1. Context. The weak global environment is affecting the economy through lower remittances and represents a clear downside risk to the outlook. Tonga also remains at high risk of external debt distress and is vulnerable to natural disasters. The rising debt service burden may squeeze priority public spending and crowd out private investment. A recently concluded economic dialogue with wide stakeholder participation identified the need to raise the relatively low rate of potential growth.

Abstract

1. Context. The weak global environment is affecting the economy through lower remittances and represents a clear downside risk to the outlook. Tonga also remains at high risk of external debt distress and is vulnerable to natural disasters. The rising debt service burden may squeeze priority public spending and crowd out private investment. A recently concluded economic dialogue with wide stakeholder participation identified the need to raise the relatively low rate of potential growth.

Introduction

1. Context. The weak global environment is affecting the economy through lower remittances and represents a clear downside risk to the outlook. Tonga also remains at high risk of external debt distress and is vulnerable to natural disasters. The rising debt service burden may squeeze priority public spending and crowd out private investment. A recently concluded economic dialogue with wide stakeholder participation identified the need to raise the relatively low rate of potential growth.

2. Politics. The country was deeply saddened by the sudden passing away of his Majesty King George Tupou V in March 2012. The late king’s brother, Crown Prince Tupouto’a Lavaka, has been formally proclaimed as King Tupou VI in a recent ceremony. The coronation is not expected to affect public administration following the transfer of most executive powers to the Parliament in 2006. A new government took office in early 2011 following the first parliamentary elections under which a majority of seats were popularly elected. The cabinet has been reshuffled a few times since then and the authorities will undertake a major restructuring of line ministries in 2012/13 that may disrupt some public services. It was recently announced that a new ministry will be created in charge of revenue services that will be independent of the newly appointed Minister of Finance and National Planning.

3. In concluding the 2011 Article IV consultation (May 4, 2011), the Executive Directors noted that Tonga’s economy is recovering from the recent internal and external shocks on the back of stronger tourism activity and fiscal expansion. The policy challenge now is to reduce the country’s vulnerabilities and to boost potential growth. Directors stressed that in the near term, fiscal consolidation is necessary to ensure fiscal sustainability and expand fiscal space to respond to future shocks.

Recent Developments

4. Growth. Growth is estimated by staff to have recovered to 1½ percent in FY2010/11 from zero percent in FY2008/09.1 Two factors have contributed to the recovery. First, gross fixed investment and inventory buildup have strengthened since late 2010, thanks to the construction activity funded by the China EXIM Bank loans. Second, tourism receipts rebounded from the middle of 2010. On the other hand, private consumption has remained anemic due to the decline in remittance inflows. In addition, banks’ lending standards have remained tight, constraining private consumption and investment.

5. Inflation. Inflation peaked in the second quarter of 2011 at 8½ percent year-over-year (y/y) and has been on a downward trajectory, due mainly to moderating global food and oil prices as well as exchange rate appreciation. CPI inflation had eased to around 2½ percent y/y in February 2012.

GDP Growth by Expenditure

(Year-over-year; in percent)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Sources: Country authority; and Fund staff calculations and projections.

Consumer Price Inflation

(Year-over-year; in percent)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Sources: Country authority; and Fund staff calculations.

6. Balance of payments. The trade deficit remained high but the current account balance improved to a deficit of 1½ percent of GDP in FY2010/11 (from a deficit of 6¾ percent in FY2009/10) because of the increase in official grants and tourism receipts. The level of reserves increased to around $120 million in the second quarter of 2011 (from below $90 million in 2011Q1), and had further increased to around $130 million as of end-2011, covering more than 6 months of imports of goods and services.

7. Public finances. The fiscal deficit was estimated to have been six percent of GDP in the year ending in June 2011–broadly unchanged from a year ago but higher than anticipated in the last staff report reflecting a more frontloaded utilization of the China EXIM Bank loans. An estimated 3¾ percentage points of GDP increase in capital expenditure was led by utilization of the China EXIM Bank loans (amounting to about 7½ percent of GDP). The overall balance (excluding the China EXIM Bank loan spending) showed a surplus of about 1½ percent of GDP due to restraint on current expenditure. Tax collections remained weak, however, due mainly to anemic consumption and customs taxes.

