1995. A large part of these advances comprised on-lending from the Asian Development Bank. Thus, the total outlays outstanding amounted to T$67 million. The total return to the government in 1994/95 was T$0.5 million in interest and T$1.9 million in dividends (from the BOT, the NRBT, and Air Pacific).

37. The government has acknowledged the need to improve the performance of the public enterprise sector, most recently in its 1996/97 Budget Statement.16 It announced the establishment of a public enterprise monitoring unit in the Ministry of Finance. It already set in motion in 1990 a process of corporatization but so far only a few enterprises have been corporatized and without much effect on their operations. There have not been any significant privatizations.

IV. Money and Banking

A. Institutional Structure

38. Tonga’s financial system comprises the National Reserve Bank of Tonga (NRBT), the country’s central bank; three commercial banks; and the Tonga Development Bank (TDB). It has undergone a rapid transformation over the past decade, with the establishment of the NRBT and the increase in the number of commercial banks from one to three.

39. The NRBT was established in 1989 to carry out the standard central banking functions.17 The commercial Bank of Tonga (BOT), in existence since 1977, is 40 percent owned by the government, and 30 percent each by the Bank of Hawaii and Westpac, and is run by the latter under a management contract. In late 1993, two new banks were licensed, the MBf Bank, a locally incorporated joint venture with the MBf Finance Company of Malaysia as the foreign investor; and the ANZ Bank, a branch of the Australia and New Zealand Banking Group Ltd., of Australia. The TDB, set up in 1977, is 95.7 percent owned by the government and the remainder by the BOT. It was established in 1977 to foster the agricultural sector and rural development using resources obtained mainly from concessional external borrowing; it does not accept deposits.18

B. Monetary Instruments

40. The monetary objectives of the NRBT are defined as promoting monetary stability and a sound financial structure, and fostering conditions conducive to the economic development of the country. The NRBT pursues these objectives in close consultation with the government. Most changes in monetary instrument settings require approval of His Majesty in Council.19 The NRBT Governor is appointed by the King for a period of five years and is eligible for reappointment. Responsibility for policy and affairs lies with the Board of Directors which comprises, in addition to the Governor, six otter directors appointed by the King; the King also appoints the Chairman of the Board, presently the present Prime Minister; the Secretary to the Treasury represents the Ministry of Finance on the Board. The operational target of monetary policy is an adequate supply of foreign reserves so as to safeguard the credibility of the pegged exchange rate regime. The NRBT has defined 4 to 5 months’ coverage in terms of non-aid related goods and services as comfortable and three months the minimum. It has at its disposal a range of instruments to conduct indirect, market-based monetary control.

41. In 1993, the NRBT began weekly issues of notes designed to become the primary method for influencing banking system liquidity. The notes can be purchased by any entity but in practice most are bought by commercial banks and the remainder by the TDB. However, poor profitability prevents the NRBT from deploying this instrument to its fullest (Annex). It rejects all bids that fall outside a preannounced narrow interest rate range and consequently often cannot sell the desired volume of notes. The maturities it offers range from 28 days to 5 years.

42. The NRBT introduced reserve requirements in 1993 for prudential as well as monetary policy purposes. The requirements are calculated on the basis of outstanding deposit liabilities at the end of the preceding month, and reserves must be maintained on a daily basis throughout the following month. Required reserves are unremunerated. Initially set at 5 percent, requirements were raised to 10 percent in December 1995. The highly uneven distribution of liquidity across the banks, with most of it concentrated in the BOT, impairs the effectiveness of this instrument.

43. To assist banks with their short-term liquidity needs, the NRBT offers repurchase agreements (repos) on its notes and government securities. The repos are priced at 3 percentage points above the minimum lending rate for the first ten days and 6 percentage points after that. Fluctuations in liquidity force all banks from time to time to resort to this facility. The statutory minimum lending rate, raised to 7 percent in December 1995, derives its leverage mostly from the fact that it determines the price of repos. Hampered in the use of its monetary instruments, and confronted with excessive credit growth that was depleting foreign reserves, the NRBT also relied heavily on moral suasion throughout 1995 and 1996.

C. Recent Developments

Money and credit

44. The licensing of two new commercial banks in late 1993 introduced competition into the banking system. A rapid increase in credit was the result, while liquidity rose and net foreign assets declined (Tables 3 and 4).

45. The new banks were able to gain market share quickly because credit had been restrained for two years as the BOT wrote off substantial amounts of nonperforming assets; in 1993/94, overall credit actually contracted.20 Moreover, the economy was buoyant with the proceeds from squash exports. Commercial bank credit to the private sector grew rapidly, by 24 percent in 1993/94 and 39 percent in 1994/95. Most of the lending was to three sectors: personal lending, which tripled; commerce and trade, which doubled; and housing, which grew by half (Table 19).

