Back Matter

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


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.

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.


  • 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. 119.

  • Temu, I., 1995, “Current Economic Trends in the South Pacific,” Pacific Economic Bulletin (December) 10, pp. 122.

  • 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).


Statistical and fiscal years end June 30.


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


Tonnes refers to metric tons.


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.


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.


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.


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


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


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.


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


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.


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.


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.


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


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.


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.”


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.


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.


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


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


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.


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


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.


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


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


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


This annex was prepared by Perry Warjiyo.


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.


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.


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


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.


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.


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.


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.


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.


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.

Tonga: Recent Economic Developments
Author: International Monetary Fund