Key Themes for the Consultation

A. Spillovers and Risks

Staff’s views

8. Outlook. Economic activity is expected to continue its recovery in the medium term, albeit decelerate slightly to 1.2 percent in FY2012/13 from 1.6 percent in 2011/12 due to the withdrawal of fiscal stimulus related to the completion of the constructions funded by the China EXIM Bank loans (Table 1). Over the medium term, growth is expected to remain at around 1.8 percent, in line with the historical average. Underlying this medium-term projection, private consumption is anticipated to be more resilient with the bottoming out of the decline in remittances while both investment and exports are projected to be stronger, helped by a gradual easing of financing conditions and several ongoing programs to boost exports and tourism. On the other hand, Tonga has been one of the region’s leading reformers in reducing the costs of doing business and undertaking public enterprise reform according to the Asian Development Bank (Central African Republic) and World Bank (WB), and a further continuation of reforms, if implemented, could raise its potential growth above what is reflected in the baseline projection.

Table 1.

Tonga: Selected Economic Indicators, 2007/08–2012/13 1/

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

Fiscal year beginning July.

Including preliminary data.

From the Banking Survey, which includes the Tonga Development Bank.

9. Spillovers and risks. Risks to the outlook are tilted toward the downside. On the domestic front, growth would be lower if the fiscal authorities are unable to boost priority spending on productive sectors due to cash constraints and/or scale-up domestic borrowing. On the external front, given Tonga’s interconnectedness to the regional economy (Figure 1 and Box 1), a severe shock to global growth would hit Tonga’s economy hard, feeding through a number of channels:

  • Remittances. Remittances from the large number of Tongans who live abroad had averaged about 32 percent of GDP over the last decade. During 2010/11, remittances dropped by 9¼ percentage points of GDP (from 2007/08) to 21 percent of GDP. Remittances from New Zealand declined by 30 percent and those from the US declined by 25 percent, while remittances from Australia increased by 50 percent, thanks partly to the Pacific Seasonal Worker Pilot Scheme that was launched in August 2008. Staff analysis suggests that macroeconomic conditions in remitting countries (mainly Australia, New Zealand and the United States) and exchange rate fluctuations influence remittances, providing a direct channel of spillover from lower global growth. On the expenditure side of GDP, private consumption (85 percent of GDP) will be affected the most, especially given the ongoing domestic credit crunch.

  • Exports and Tourism. The export-to-GDP ratio is low (less than 5 percent of GDP) and mainly destined to Australia, New Zealand and the United States (28 percent in total), so the impact through the trade channel is likely to be small. Tourism has been the second largest source of foreign exchange (8–10 percent of GDP) after remittances and a key sector of growth that is highly susceptible to the global business cycle as observed in 2009/10 when tourist arrivals declined by 12 percent from the previous year. Despite signs of bottoming out, both cruise ship and air arrivals in 2010/11 stayed below pre-crisis levels.

  • Foreign Aid. Foreign aid (about 5–10 percent of GDP) could be susceptible to a tail event in Europe as the European Union has been one of the largest providers of budget support grants.2 Lower project and budget support grants will lead to reduced public spending given the cash constraints of the government. However, the important role played by multilateral donors (Central African Republic and WB), China, and the planned medium-term rise in foreign aid by Australia and New Zealand would help mitigate those risks.

  • Commodity prices. A decline in global food and fuel prices could provide some relief to household budgets. However, if fuel prices were to increase due to supply disruptions or geopolitical events, the country would suffer from higher inflation and a wider current account deficit, in addition to weak growth.

Figure 1:
Figure 1:

Channels of Spillovers to Tonga

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Tonga: Growth Spillovers from the Global Economy

Shocks to external growth and terms of trade are found to affect Tonga’s growth. Remittances, tourism and exports are important transmission channels for such external shocks.