46. The expansion in lending was funded from deposits the new banks attracted away from the BOT, which in turn ran down its holdings of NRBT notes. Nongovernment deposits increased by 45 percent in the three years following 1992/93 (Table 20). Term deposits increased particularly fast in response to a rising interest margin over demand deposits.

47. The NRBT accommodated the rapid credit growth during 1993/94 and most of 1994/95, permitting a reduction in the volume of outstanding notes. It was motivated by a desire to give the new banks a chance to establish themselves. In early 1995, the NRBT became concerned with the pace at which foreign reserves were declining from their peak of 7 months’ import coverage in 1992/93. It engaged the banks in a discussion on the pace of credit growth and urged them to redirect their lending from personal and housing loans toward export-oriented and investment activities. It also raised the interest on its notes slightly, suspended its rediscount facility, and, in May 1995, raised the minimum lending rate with a symbolic amount (from 5.25 to 5.4 percent).

48. The measures failed to arrest the decline in reserves, which reached 4½ months’ import coverage by December 1995, and the NRBT felt compelled to take more drastic action. After the necessary approval from the Privy Council, it announced on December 8, 1995, an increase in the reserve requirement to 10 percent (effective as of February 1996); and an increase in the minimum lending rate from 5.4 percent to 7 percent. The NRBT also commenced more active sales of notes. It reinforced its instruments with strong moral suasion aimed at keeping credit to the level of October 1995. In combination with the economic recession that had set in by then, time measures were successful in restraining growth in monetary aggregates: in 1995/96, broad money grew only by 3 percent and private sector credit by 10 percent; foreign reserves stabilized at about 3½ months of imports at the end of 1995/96.

Interest rates

49. Interest rates were liberalized in July 1991, as part of the move toward indirect monetary control (Table 21). The NRBT has kept rates on its notes in line with bank deposit rates. Bank deposit rates have tended to be positive in real terms, but the nominal interest differentials with Australia and New Zealand have been consistently negative and, since 1994/95, widening as rates in those countries increased sharply. The spread between deposit and personal home lending rates, after an initial drop in 1994/95 attributed to the heightened competition, widened again in 1995/96, probably reflecting an increased risk premium as banks started to encounter problems in collection.

D. Banking Supervision and Bank Soundness

50. Under the NRBT Act of 1989 and the Financial Institutions Act of 1991, the NRBT has the authority and responsibility to supervise financial institutions (i.e., commercial banks and the TDB) in order to foster a stable financial system and safeguard the security of depositors’ funds. The development of a supervisory capacity in the NRBT started in earnest in 1993, and is still in its infancy.

51. The presently applicable prudential regulations are those contained in the Financial Institutions Act. They pertain to licensing; capital requirement (5 percent of unimpaired assets); and limits on equity investments (25 percent of capital), on lending to related parties (30 percent), and on single risks (30 percent). Amendments to the Financial Institutions Act are pending that would give the NRBT the ability to flexibly issue prudential regulations in line with international standards, including for loan classification, provisioning and interest suspension, and for risk-weighted capital adequacy, which do not exist at present. The amendments would also strengthen the NRBT’s crisis management authority.

52. Off-site supervision consists of the analysis of monthly reports that banks are required to submit on their financial condition (these reports also form the basis of the monetary statistics). So far there have only been a few experimental on-site inspections, carried out with assistance from the Reserve Bank of Australia. The results of the off- and on-site examinations were discussed between the NRBT Governor and the bank managers. Scarcity of professional staff is an obstacle to the further development of supervision.

53. The fast growth in lending, followed by the economic recession of 1995/96, is likely to have impaired the quality of banks’ loan portfolios. However, in the absence of prudential regulations in accordance with international standards, the financial data of the banks are difficult to interpret. The BOT posted a profit in 1995 of T$3.6 million, despite provisions for doubtful and bad loans equal to 8 percent of its portfolio; the ANZ posted a profit of T$0.3 million, with a negligible volume of nonperforming loans; and the MBf suffered a loss of T$0.3 million, with provisions equal to 2 percent of portfolio. On average, the banks were well capitalized with an average capital-to-liability ratio of about 35 percent, well above the required 5 percent, but the very high capitalization of the BOT distorts this figure.21

Tonga Development Bank

54. The lending of the TDB is concentrated on agriculture and rural development (50 percent of total at end-1995/96) and industry and trade (40 percent). Its main source of funding, in addition to its capital and reserves, are foreign concessional loans, either contracted directly or on-lent by the government. At end-1995/96 these foreign sources accounted for about 44 percent of its assets; and capital and reserves accounted for 41 percent (Table 22). To supplement its liquidity, reduce its reliance on external sources, and better match its funding to the seasonal nature of its lending, the TDB began issuing short-term promissory notes and five-year bonds in July 1993; at end-1995/96, the outstanding volume was T$7.7 million, or about 15 percent of TDB’s assets. The interest rates on these securities varied from 3 percent on one-month notes to 6.5 percent on the bonds.

