Tonga: Joint IMF/World Bank Debt Sustainability Analysis 20081
Author: International Monetary Fund
Publication Date:
31 Jul 2008
eISBN:
9781451837506
Language:
English
Keywords:
ISCR; CR; debt; real GDP; reconstruction loan; Tonga; NPV; flows increase; creating flow; disbursement horizon; debt stock; debt service-to-revenue; Debt sustainability analysis; Debt sustainability; Fiscal stance
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This 2008 Article IV Consultation highlights that Tonga’s economy has shown resilience in the aftermath of the November 2006 riots and is now on a path to recovery. The key factor underpinning this resilience has been private investment. Donor-supported government reconstruction loans are expected to add further momentum to the recovery. However, the global upswing in fuel and food prices has intensified pressure on inflation and external reserves. Tonga’s external position is expected to weaken, reflecting mainly the impact of rising food and fuel prices.

Abstract

This 2008 Article IV Consultation highlights that Tonga’s economy has shown resilience in the aftermath of the November 2006 riots and is now on a path to recovery. The key factor underpinning this resilience has been private investment. Donor-supported government reconstruction loans are expected to add further momentum to the recovery. However, the global upswing in fuel and food prices has intensified pressure on inflation and external reserves. Tonga’s external position is expected to weaken, reflecting mainly the impact of rising food and fuel prices.

Under the baseline scenario, the NPV-of-debt to GDP as well as the NPV-of-debt to export ratios remain above the country-specific indicative thresholds for a prolonged period. Consequently, the Low Income Country Debt Sustainability Analysis (LIC DSA) indicates that Tonga remains at a high risk of external debt distress. At the same time, Tonga benefits from very high remittance inflows (over 30 percent of GDP), which are by far the largest source of foreign exchange earnings and have a countervailing effect by helping to mitigate liquidity risks. Moreover, Tonga’s overall public sector debt indicators, while elevated over the short term, show a decreasing trend over the longer run. Taking into account the cushion provided to the economy by the large workers remittances, the debt should remain manageable.

The LIC DSA suggests limiting the utilization of the nonconcessional reconstruction loan while lengthening its disbursement horizon, together with increases in donor grant and concessional financing to support future developments, are crucial for further improving Tonga's public debt dynamics. Fiscal prudence and policies to enhance growth prospects are also critical underpinnings to debt sustainability over the medium term.

I. Background

The external and public debt sustainability analyses are based on the standard LIC DSA framework.2 The DSA presents the projected path of Tonga’s external and public sector debt burden indicators, and draws some conclusions on the forward-looking sustainability of debt.

Tonga’s total public sector debt stock (including publicly guaranteed debt) declined to 45¼ percent of GDP in FY06/07 from 48½ percent of GDP in FY05/06. External debt to GDP fell as donor financing declined in real terms, while fiscal consolidation to limit domestic budget financing also contributed to a downward trend in domestic public debt to GDP.

Following the civil unrest in November of 2006, the government made a significant effort toward securing financing for the reconstruction of the capital city of Nuku’alofa. This includes donor grants of about $15 million, to be channeled through designated banks to business entities affected by the riots in the form of off-budget, low interest rate loans in the second half of FY07/08. The government also signed a long-term reconstruction loan from the EXIM Bank of China in November 2007. Disbursements of this loan have been postponed, as the government is currently reassessing the overall financing requirement for the reconstruction, with an aim to reduce the overall loan utilization and lengthening the disbursement horizon.3

II. Baseline

Tonga’s DSA builds on the baseline scenario assumptions presented in Box 1. It assumes real GDP growth rate at its historical average, fiscal consolidation, a utilization of $50 million of the reconstruction loan over FY08/09–FY12/13, with an even disbursement of $10 million per year and repayments after a five-year grace period. The baseline assumes no other major external nonconcessional borrowing. The authorities are currently reassessing the overall financing requirement to be supported by the reconstruction loan, with an aim to significantly reduce the overall size of loan utilization while lengthening the disbursement horizon. Accordingly, the assumption on the reconstruction loan under the baseline is likely to be an upper bound.

Tonga: Baseline Vis-a-Vis 10-year Average

(used in the DSA)

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Sources: Staff estimates.

III. External DSA

External debt declined to 40½ percent of GDP in FY06/07, from 42½ percent of GDP in FY05/06, over 80 percent of which is on concessional terms. Under the baseline scenario, the NPV of PPG external debt is projected to increase by about 5 percent of GDP, to 38 percent of GDP by FY12/13, above its indicative threshold of 30 percent, but decline subsequently to 16½ percent of GDP by FY27/28.4 The NPV of debt and debt service-to-revenue ratios also remain well below their respective indicative thresholds of 200 percent and 25 percent over the projection period (Table 1a).

Table 1a.

Tonga: External Debt Sustainability Framework, Baseline Scenario, 2005/06–2027/28 1/

(In percent of GDP, unless otherwise indicated)

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Source: Staff simulations.