Methodology

The empirical estimation follows a Bayesian Vector Autoregression (BVAR) approach by Osterholm and Zettelmeyer (2008).1 This method uses informative priors on steady-state values and thus improves the efficiency and is particularly appropriate given the short sample period. The sample covers the period of 1996Q1–2011Q2. The external GDP growth rate is an average of the growth rates in Australia, New Zealand, and the United States, weighted by their relative shares of Tongan exports during the sample period. The quarterly growth rate in Tonga is estimated as a function of the number of containers that arrived in the country, as quarterly GDP growth data are not available.

Effects of External Growth and Terms of Trade Shocks on Growth in Tonga

Shocks to external growth are found to have a larger impact than shocks to terms of trade on growth in Tonga. A 1-percentage point negative shock to external growth of its major trading partners causes Tongan growth to decline by 1.3 percentage points after four quarters and 1.4 percentage points after six quarters. On the other hand, a 10-percent increase in global fuel prices causes Tongan growth to decline by 0.2 percentage points after two quarters.

  • Remittances are the most important transmission channel of external growth shocks, followed by tourism and exports. A 1-percentage point negative external growth causes remittances growth to decline by 12 percentage points after four quarters.

  • Tourism and exports are more important than remittances to transmit the impact of shocks to terms of trade. A 10-percent increase in global fuel prices causes tourism growth (export growth) to decline by 15 (10) percentage points after four quarters.

Impulse Responses to an External Growth Shock

(In percentage points)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Source: Fund staff estimates.

Impulse Responses to a Terms-of-Trade Shock

(In percentage points)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Source: Fund staff estimates.
1 Osterholm, P. and J. Zettelmeyer, 2008, “The Effect of External Conditions on Growth in Latin America,” IMF Staff Papers, Vol. 55, No. 4, pp. 595–623 (Washington: International Monetary Fund).

Authorities’ views

10. Outlook and risks. The authorities agreed that the China EXIM Bank loans have supported the economic recovery (albeit with a relatively low multiplier effect due to the high import content of the reconstruction loan) but that private domestic demand can replace the fiscal stimulus and help maintain a growth rate of 1-2 percent over the medium term. They also shared the staff’s view that the weak global environment represents a clear downside risk, in particular through spillovers on remittances and tourism. The authorities recognized the importance of boosting public priority spending and continuing the public enterprise reform momentum to support private sector development.

B. Enhancing Resilience to Shocks

Rebuilding fiscal buffers

11. Background. Staff projects a fiscal deficit of about 2¾ percent of GDP in FY2011/12 (an improvement of 3¼ percentage points of GDP from the 2010/11 level) primarily due to higher grants, continued restraint on current spending, and lower capital expenditure. Increased budget support grants are expected to help the government build up cash balances to better plan for public services.3 Capital expenditure is expected to be lower by 2 percentage points of GDP due to the accelerated completion of the reconstruction of the central business district and near completion of the road projects using the China EXIM Bank loans. The overall balance (excluding the China EXIM Bank loans) is expected to rise to a surplus of about 3⅓ percent of GDP in 2011/12 (Table 2).

Table 2.

Tonga: Summary of Government Operations, 2007/08-2012/13

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Sources: Data provided by the Tongan authorities; and Fund staff estimates.
Staff’s views

12. Debt sustainability. While the 2011/12 budget execution goes some way toward reducing fiscal vulnerabilities, Tonga remains at a “high risk of external debt distress” according to the World Bank-IMF debt sustainability analysis (DSA). In addition, free cash balances of the government amount to less than two months of current spending. These vulnerabilities call for rebuilding the fiscal policy buffer that was drawn down following the acquisition of two loans from the China EXIM Bank with a face value totaling around 25 percent of GDP (Figure 2). To create room to deal effectively with potential shocks, including frequent natural disasters, and reduce the net present value (NPV) of public external debt below 30 percent of GDP (indicative DSA threshold level), the authorities should continue to rebuild cash balances in the short term to at least two months of current spending and attain an average primary surplus of about 1 percent of GDP in the medium to long term.