55. The TDB’s agricultural lending was, to a large extent, to squash growers; other export crops that attracted a lot of credit were vanilla and root crops. Lending for rural developments includes financing of development projects for women, rural developments on the outer islands, and social projects (home improvement, handicrafts, etc.). With the entry of the two new commercial banks, the TDB met increased competition in most of its areas of lending. To retain some of its better agricultural customers, it expanded its services from crop financing to personal and educational loans. Its market share in private sector lending has declined from 50 percent in 1993/94 to 40 percent at end-1995/96.

V. External Sector

A. Overview

56. Tonga’s external balance of payments has been characterized by large trade deficits and negative balances on its service account, for the most part offset by private and official transfer receipts (Table 5). On average, the current account has tended to be in deficit due to foreign loans contracted to finance development projects. In 1993/94 and 1994/95, the current account turned sharply negative, the combined effect of declining squash exports and imports that kept growing due to expansionary monetary and fiscal conditions and an increase in development spending. As a result, international reserves fell sharply, from a peak of seven months9 coverage of imports at end-1992/93 to only 3½ months at end- 1995/96.

B. Exports

57. Despite the decline since 1993/94, squash remained the principal export commodity, accounting for about half of total (Table 23). Fish increased, while manufacturing exports declined further. Squash is exported exclusively to Japan, which explains the dominance of that country as an export destination (Table 24).

58. The drop in squash export proceeds since 1993/94 has been caused by both volume and price developments.22 In 1994/95, prices suffered from a deterioration in quality as production exceeded the storage and shipment capacities. The production cut and resulting scarcity in 1995/96 prompted a recovery in prices. Fish exports benefitted from the purchase in 1993/94 by the state-owned Sea Star Fishing Company of two more vessels; exports consisted mainly of tuna, most of it to canneries in Western Samoa, and sea cucumber, mostly to Asia. Vanilla exports benefitted from the introduction of new technologies, one of them to turn still immature beans into an extract, and another to artificially dry mature beans. Exports of root crops did well in 1995/96, mainly to Tongan expatriate communities in Australia, New Zealand and the U.S. Reportedly there were also large unrecorded exports of those crops to relatives abroad, in return for remittances or goods received for resale. Manufactured exports have been declining continuously since 1989/90; the remaining exports comprise toys, handbags, spectacle cases, shoes, and T-shirts.

C. Imports

59. Imports grew rapidly in 1993/94 and 1994/95, before levelling off in 1995/96 due to the firming of monetary policy and the onset of the recession (Table 24). The increase was concentrated in consumer and intermediate goods—many of latter apparently used for final consumption. Imports of capital goods were steady, with fluctuations due to the implementation of development projects. This composition of imports is reflected in the sectoral distribution. Private sector imports accounted for most of the growth, while public sector imports grew in 1993/94 and 1994/95, when a number of infrastructure projects were carried out. In terms of commodity groupings, the steady increase in food imports was notable. The rise in fuel imports was due to a growing number of cars and increasing electricity consumption.

60. The origin of imports continued to be predominantly Australia and New Zealand for consumer and intermediate goods; Japan became an important supplier of (used) motor vehicles; and Fiji was an important source of petroleum products (Table 25).

D. Services and Transfers

61. Tonga’s services balance has tended to be negative on account of large transportation payments and comparatively smaller travel and other receipts (Table 26). Transportation payments increased in 1993/94 and 1994/95 in line with growing imports. Receipts from telecommunications (captured under “others”) increased markedly in 1995/96. Travel receipts increased, especially in 1995/96; measured as foreign exchange conversions by non-residents, they cover traditional tourists as well as Tongans who are visiting from abroad or who come as seasonal workers in the squash sector. One of the services debits which showed a marked increase was payments for aid-funded services, reflecting technical assistance provided by expatriates in Tonga and scholarships for Tongans to study abroad. Net investment income has remained relatively stable. The impact of declining levels of official reserves was partly offset by higher interest rates. Investment payments were mainly to service Tonga’s external debt.

62. Official and private transfers continued to be Tonga’s major source of foreign exchange, running in 1995/96 at T$21 million and T$34 million, respectively. Net private transfers were mostly remittances from Tongans living abroad and nonprofit organizations. Household remittances increased sharply in 1995/96, suggesting they may have been motivated by the drop in incomes that year due to the economic recession.23 The other component of private transfers were inflows from nonprofit organizations, mainly foreign affiliates of local church denominations, to be used for church (and church school) construction and renovation. For some of these inflows, the churches merely acted as intermediaries between Tongans and their foreign relatives. The increased private payments suggested may have been related to higher transfer to Tongans studying abroad.

