Tonga
Recent Economic Developments
Author:
International Monetary Fund
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Publication Date:
27 May 1997
eISBN:
9781451837407
Language:
English
Keywords:
ISCR; CR; public enterprise; Tongan authorities; exchange rate; private sector; commercial bank; NRBT note; tertiary sector; foreign exchange; Tonga telecommunication commission
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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/

A01crt01
A01crt01
1/ Statistical year ending June. 2/ An increase indicates an appreciation of the pa’anga. CHART 2

TONGA: RECENT ECONOMIC DEVELOPMENTS, 1993–96

A01crt02
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

Table 15.

Tonga: Development Expenditures plus Net Lending by Source of Funding. 1991/92-1996/97

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Sources: Tonga Ministry of Finance; and Fund staff estimates.
Table 16.

Tonga: National Debt Outstanding, 1991/92-1995/96 1/

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Sources: Data provided by the Tongan authorities; World Bank Reporting System; and Fund staff estimates.

Component may not add to totals because of rounding.

Comprises government and government-guaranteed debt

As of March 31.

Table 17.

Tonga: Public Enterprise Sector (as at 30 June 1995)

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Source: Data provided by the Tongan authorities.

Face value.

Percent of shares held by government; MOF–Part of Ministry of Finance; PMO–Part of Prime Minister’s Office.

Includes some casual workers and part-time workers.

Tonga Investment limited (TIL) is a holding company, including 7 enterprises: Frisco, Home Gas, Pili Quarry, Palm Soap, Pacific Warehouse Co. Ltd., Primary Produce, and Coconut Oil.

Another public enterprise, Tonga Timber limited, was created after June 30, 1995 out of a government department. It is 100 percent government owned and has a staff of 77.

Table 18.

Tonga: Accounts of the National Reserve Bank of Tonga, 1991/92-1995/96

(In millions of pa‘anga; end-period)

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

In April 1993, NRBT notes were issued to replace term deposits of commercial banks.

Defined as money supply divided by reserve money.

Table 19.

Tonga: Bank Credit by Sector, 1991/92-1995/96

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Source: National Reserve Bank of Tonga.

Excludes holdings of government securities.

Table 20.

Tonga: Consolidated Accounts of Deposit Money Banks, 1991/92-1995/96

(In millions of pa‘anga; end of period)

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Source: National Reserve Bank of Tonga.
Table 21.

Tonga: Interest Rate Structure, 1991/92-1995/96

(In percent per annum; end of period)

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

Minimum lending rate was raised to 5.4 percent in June 1995, and to 7 percent in December 1995.

The NRBT notes were introduced in April 1993. Prior to that, the NRBT had long-term deposits from the BOT.

Prior to September 1992, for deposits greater than T$l00,000. After September 1992, interest rates are set on customer basis.

Base rate is the lowest rate charged. Prior to December 1992, it was the preferential rate.

For loans to export-oriented industries, manufacturing and raw materials processing, and tourism activities except restaurants.

Loans less than T$1,000 for activity in agriculture, fisheries, and livestock.

Average rate for saving and time deposits minus average CPI.

Difference between 3-month deposit rate in Tonga and rate on 3-month Australian treasury bills.

Based on lending rate for personal homes and average rate on saving and deposit rate.

Statutory reserve requirements (introduced March 1993) were 5 percent and raised to 10 percent in December 1995. They are not remunerated.

Table 22.

Tonga: Accounts of the Tonga Development Bank, 1991/92-1995/96

(In millions of pa‘anga; end of period)

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Source: Tonga Development Bank.

Direct borrowing by the Tonga Development Bank from foreign sources. The exchange risk is assumed by the government.

Borrowing by the Government from foreign sources for on-lending to the Tonga Development Bank. The exchange risk is carried by the government.

Table 23.

Tonga: Exports by Major Commodity, 1991/92-1995/96 1/

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Source: Tonga Statistics Department.

Values are on f.o.b. basis.

Includes reexports.

Table 24.

Tonga: Imports by Commodity. Category, and Sector, 1991/92-1995/96 1/

(In million of U.S. dollars)

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Source: Tonga Statistics Department.

Values are on c.i.f. basis.

Table 25.

Tonga: Direction of Trade, 1991/92-1995/96

(In percent of total)

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Source: Tonga Statistics Department.
Table 26.