13. 2012/13 budget and medium-term fiscal framework (Table 2). In order to maintain spending on development priorities, laid out in the Tonga Strategic Development Framework (TSDF), and achieve fiscal consolidation, it will be essential to raise the tax effort. The 2012/13 budget and medium-term fiscal framework should aim to raise the relatively low tax-to-GDP ratio by at least 0.5 percentage point of GDP annually for the next two years based on the recommendations of the PFTAC tax review (%Box 2).

Figure 2.
Figure 2.

From Crisis to Recovery – Rebuilding Policy Buffers 1/

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

1/ The overall buffer index is the sum of the 5 individual buffers normalized by their respective standard deviations during 2004–07.

Tonga: Tax Reform

Tonga faces a number of fiscal challenges in part due to weak revenue performances. Tonga has implemented a series of tax reforms over the past few years: (i) introduction of a value-added tax known as consumption tax (CT) in 2005, (ii) modernization of income taxes in 2008, and (iii) reduction in customs tariffs since 2008 as part of its accession to WTO. In the early stages of the reforms, revenues rose faster than expected. However, recently collections have been anemic due to the weak economy, decline in remittances and a shrinking share of trade taxes (despite increases in excises).

Composition of Tax Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Sources: Country authority; and Fund staff calculations.

A recent PFTAC review of Tonga’s revenue policy highlighted some of the tax reform priorities.1 The review finds that the tax policy setting in Tonga is reasonable in a comparative context but there is room for improvement in the efficiency and effectiveness of revenue collection.

The first pillar: Tax policy reforms – remove leakages and reduce distortions

  • (a) Eliminate discretionary exemptions: The process for approving and monitoring exemptions should be strengthened including by publishing potential costs of the exemptions.

  • (b) Introduce a simplified presumptive taxation for small- and medium-sized enterprises (SMEs): While rates could be low, it would encourage the SMEs to enter the formal sector of the economy.

  • (c) Penalties and interest rates: The penalties regime should be reviewed to reduce the severity of the current regime, and to differentiate between interest and penalties for non-compliance versus under-reporting.

  • (d) Taxation of natural resources: Tonga has already allowed exploration for deep sea mining and a taxation structure should be put in place before any mining agreements are negotiated.

The second pillar: Reforms of tax administration

Success of a country’s tax policy lies with the capacity and capabilities of its tax administration. Training of staff, simplifying tax return forms, establishing comprehensive audit and collection monitoring system, and educating taxpayers are essential. Emphasis should be given to arrest the decline in CT productivity and raise it to the levels comparable to regional peers by: (i) increased scrutiny of taxpayers who are close to the threshold to improve compliance; and (ii) faster refunds of input tax credits to encourage businesses to file claims in a timely manner.

Selected PICs: Comparison of Value Added Tax (VAT) Productivity 1/

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Source: Cotton, Jenkins, and Mullins (2011).

VAT productivity is defined as VAT-to-GDP ratio divided by the VAT rate.

1 Cotton, Jenkins, and Mullins (2011): “Revenue Policy and Administration Review”, Aide-Mémoire, International Monetary Fund, Pacific Financial Technical Assistance Center.

Otherwise, the expenditure envelope available for 2012/13 and 2013/14 would imply a harmful cut in the wage bill and/or increased domestic borrowing to rollover the rising external debt repayments of the China EXIM Bank loans.4 The higher revenues and the level of budget support grants committed to by the donor community will help raise domestically-funded priority spending as the China EXIM Bank loan stimulus is withdrawn, while achieving an overall surplus (excluding the China EXIM Bank loans) of about 1 percent of GDP in 2012/13 and in the medium term. This should also be accompanied by strengthening debt management and avoiding any new external borrowing at least until 2014/15 when the NPV of debt-to-GDP should fall below the indicative DSA threshold level.

Selected PICs: Public Sector Debt

(In percent of GDP, 2011)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Sources: Country authorities; and Fund staff calcualtions.