63. Net official transfers amounted to an average of US$22 million over the past three years. The increase in receipts for official transfers of US$4 million in 1994/95 was associated with an infrastructure projects funded by the Japanese government (Table 27). Australia and Japan were the largest donors, followed by New Zealand and the European Union.

E. Capital Account and Debt

64. Official loans made up the bulk of Tonga’s capital account; disbursements, which doubled in 1994/95 and remained high in 1995/96, reflected the timing of development projects. The balance on nonofficial capital has oscillated widely but has generally been positive. It is being offset by consistently negative errors and omissions, suggesting unrecorded capital outflows. Foreign direct investment has been minimal, except for 1993/94 when two new commercial banks commenced operations.

65. Total external debt stood at about 36 percent of GDP at end-1995/96 (Table 28). The Asian Development Bank accounted for 42 percent of the total outstanding external debt at end-June 1996; other major lenders have been Germany (23 percent of total debt), the International Fund for Agricultural Development (9 percent), European Investment Bank (9 percent), and the International Development Agency (7 percent) for multilateral loans.24 Most of these loans were contracted by the government for financing development projects, especially in agriculture and infrastructure. Some of them were extended to the TDB for on-lending to the private sector. There were small amounts of commercial loans in the form of suppliers’ credits extended to the Cable and Wireless Company to finance the country’s telephone satellite links.

66. Due to the concessional nature of external borrowing, debt service has remained low; still, as a percentage of exports of goods—the measure adopted as one of the official fiscal limits—it was 16 percent in 1995/96. The effective interest rate over the past three years averaged about 1 percent, and the amortization rate was around 3 percent.

F. Exchange Rate and Foreign Reserves

67. In February 1991, the pa’anga was delinked from the Australian dollar and pegged to a currency basket. The basket comprises the Australian, New Zealand, and U.S. dollars; the U.S. dollar is the intervention currency. These currencies are the principal currencies in which foreign exchange receipts were denominated; the share of the yen was small despite the importance of exports to Japan, partly because there are no remittances denominated in yen.25

68. Effective exchange rates—as measured by the IMF Information Notice System and based on 1980-82 trade and competitor weights—have remained quite stable since the basket was introduced. The real effective exchange rate depreciated in 1994/95 when inflation dipped to zero, but appreciated in 1995/96 on the back of the nominal appreciations of the New Zealand and Australian dollars.

69. The official policy is to maintain foreign reserves in a range of 3 to 4 months import coverage. Reserves follow a pronounced seasonal pattern that reaches its peak in the January quarter, after squash proceeds have come in, and its trough in the September quarter (Chart 2). As a result of the expansionary demand conditions and the concomittant rise in imports, reserves coverage26 has dropped from a high of seven months in 1992/93 to 3½ months in 1995/96.

Table 8.

Tonga: Production of Manufactured Goods, 1990-94

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Source: Tonga Statistics Department.
Table 9.

Tonga: Tourism Statistics, 1991/92-1995/96

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Source: Data provided by the Tongan authorities.

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

Including passengers and crew members.

Balance of payments data from foreign exchange records.

Table 10.

Tonga: Consumer Price Index, 1991/92-1995/96

(Annual average percent change)

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Sources: Tonga Statistics Department; and National Reserve Bank of Tonga (NRBT).

The underlying rate, constructed by the NRBT, comprises 81 percent of headline items. Highly volatile items, such as domestic fruits and vegetables, have been excluded.

Table 11.

Tonga: Population and Labor Market, 1991/92-1995/96

(In persons, unless otherwise specified)

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Sources: Tonga Statistics Department, Labour Force Survey 1993/94; and Tongan authorities.
Table 12.

Tonga: Central Government Revenues, 1991/92-1996/97

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Sources: Tonga Ministry of Finance; and Fund staff estimates.

Income from the post office has been netted against expenditures.

Includes transfers from revolving lands and local community contributions to the development budget. Also includes transfers from the duty free shop and changes in the account balance of commercial activities which were off-budget up to 1992/93.

Table 13.

Tonga: Central Government Current Expenditures, 1991/92-1996/97

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Sources: Tonga Ministry of Finance; and Fund staff estimates.

Excludes amortization on public debt, appropriations to the development budget, and sinking funds, which are included in the Tongan budget presentation.

Excludes government store expenditure.

Information on the share of defense expenditure is not compiled separately.

Table 14.

Tonga: Central Government Development Expenditures by Function, 1991/92-1995/96

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Sources: Tonga Ministry of Finance; and Fund staff estimates.

Expenditures that pass through the Treasury only. In-kind grants are for the most part not included.

Includes administrative buildings and printing