Tonga: Services and Transfers, 1991/92-1995/96

(In millions of U.S. dollars)

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Sources: Tonga Statistics Department, and Fund staff estimates.

Calculated as the difference between official transfer receipts in this presentation, which are based on donor reports, and official transfer receipts in the Tongan balance of payments. The latter are calculated as grants passing directly through the budget plus imports of grants-in-kind, which are believed to be significantly undervalued. Thus, “aid-funded services” captures part of this undervaluation.

Table 27.

Tonga: Disbursements of Official External Loans and Grants, 1991/92-1995/96 1/

(In millions of U.S. dollars)

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Source: Data provided by the Tongan authorities.

Comprises all official external grants and loans at the donors‘ valuation. In contrast to the Tongan balance of payments and budget data, this measure captures all aid-in-kind, including services (e.g., education) given to Tongan residents in the donor country and technical assistance.

Excludes defense aid.

1993/94 includes the World Health Organization and the United Nations Fund for Population Activities.

Table 28.

Tonga: External Debt and Debt Service, 1991/92-1995/96 1/

(In millions of U.S. dollars, end of period)

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Sources: Data provided by the Tongan authorities; World Bank Reporting System; and Fund staff estimates.

Components may not add to totals because of rounding.

Comprises government and government-guaranteed debt.

Percent of outstanding stock of debt at the beginning of the year that was amortized during the year.

ANNEX 1: Tonga: Central Bank Profitability and Indirect Monetary Control1

I. Introduction

1. Tonga’s financial sector has undergone a remarkably rapid transformation over the past decade. A key ingredient was the establishment of a central bank and shift from direct controls to indirect monetary management. However, when challenged by the rapid credit growth in 1994 and 1995, following the opening up of the banking system to competition, the National Reserve Bank of Tonga (NRBT) found itself unable to deploy its indirect instruments fully due to its poor profitability. This annex presents some institutional background, followed by a description of the weaknesses in the central bank’s balance sheet and profit and loss account, and a discussion of the implications of the poor profitability for monetary policy.

II. Institutional Background

The NRBT

2. A milestone in the development of Tonga’s financial sector was the establishment of the NRBT on July 1, 1989, as the country’s central bank. The NRBT assumed all the traditional central banking functions stipulated in its act,2 except for that of the government’s principal banker and fiscal agent which continued to be fulfilled by the BOT.3

3. Responsibility for the issue of currency was transferred from the Commissioners of Currency and the Commissioners of Coinage. The commissioners had been investing the assets backing up the currency circulation with the BOT, which managed the country’s foreign reserves, but via the Treasury. Therefore, at the time of the NRBT’s establishment, the commissioners’ liability for the currency circulation was backed up by a claim on the Treasury; in turn, the Treasury had a domestic currency deposit with the BOT which funded part of the BOT’s foreign assets. While the commissioners’ liabilities were legally transferred to the NRBT, the Treasury’s domestic currency deposit with the BOT was not.

4. The NRBT took over from the BOT the function of managing the country’s foreign reserves. For that, it took the foreign assets of the BOT in exchange for interest-bearing deposits. Thanks to low domestic interest rates, foreign reserves management had been quite profitable for the BOT, and continued to be so for the NRBT, at least until interest rates were deregulated. The government, which had shared in the BOT profits,4 perceived this as a sufficient financial basis for the NRBT.

5. Following the enactment of the Financial Institutions Act in 1991, the NRBT set out to implement market-based monetary control. Until its establishment, monetary control had been based on the government’s policy regarding currency backing,5 and was supported by direct instruments, notably ceilings on lending rates, and credit controls in the form of a maximum loans-to-deposits ratio.6 In July 1991, the NRBT abolished interest rate ceilings and, in March 1993, it replaced the maximum loans-to-deposits ratio with a statutory reserve requirement, unremunerated and set at 5 percent of deposits. Furthermore, in April 1993, it started to issue its own securities on a weekly basis and ceased offering term deposits to the banks. The issue of the notes paved the way for flexible monetary management through primary and eventually secondary or open market operations. The NRBT further complemented its set of instruments with repurchase agreements in notes to replace the rediscount facility. Finally, it has tried to develop the minimum lending rate into a signaling device.