14. Tax reforms. The sequenced implementation of the PFTAC tax review will help achieve the revenue targets (Box 2). In particular, the 2012/13 budget should include specific tax reform measures aimed at: (i) reducing tax concessions and strengthening the process for granting new exemptions; (ii) broadening the tax base by introducing a presumptive tax for small- and medium-sized enterprises (SMEs); (iii) rationalizing the penalties and interest regime for non-compliance; and (iv) ensuring better revenue services and expediting tax refund processes. The 2013/14 budget could consider limiting deductions for income taxes and introducing a natural resource tax regime particularly for seafloor mining with PFTAC TA.

Selected PICs: Tax Revenues

(In percent of GDP; average over 2008-11)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Sources: Country authorities; and Fund staff calcualtions.

15. Expenditure reforms. On the expenditure side, Tonga needs to build on the recent progress in public financial management (PFM). The publication of monthly financial reports have improved fiscal transparency and clearly identified the need to limit within-year reallocations to non-priority programs. Over the short term, continued efforts should be put on reining in the wage bill by adhering to the partial recruitment freeze and containing across-the-board wage rises instituted in 2011.5 This would avoid a squeeze on non-wage expenditures, a problem that has plagued Tonga in the past.

16. Quality of spending. Over the medium term, the focus should remain on improving the quality of spending and implementing a medium-term budget framework (MTBF). To ensure a sustainable reduction in the share of the wage bill to 45 percent of domestic expenditures as envisaged by the Government, a broader restructuring of the public services that efficiently consolidates line ministries and introduces a performance-management system will be essential. While the authorities aim to reduce the share of the wage bill to 45 percent of domestic spending within three years, the staff projects a more gradual reduction in the wage bill to about 47¼ percent by 2016/17 given the no-redundancy policy and assuming wage rises broadly in line with inflation. This will allow a gradual increase in spending on priority economic and social sectors, including maintaining the recently constructed roads financed by the China EXIM Bank (%Box 3). In this context, the implementation of the MTBF will help better align budgetary allocations with government priorities. However, the MTBF alone will not ensure quality spending without improved monitoring of spending outcomes and limiting within-year reallocations. A better quality of spending and improvements to PFM systems should help garner further budget support under the common policy matrix.

Authorities’ views

17. The authorities are cognizant of the high debt burden and are committed to a medium-term fiscal consolidation. They recognized the need for revenue enhancement to meet future debt service obligations and deficit targets while maintaining an adequate level of public services. The Ministry of Finance and National Planning intends to submit to cabinet legislation relating to the introduction of a presumptive tax for SMEs and will consider staff’s other tax reform proposals for the 2012/13 and 2013/14 budgets. The authorities felt that expenditure prioritization would be a challenging task but would continue its efforts on reducing wasteful expenses and aim to bring down the wage bill to 45 percent of government funded expenditure over the next three years from about 54 percent at present. The Government recognizes that containing the wage bill requires limiting across-the-board pay rises and sees the public sector restructuring as an opportunity to realign personnel with policy priorities. With regard to future infrastructure projects, the authorities wanted to explore public private partnerships as an option and committed not to borrow externally until the risk of external debt distress recedes.

Maintaining external stability

18. Background. Buoyant official development assistance has helped further build up the reserve buffer (Figure 2). The current account balance is projected to be at a deficit of 6 percent of GDP in 2011/12 and average around 3¾ percent of GDP in the medium term as concessional loan funded imports taper off and the decline in remittances bottoms out (Table 4). The capital and financial account is projected to be around 7 percent of GDP in FY2011/12 and gradually decline to around 2 percent of GDP over the medium term as official foreign borrowing is phased out. As a result, reserves are expected to decline somewhat but remain adequate in terms of traditional prudential metrics and within the National Reserve Bank of Tonga’s (NRBT) comfort zone of three–four months of imports.

Table 3.

Tonga: Depository Corporations Survey, 2007/08-2012/13 1/

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

Comprises the National Reserve Bank of Tonga (NRBT) and other depository corporations (ODCs), including the Tonga Development Bank (TDB).

Comprises bills and promissory notes issued by financial sector and held outside the sector.