Includes both public and private sector external debt.

Derived as [r- g - r(1+g)]/(1+g+r+gr) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and r = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

Assumes that NPV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the NPV of new debt).

Reflecting Tonga’s low exports, the NPV of PPG external debt-to-exports ratio is projected to exceed the respective indicative threshold of 100 percent. However, this is mitigated by the fact that large remittances, which are the largest source of foreign exchange earnings (one half of Tongans live abroad, mostly in Australia, New Zealand, and the United States) have a countervailing effect by helping to reduce liquidity risks.5 Efforts to improve the policy framework, including fiscal consolidation, will also be critical to reduce risks of external debt distress.

Tonga: External Public Debt Indicators

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Represents Low Income Country DSA indicative thresholds for Tonga that is classified as a poor performer under the World Bank’s Country Policy and Institutional assessment.

The alternative scenarios and bound tests indicate Tonga’s vulnerability of its external debt position to negative shocks to remittances and exports (Table 1b, Figure 1). Stress tests also underscore the importance of limiting the nonconcessional borrowing to reduce the risk without undermining debt sustainability. Moreover, a return of key variables, including GDP and export growth, to their historical averages, would imply a deterioration in all ratios.

Figure 1.
Figure 1.

Tonga: Indicators of Public and Publicly Guaranteed External Debt Under Alternative Scenarios, 2007/08-2027/28

Citation: IMF Staff Country Reports 2008, 261; 10.5089/9781451837506.002.A002

Source: Staff projections and simulations.
Table 1b.

Tonga: Sensitivity Analyses for Key Indicators of Public and Publicly Guaranteed External Debt, 2007/08–2027/28

(In percent)

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Source: Staff projections and simulations.

Variables include real GDP growth, growth of GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows.

Assumes that the interest rate on new borrowing is 2 percentage points higher than in the baseline, while grace and maturity periods are the same as in the baseline.

Exports values are assumed to remain permanently at the lower level, but the current account as a share of GDP is assumed to return to its baseline level after the shock (implicitly assuming an offsetting adjustment in import levels).

Includes official and private transfers and FDI.

Depreciation is defined as percentage decline in dollar/local currency rate, such that it never exceeds 100 percent.

Applies to all stress scenarios except for A2 (less favorable financing) in which the terms on all new financing are as specified in footnote 2.

IV. Public Debt Sustainability Analysis

Tonga’s public debt sustainability depends critically on fiscal prudence, the government's commitment to limit new public borrowing, and its adoption of a phased approach to utilizing the reconstruction loan (Table 2a). Under the baseline scenario, total NPV of public debt is projected to increase by 5 percent of GDP by 2012/13 (to 43 percent of GDP), and gradually decline to about 18 percent of GDP over the longer term, benefiting in part from a favorable fiscal policy stance under the baseline scenario. Domestic public debt is also projected to narrow markedly under this scenario, in line with recent policy commitments, to below 6 percent of GDP by 2012/13 and less than 1 percent of GDP by 2027/28.

Table 2a.

Tonga: Public Sector Debt Sustainability Framework, Baseline Scenario, 2005/06–2027/28

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and Fund staff estimates and projections.

[Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt is used.]

Gross financing need is defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period.

Revenues excluding grants.

Debt service is defined as the sum of interest and amortization of medium and long-term debt.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Alternative scenarios and stress tests highlight the vulnerability of the total public debt to growth shocks, which could lead to a sharp deterioration in the debt burden indicators. Furthermore, if other debt-creating flows increase, or the primary fiscal deficit returns to its historical average of 0.6 percent of GDP, the public debt dynamics would become much less favorable. The size of the reconstruction loan also remains a key risk, especially if it were to be fully disbursed in the next two years (FY08/09–09/10), as originally planned.

V. Staff Assessment

Tonga remains at a high risk of external debt distress. At the same time, Tonga benefits from very high remittance inflows, which are the largest source of foreign exchange earnings and have a countervailing effect by helping to mitigate liquidity risks. Moreover, Tonga’s overall public sector debt dynamics, while elevated over the short term, shows a decreasing trend over the longer run, suggesting that it should remain manageable.

Stress tests highlight key vulnerabilities to debt sustainability over the medium term, including lower GDP growth, major external shocks, and borrowing on less concessional terms. This underscores the importance of sound macroeconomic policies to improve growth potential on a sustainable basis, export diversification, and continued efforts in fiscal consolidation. Moreover, limited use of nonconcessional borrowing and increased utilization of donor grants and concessional financing would substantially improve the public debt dynamics and reduce the risk of external debt distress. A sound public debt policy, in line with the medium-term fiscal framework, is also essential to guide future development financing in Tonga. In this context, priorities should be given to projects which would help generate high growth and employment to ensure debt service capacity in the future.

Baseline Assumptions

Real GDP growth is projected to average 1¾ percent over the period 2007/08–2012/13. This reflects a transitory growth stimulus spurred by reconstruction activity in the capital city over the first two years, and a return to a historical average of 1½ percent thereafter. This conservative long-run growth outlook reflects structural impediments which continue to constrain Tonga’s growth potential.