Commercial banks

6. Since its establishment in 1974, the BOT had been Tonga’s sole commercial bank.7 Additionally, there was the Tonga Development Bank (TDB). Against the background of a buoyant economy in the early 1990s, the NRBT concluded that there was a need for additional banks in Tonga. The Financial Institutions Act provided the NRBT with a legal foundation for the licensing and supervision of banks and other financial institutions in Tonga. In late 1993, the NRBT permitted the MBf Bank Limited to locally incorporate, and the ANZ Bank to open a branch.

7. The two new banks were quite successful in building up a base of private and public sector deposits, and capturing a share of the loan market. A number of factors helped them. The government had started to run surpluses which it placed on a competitive basis with all three banks. Moreover, there was pent-up demand for credit because the BOT had been contracting credit in 1993 (and continued to do so in 1994 and 1995) as it cleaned up its portfolio. Growth in commercial bank credit to private sector increased markedly in 1993/94 and 1994/95, before slowing in 1995/96 in response to the tightening of monetary policy (Chart 1). The attempts to tighten monetary policy in 1995 presented the first challenge to the NRBT’s indirect monetary control instruments, and it exposed the weaknesses in its balance sheet.

CHART 1.
TONGA FINANCIAL SECTOR DEVELOPMENTS, 1993-96
A01appcrt01
Source: Data provided by the Tongan authorities. 1/ Deposit money banks (ANZ, Bank of Tonga, and MBF). 2/ Tonga Development Bank.

III. NRBT Balance Sheet and Profitability

8. The NRBT’s balance sheet is beset by a number of structural problems, some that have been there from the inception, and others that arose later. These problems depressed the NRBT’s profitability and with the added costs of indirect monetary control, pushed it into losses starting in 1995/96 (Tables 1 and 2).

Table 1.

Tonga: NRBT-Balance Sheet

(In millions of pa’anga)

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Source: NRBT annual reports.
Table 2.

Tonga: NRBT-Profit and Loss Analysis

(In millions of pa’anga)

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Source: NRBT annual reports.

9. The first weakness has already been alluded to. It is the fact that the government did not transfer the domestic currency counterpart to the currency circulation at the time of the NRBT’s establishment. The amount involved is T$5.3 million, which the NRBT reports as a claim on government (although not as a nonperforming asset, even though the government still has to formally recognize the claim). The effect is that the NRBT does not benefit from any seigniorage income over the currency stock at the time it was established. Currency issue since then has been small.8

10. A second problem is that the NRBT was weakly capitalized to begin with. The paid up capital was only T$l million. Moreover, while the NRBT made profits in the beginning of its existence, most of those were paid out to the government, and the allocations to general reserves were minimal. In total, form 1989/90 to 1994/95, T$7 million was distributed. At end-1995/96, the NRBT’s capital plus reserves amounted to T$2.5 million, or 5 percent of total assets.9

11. A third weakness derives from the NRBT’s decision to invest a substantial amount (20 percent of assets) in a new office building which was completed in 1993/94. The NRBT itself occupies only about 40 percent of the building, and the remainder is leased. The high operating costs of this modern building are likely to make for a poor return (details are not available from the published financial statements).

12. A fourth problem has to do with foreign reserves management. In 1993, the NRBT invested a large part of its foreign assets, which had been short term until then, in Australian government bonds. As Australian interest rates started to rise again in 1994, the NRBT suffered a large capital loss (T$4.3 million). A change in asset valuation practices, from marking to market to historic cost pricing, on the grounds that the NRBT would keep these bonds until maturity, prevented a realization of these losses. This situation affects the NRBT’s profitability indirectly in that it potentially entails opportunity losses since it freezes the currency and maturity composition of the NRBT’s foreign assets.

13. Despite these weaknesses, the NRBT was able to make profits until 1995/96 for two reasons.10 One, its operating expenses grew gradually, as it built up its staff, and with the expenses associated with the new building starting only in 1993/94. The second reason is that prior to the interest liberalization in 1991, and the introduction of NRBT note auctions in 1993, the costs of monetary management were relatively low. In fact, the NRBT made a substantial interest margin on its foreign assets and its liabilities to the BOT.