Table 4:

Tonga: Balance of Payments Summary, 2007/08–2012/13 1/

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: the Tongan authorities; and Fund staff estimates.

Projections include adjustments for imports related to two loans from the China EXIM Bank.

Includes all official grants excluding project funds related to capital formation.

Change in gross official foreign reserves.

Tonga: FX Reserve Adequacy

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

in months of next year’s imports of goods and services.

Tonga: Improving Expenditure Quality1

Improving the quality of spending is critical to maintain public service delivery while pursuing fiscal consolidation. In the 2011/12 budget, the authorities emphasized the importance of carefully reprioritizing public expenditure in order to adequately resource priority areas in the face of tight fiscal constraints. To achieve this, the authorities need to focus on three key principles:

  • First, a higher proportion of expenditure needs to be directed to priority sectors in the annual budget, particularly to infrastructure and economic sectors.

  • Secondly, a higher proportion of expenditure needs to be directed to critical programs within each sector.

  • Thirdly, budget execution needs to be strengthened so that resources are not reallocated away from priority sectors and critical programs within each sector during the budget year.

Allocations to Priority and Other Sectors

(Share of actual government expenditure)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Sources: Country authority, and World Bank staff calculations.

Regional Comparison: Allocations to Priority and Other Sectors

(Share of budgeted government expenditure, FY2010/11)1/

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Sources: Country authorities, and World Bank staff calculations.1/ Indicative allocations.

To date, the authorities have been more successful in prioritizing allocations in the budget (both between and within sectors), than in maintaining those priorities during the budget year through strict budget execution. To address this weakness, a number of aspects of budget execution need to be strengthened over the medium term.

  • Expenditure from the Contingency Fund (CF) and the transfer of resources between ministries through the CF has tended to shift resources from higher to lower priority sectors in recent years. This trend needs to be reversed, through the strict reservation of CF funds for urgent, vital and unforeseeable expenditure and the avoidance of interministerial transfers.

  • Within ministries, considerable resource transfers are occurring between line items, major expenditure categories and sub-programs. These transfers tend to reduce the quality of expenditure, by shifting resources to lower priority areas and lower value expenditure types.

  • The authorities have strengthened in-year budget monitoring in 2011/12, which could provide a solid foundation for improving the dialogue with line ministries on budget execution. The realignment of budgetary allocations to match the new ministerial structure in 2012/13 should be taken as an opportunity to redefine line ministry programs, enabling existing transfer rules to be applied with greater effect. There may also be merit in introducing new rules to limit transfers involving particular line items, major expenditure categories or sub-programs that are critical to the achievement of key policy objectives and where significant problems have been experienced to date.

Note: ‘Priority’ sectors refer to education and training, health, and infrastructure – as identified within the TSDF; ’Economic’ sectors refer to agriculture and fisheries, commerce, and tourism; ’Law & order’ sectors refer to police and prisons, justice, and crown law; ‘Other’ sectors refer to all other sectors, with the exception of finance which is excluded from the analysis to avoid distortions caused by equity, redundancy and debt service payments.

1 Prepared by Virginia Horscroft and Tobias Haque of the World Bank.

19. Exchange rate flexibility. The improved balance of payment position, allowed the NRBT to let the currency appreciate by 13 percent against the US$ (and 9 percent in real effective terms) from December 2010 to the peak of August 2011 (before returning to a level of 6 percent appreciation by end-2011) to help curb inflation pressures stemming from rising fuel and food import prices, as in other Pacific Island countries. The currency is assessed to be broadly in line with its medium-term fundamentals (%Box 4). The macroeconomic balance approach and the purchasing power parity approach indicate a slight overvaluation that is within the margin of error. In addition, foreign exchange interventions and tourist arrivals continue to show no significant loss of competitiveness. With headline inflation on a downward trajectory and forecast to be around 5 percent in the near term, staff advises against further exchange rate appreciation. In fact, should downside risks to global growth materialize and spill over to Tonga, the exchange rate can absorb most of the shock while reserves can be used to smooth some of the impact.