Inflation, as measured by the GDP deflator, is projected to average at around 8 percent over the projection period of 2007/08–2012/13, reflecting partial pass through of world food and fuel price increases assumed by the WEO. In U.S. dollar terms, GDP deflator inflation is projected to average around 4 percent over the same period, reflecting modest depreciation of the pa’anga against the U.S. dollar.

The fiscal balance is projected to achieve a virtual balance during 2007/08–2008/09 and small surpluses over 2009/10–2012/13, based on the authorities’ stated objectives to limit domestic financing of the budget. In the long run, tax revenue is projected to stabilize near its historical average of around 32 percent of GDP, while total expenditure to come slightly below its historical average of 32 percent of GDP through a modest containment of the wage bill in real terms. This implies a fiscal surplus of ¼ percent of GDP in the long run to build fiscal savings.

The current account deficit is projected to narrow to about 7 percent of GDP over the medium term and stabilize around that level thereafter (from 10 percent of GDP in 2007/08). Export base is projected to remain narrow and relatively undiversified, while strong remittance inflows are expected to continue. Growth of imports is projected to moderate markedly as reconstruction-related imports subside and world food and fuel prices stabilize. Meanwhile, the outlook for net foreign direct investment remains favorable, broadly in line with the past five-year average of 5½ percent of GDP. Official foreign reserves are projected to remain comfortable in terms of import cover.

Reconstruction financing under the baseline represents an illustrative scenario where a soft-loan of about $10 million per year would be disbursed over a five-year period during 2008/09–2012/13. The cumulative loan disbursement of about $50 million represents a plausible upper bound on the utilization of the $63 million reconstruction loan over the next five years. This loan has an interest rate of 2 percent and a maturity of 20 years, with a 5-year grace period.

Table 2b.

Tonga: Sensitivity Analysis for Key Indicators of Public Debt 2007/08–2027/28

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Sources: Country authorities; and Fund staff estimates and projections.

Assumes that real GDP growth is at baseline minus one standard deviation divided by the square root of 20 (i.e., the length of the projection period).

Revenues are defined inclusive of grants.

Figure 2.
Figure 2.

Tonga: Indicators of Total Public Debt Under Alternative Scenarios, 2007/08-2027/28 1/

Citation: IMF Staff Country Reports 2008, 261; 10.5089/9781451837506.002.A002

Sources: Staff projections and simulations.1/ Most extreme stress test is test that yields highest ratio in 2017/18.2/ Revenue including grants.
1

This DSA was prepared jointly with the World Bank in accordance with the Debt Sustainability Framework for low-income countries approved by the Executive Boards of the IMF and IDA. The debt data underlying this exercise were provided by the Tongan authorities.

2

See “Debt Sustainability in Low-Income Countries: Proposal for an Operational Framework and Policy Implications” (http://www.imf.org/external/np/pdr/sustain/2004/020304.htm and IDA/SECM2004/0035, 2/3/04), “Debt Sustainability in Low-Income Countries: Further Considerations on an Operational Framework and Policy Implications” (http://www.imf.org/external/np/pdr/sustain/2004/091004.htm and IDA/SECM2004/0629, 9/10/04), and reference to “Staff Guidance Note on the Application of the Joint Bank-Fund Debt Sustainability.”

3

The 2008 DSA baseline shows an improved public debt and debt service profiles over the medium to long term as compared with those presented in the 2007 DSA where the reconstruction loan was assumed to be disbursed and utilized fully over a two-year period during FY08/09–09/10.

4

The average World Bank’s Country Policy and Institutional Assessment for the period 2005–2007 classifies Tonga as a poor performer. The corresponding debt distress thresholds are: NPV of debt-to-exports (100 percent), GDP (30 percent), and revenues (200 percent); and debt service in percent of exports (15 percent) and revenues (25 percent).

5

The baseline scenario assumes that net private transfer receipts will climb to an average 45½ percent of GDP over the projection period from a historical average of 33½ percent, mainly reflecting the recent increase in the number of Tongan workers abroad as well as a reduction in transfer costs.

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Cover IMF Staff Country Reports
Tonga: 2008 Article IV Consultation: Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Volume/Issue:
Volume 2008: Issue 261
Publisher:
International Monetary Fund
ISBN:
9781451837506
ISSN:
1934-7685
Pages:
53
DOI:
https://doi.org/10.5089/9781451837506.002
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    Tonga: Indicators of Public and Publicly Guaranteed External Debt Under Alternative Scenarios, 2007/08-2027/28

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    Tonga: Indicators of Total Public Debt Under Alternative Scenarios, 2007/08-2027/28 1/

Tonga: Indicators of Public and Publicly Guaranteed External Debt Under Alternative Scenarios, 2007/08-2027/28

Tonga: Indicators of Total Public Debt Under Alternative Scenarios, 2007/08-2027/28 1/