IV. Implications for Monetary Policy and Remedies

14. In 1995, the NRBT’s poor profitability acted as a constraint on the use its indirect instruments to restrain credit growth. It concluded that it could not afford the interest rates that it would take to absorb the necessary volume of liquidity from the banking system. Unfortunately, large volumes of low interest deposits from the BOT were maturing at that time. Ultimately, the NRBT resorted to increasing reserve requirements—costless since they are not remunerated, and to moral suasion. High reserve requirements risk disintermediation, and moral suasion is distortionary. Another problem with reserve requirements is the unequal distribution of liquidity across the banks. In the event that the requirements have to be increased further, the NRBT may well be forced to give liquidity support to the least liquid banks. It is especially under such conditions that NRBT note issues are a much more flexible instrument.

15. If they continue, the NRBT losses will in a few years eliminate its capital and reserves. While this may have accounting consequences, the monetary implication of ongoing losses is that through them the NRBT injects reserve money, seriously complicating its own monetary management. The straightforward solution would be for the government to strengthen the NRBT’s balance sheet, first, by honoring the outstanding claim, and second, through a recapitalization. An alternative would be for the government to shift some of its deposits with commercial banks to the NRBT. The NRBT could then afford not to roll over an equal portion of its notes, and save the interest on them, without affecting banking system liquidity. However, it would improve the NRBT’s profitability only if the government were willing to accept a below market interest rate on those deposits.

References

  • Asian Development Bank, Tonga: Economic Performance and Selected Development Issues (Manila: June 1996).

  • Bank of Tonga, Annual Report (Nuku’alofa: various issues).

  • Foreign Investment Advisory Service, Kingdom of Tonga: A Review of the Investment Environment (June 1996).

  • Government of Tonga, Report of the Minister of Finance for the year 1995 (Nuku’alofa: various issues).

  • Kingdom of Tonga, Budget Statement for the year 1996-97 (Nuku’alofa: 1996).

  • Kingdom of Tonga, Estimates of Recurrent Revenue and Expenditure and Estimates of Development Funding and Expenditure of The Kingdom of Tonga for the Year Ending 30 June 1997 (Nuku’alofa: 1996).

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  • National Reserve Bank of Tonga, Quarterly Bulletin (Nuku’alofa: various issues).

  • National Reserve Bank of Tonga, Annual Report (Nuku’alofa: various issues).

  • Oh, J., 1994, “Current Economic Trends in the South Pacific,” Pacific Economic Bulletin (December) 9, pp. 1–19.

  • Temu, I., 1995, “Current Economic Trends in the South Pacific,” Pacific Economic Bulletin (December) 10, pp. 1–22.

  • Tonga Development Bank, Annual Report (Nuku’alofa: various issues).

  • Tonga Statistics Department, Labour Force Survey 1993/94 (Nuku’alofa: October 1995).

  • The Economist Intelligence Unit, Pacific Islands: EIU Country Report (London: various issues).

  • The Economist Intelligence Unit, Pacific Islands: EIU Country Profile 1995-96 (London: 1995).

  • World Bank, Pacific Island Economies: Building a Resilient Economic Base for the Twenty-First Century (Washington, D.C.: 1996).

1

Statistical and fiscal years end June 30.

2

Separate data for agriculture, forestry, and fisheries are not available.

3

Tonnes refers to metric tons.

4

The quota was introduced on a voluntary basis in 1992/93 and set at 10,000 tonnes; the next year it was raised to 13,000, with actual exports far in excess. In 1994/95, the quota became binding and was set at 17,000, raised to 17,500 tonnes in 1995/96. In early 1996 it was abolished.

5

Soil depletion has been blamed for the decline in squash production. In view of the increased use of fertilizer, the government has introduced a licensing system for agrochemicals and is now developing guidelines to control the use of these and other hazardous materials.

6

The cost of electricity in Tonga (US$0.30 per kwh) is among the highest in the world, and even higher than in smaller Pacific island countries.

7

Tourism statistics do not distinguish between foreigners and emigrated Tongans on family visit.

8

Estimates of the number of Tongans living abroad range from 45,000 to 100,000, predominantly in Australia, New Zealand, and the United States.

9

In the Tongan budget definition, recurrent expenditures include debt amortization, and revenues include borrowing. However, in this report expenditures and revenues exclude these items in accordance with Government Finance Statistics (GFS). The lack of a consolidated presentation of recurrent and development budgets on a GFS basis complicates a review of expenditures.

10

The latest such plan expired in 1995, and efforts are under way to replace it with an economic strategy and an annually revolving plan.

11

The value of imports exempted from trade taxes was T$13.4 million in 1995/96 (14 percent of total imports), of which T$1.9 million was under the IDI Act. The loss in revenue was T$6.8 million or 11 percent of revenues.