Effective Exchange Rates vs Commodity Prices

(Index, 2005=100)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Sources: INS; and IMF staff estimates.1/ Other PICs include Marshall Islands, PNG, Samoa, Solomon Islands, and Vanuatu.
Authorities’ views

20. Outlook and policy stance. The authorities shared the staff’s exchange rate assessment. They agreed that there is no further need for appreciation given the current inflation trajectory and noted that the NRBT would let the reference currency basket remain broadly at current levels. The authorities recognized that the recent buildup in reserves was due mainly to a surge in official grants and a large one-off private capital inflow, and projected the reserves to decline as the official grants taper off. They stand ready to act preemptively to control inflation risks as well as maintain reserves above the NRBT comfort zone of three-four months of imports.

Monetary policy and financial stability

21. Context. Monetary conditions have remained accommodative over the past two years, but with no signs of a pickup in private credit (Figure 3 and Table 3). The increase in international reserves and limited sterilization led to a large accumulation of banks’ excess reserves. Yet, private sector credit growth has remained negative (-9.3 percent (y/y) in December 2011) due to the still nascent recovery and tighter lending standards. The banking system is adequately capitalized and profitable but credit costs related to the rise in non-performing loans (NPLs) following the 2004–08 credit bubble remain high; and banks have continued to restrain credit, albeit with some signs of the credit crunch bottoming out (Figure 3 and Table 6).

Figure 3.
Figure 3.

Monetary Policy and Systemic Risks

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Table 5.

Tonga: Medium-Term Scenario, 2009/10–2016/17 1/

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

Fiscal year beginning July.

Table 6.

Tonga: Financial Soundness Indicators, 2007/08-2010/11 1/

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Sources: National Reserve Bank of Tonga and IMF IFS database.

Data as of end of fiscal years.

Tonga: Exchange Rate Assessment

Tonga’s exchange rate is assessed to be broadly in line with its medium-term fundamentals based on standard analytical approaches. Other indicators also do not suggest pressures of a misalignment. There is considerable uncertainty in these results, mainly because external balances are heavily influenced by a small number of factors such as tourism and remittances, and these factors (in particular tourism) could be quite volatile going forward.

Standard exchange rate assessment methods

  • The macroeconomic balance approach suggests that the exchange rate is over-valued by 4 percent compared to its equilibrium level, which is determined as a function of fundamentals relative to Tonga’s trading partners. These fundamentals include the fiscal balance, economic growth, income, foreign aid, and demographics.

  • The purchasing power parity approach suggests that Tonga’s currency is above its long-run equilibrium level by around 6 percent in real effective terms.

Other indicators

  • The current account deficit has been improving due to the rise in official grants. While a temporary rise in the deficit is expected in this fiscal year, reflecting higher imports along with the economic recovery, the deficit is expected to average around 33/4 percent of GDP over the medium term.

  • Reserves are expected to remain adequate within the NRBT comfort zone of three-four months of imports.

  • Exports have recovered from the low level in 2008/09 and are expected to pick up gradually in the medium term reflecting the ongoing programs to boost exports.

  • The number of tourists has increased markedly in recent years. Tonga has gained market share as a tourist destination, especially for tourists from New Zealand.

  • The costs of doing business rankings from the World Bank’s Doing Business Survey do not suggest any significant loss in competitiveness.

Equilibrium Real Exchange Rate Estimates

(Percent misalignment)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Source: Fund staff estimates.

New Zealand Tourists to Selected Pacific Islands

(In thousands)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Source: New Zealand authorities.

Business Climate Indicators

(Rank)1/

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Source: World Bank Doing Business (2012 Doing Business Report).1/ Higher rank indicates more costly.
Staff’s views

22. Policy stance. Staff continues to recommend that the NRBT maintain an accommodative stance. While interest rate spreads remain high due to heightened credit risks and structural issues, albeit in the mid-range of PICs; lending rates have fallen and are expected to decline further. However, in the event of a severe global shock, the country would have little room to implement counter-cyclical monetary policies in view of the limited effectiveness of the transmission mechanism and banks’ cautious approach to lending (see below).

Selected PICs: Interest Rate Spreads

(In percent, latest available)

Citation: IMF Staff Country Reports 2012, 166; 10.5089/9781475506099.002.A001

Sources: Country authorities and Fund staff calculations.

23. Financial deepening. Encouraging intermediation will require strengthening banks’ balance sheets and the institutional framework for lending. While progress has been made in provisioning for NPLs and reforming the Personal Property Securities Act (the new electronic registry went live in April 2011) to ensure timely registration of collateral, there is an urgent need to institute a centralized credit bureau, facilitate land lease transactions, and enact a bankruptcy protection law to reduce credit risks and improve collateral recoveries. Such changes, together with effective supervision of banks to ensure financial stability and transparency (especially, in interest rate and fee structure), could potentially reduce borrowing costs and improve access to finance. Staff reiterates the importance of continuing to resist pressure to administer banks’ interest rates as it may lead to a further rationing of credit. Given the dominant role of credit risks in explaining interest rate spreads in Tonga, mechanisms to encourage greater risk sharing such as a partial guarantee fund (capitalized by donors or the Government through a budgetary allocation) channeled through the banking sector to priority economic sectors with clear eligibility criteria may have a better chance of success. The expansion of a mandatory retirement scheme to the formal private sector could encourage financial savings and provide a secure source of retirement income to its members. At the same time, the retirement fund should be appropriately regulated and prudent investment guidelines established.

Authorities’ views

24. Outlook and policy stance. The authorities agreed that it remains appropriate to maintain an accommodative stance and encourage bank lending while banks are repairing their balance sheets. They noted the private sector lobbies’ demand to administer banks’ interest rates but shared staff’s view that administering banks’ interest rates would potentially cause a further rationing of credit.

C. Building Faster and More Inclusive Growth

25. Developments. Poverty has risen from 16.2 percent in 2001 to 22.5 percent of the population in 2009 according to the latest Household Income and Expenditure Survey (HIES). The slow pace of economic growth is partly to blame but the recent decline in remittances has also played a role.

26. Higher growth (%Box 5). An increase in growth is needed for making a significant dent in poverty levels. The key sources of growth Tonga can harness are those where it can command premium prices to cover the higher production costs endemic to small and remote economies – such as from natural resource rents in agriculture, tourism and fisheries. Exploration for seabed minerals have commenced and hold promise but commercial viability and potential revenues are yet to be determined. Private investment in these sectors could be fostered by reforming the onerous business licensing requirements, privatizing Tonga’s largest hotel (currently dilapidated), and lengthening the duration of land lease titles and facilitating their transfer. Implementation of the government’s infrastructure investment plan and public enterprise reform program will be critical to further reduce the costs of doing business. Reducing the high cost of electricity could be achieved by implementing the Tonga Energy Road Map (TERM) with assistance of the World Bank and other development partners. While renewable energy capacity is being developed, the installation of a tank farm, consisting of large diesel storage tanks, could result in savings but should be undertaken after a cost-benefit analysis and preferably with private sector participation to minimize fiscal risks.

27. Inclusive policies. In addition to higher growth, a set of mutually reinforcing policies will also likely be needed to increase inclusiveness. While reconstruction using the China EXIM Bank loans supported GDP growth and better infrastructure, linkages to the rest of the economy were limited due to foreign contracting and labor. Going forward, the challenge would be to foster more labor-intensive value-added industries such as tourism and agro-fisheries as well as utilize the seasonal work programs in Australia and New Zealand to absorb a greater proportion of the labor force as the public sector wage bill is contained. In an environment of reduced remittance receipts, recourse to this form of insurance arrangement is limited. Thus, consideration should be given to introducing social protection schemes such as community public work programs and reforming the electricity tariff to build a lifeline tariff to protect the poorest consumers. Currently, Tonga provides good access to basic education and health but formal social protection programs are limited to the public service contributory pension scheme (Table 7).

Table 7.

Tonga: Millennium Development Goals

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Source: World Bank, World Development Indicators database.