12

Between 1981 and 1995, the number of full-time government workers went up by 60 percent. Tonga now numbers 50 government workers (including casual workers) per 1,000 citizens, high compared even to other small Pacific island economies.

13

Development expenditure and net lending in this presentation is based on donors’ coverage and valuation of official grants. This coverage includes many items not included in the Tongan budget, while valuation also occasionally exceeds Tongan figures.

14

Little information was available concerning the in-kind funded development expenditures in 1995/96.

15

The lower number assumed three quarters of retirees would opt for the lump-sum payment rather than the more generous annuity; the higher number assumed three quarters would opt for the annuity.

16

There it was stated: “The problem with commercial activities within government are two-fold. First, the service or goods produced are not properly costed so prices do not reflect their true cost of production. Secondly, it poses unfair competition with the private sector, which is contradictory to what government wants to promote. The government is endeavoring to reduce these activities and pass them on to the private sector.”

17

Prior to that, the Commissioners for Currency and Coinage were responsible for currency issues, and the BOT managed the country’s foreign reserves. The BOT also acted as the government’s principal banker and continued in that capacity after 1989.

18

As an exception to this rule, it accepts deposits in two branches on remote islands which it took over from the BOT out of social considerations when the BOT decided they were not commercially viable.

19

His Majesty in Council (or Privy Council) is the cabinet of ministers when the King is presiding.

20

At end-1995, ANZ had 21 percent of banking system assets and MBf 11 percent.

21

The origin of this very high capitalization are the BOT’s profits on the country’s foreign assets during the period from 1977 to 1989.

22

See Chapter II for a fuller description of the background to trends in squash and other export commodities.

23

There was also the widespread, largely unrecorded phenomenon of Tongans returning from abroad with large quantities of new or second hand goods, and of Tongans being sent such goods by relatives abroad. Entering duty free as “personal effects,” these goods found their way to the sprawling flea markets where they were sold at large mark-ups.

24

Aid from bilateral donors is now exclusively on a grant basis.

25

Remittances are mostly denominated in US dollars (55 percent), and Australian and New Zealand dollars (19 percent each).

26

The NRBT measures reserves coverage in terms of months of imports of non-aid related goods and services.

1

This annex was prepared by Perry Warjiyo.

2

In Article 4 of the NRBT Act 1988, the NRBT’s principal purpose are described as: to regulate currency issue; manage external reserves; promote monetary stability and a sound financial structure; foster credit and exchange conditions conducive to orderly and balanced economic development; advise the Minister of Finance on banking and monetary matters; be the principal banker and fiscal agent of the government; and to undertake banking business; and the licensing and supervision of financial institutions.

3

For this, the BOT does not charge a fee; it covers its administrative expenses from the spread between its lending rates and the interest it pays on government deposits.

4

Although few profits were paid out, laying the basis for the BOT’s present excessive capitalization.

5

Mandatory 100 percent currency backing for the pa’anga was discontinued in 1969. It was replaced by the guideline that credit creation should be restricted if foreign reserves fell below four months of imports, and that it cease altogether if reserve coverage fell below three months of imports.

6

The lending rate ceiling had been raised from 10 percent to 13.5 percent in July 1989, and the ratio of loans to deposits plus free capital plus reserves had been raised from 60 percent to 65 percent in 1990/91.

7

The BOT is 40 percent owned by the government, 30 percent by the Bank of Hawaii and another 30 percent by the Westpac Banking Corporation of Australia. Westpac has a contract for managing the bank.

8

Since the establishment of the NRBT, currency circulation increased by about T$2 million to T$8.2 million at the end of 1995/96.

9

This is low compared to the capitalization of central banks in neighboring countries: in Fiji it is 9 percent, in Vanuatu 12 percent, and in the Solomon Islands 34 percent.

10

In its first year, NRBT made a profit of T$2.6 million, which then declined steadily, until in 1995/96 it made for the first time a loss of T$0.5 million.

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Cover IMF Staff Country Reports
Tonga: Recent Economic Developments
Author:
International Monetary Fund
Volume/Issue:
Volume 1997: Issue 040
Publisher:
International Monetary Fund
ISBN:
9781451837407
ISSN:
1934-7685
Pages:
65
DOI:
https://doi.org/10.5089/9781451837407.002