Tonga: 2015 Article IV Consultation-Staff Report; and Press Release
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International Monetary Fund. Asia and Pacific Dept
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Publication Date:
30 Apr 2015
eISBN:
9781475518375
Language:
English
Keywords:
ISCR; CR; Tonga; real GDP; GDP deflator; government; excess reserves; government treasury bills; reform effort; opportunity cost; reform plan; Inflation; Imports; Fiscal stance; Australia and New Zealand
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Tonga is expected to revert to a moderate growth path in the coming years, after a contraction in 2012/13.

Abstract

Tonga is expected to revert to a moderate growth path in the coming years, after a contraction in 2012/13.

Context

1. Setting. Tonga is a small agriculture-based open economy in the South Pacific with a narrow production base and low connectivity, resulting in high transportation costs, limited economies of scale, and low diversification (Figure 1). Tonga’s high dependence on remittances, foreign aid and imported energy poses challenges as it increases the economy’s sensitivity to exogenous shocks. Other exogenous vulnerabilities stem from natural disasters (e.g., severe cyclones affected Tonga in 1982, 1991 and 2014).

Figure 1.
Figure 1.

Tonga: Stylized Facts

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

A01ufig1

Population vs GDP-Weighted Distance 1/

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Source: Gibson.1/ Average distance kilometers to all other countries of the world, as weighted by GDP.
A01ufig2

Tonga: Key components of GDP

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Sources: Tongan authorities; and IMF staff estimates

2. Political developments. The second general election for the Legislative Assembly was held in November, 2014. A new prime minister was elected in December and took office in January 2015. The previous finance minister and the central bank governor remain in office. King Tupou VI’s official coronation is scheduled for July 2015, following his accession to the throne in March 2012.

3. Traction. The authorities have made progress on key policy advice outlined in the last Article IV consultation. In the 2014 staff report, staff emphasized the importance of preserving a prudent fiscal policy stance and continuing to expedite financial sector reform. The authorities have continued to apply the No New Loan policy (no external borrowing) while amending it to allow for concessional budget support provided by development partners. They adopted the Public Financial Management Reform Roadmap in 2014. The authorities also strengthened risk-based supervision, including through PFTAC technical assistance. They are also expected to enact the Receivership bill this year, although progress in business-friendly legal issues (e.g., a bankruptcy law) remains partial.

Recent Developments, Outlook and Risks

4. Recent developments. Economic growth is estimated to have recovered to around 2 percent in 2013/14, following a sharp contraction in 2012/13 induced by the completion of a large capital project.1 2 Inflation has remained subdued in recent years, ranging between 0 to 3 percent per annum, mainly reflecting low global food prices and, more recently, dramatically weaker global oil prices. This is significantly lower than the current CPI inflation reference range of 6 to 8 percent set by the National Reserve Bank of Tonga (NRBT) in 2011 (Figure 2). The external position has been strengthened, owing largely to increased grant inflows, which have raised international reserves to around 6½ months of prospective imports, well in excess of the NRBT’s target range of 3–4 months of imports (Figure 3).

Figure 2.
Figure 2.

Tonga: Recent Economic Developments

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Figure 3.
Figure 3.

Tonga: External and Monetary Developments

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

5. Outlook. Growth is expected to accelerate in the coming years owing to several temporary factors (text chart). Reconstruction works in the aftermath of Cyclone Ian in 2014 are being undertaken, while the mid-2015 coronation is expected to boost tourism. The economy is projected to expand in 2015/16, supported by buoyant construction activity on the back of public works spending for the 2019 South Pacific Games (the Pacific Games). Meanwhile, inflation is expected to increase gradually to around 3.5 percent, reflecting stronger demand generated by the Pacific Games and stable global commodity prices.

A01ufig3

Real GDP Growth - Decomposition

(In percent)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Sources: IMF staff estimates

6. Risks. The overall balance of risks is tilted to the downside (Appendix I). On external risks, spillovers from a protracted period of slower growth in advanced and emerging economies could weigh on Tonga, mainly due to its close ties with Australia and New Zealand through aid, remittances, trade and tourism. On the upside, Tonga would benefit as a net commodity importer if oil and food prices remain low for an extended period of time (Box 1). On domestic risks, slippages in delivering on policy reforms could affect the level of development partners’ budget support, leading to lower aid inflows. Any potential cost overruns relating to the Pacific Games could make it necessary to mobilize additional resources. Natural disasters similar to recent cyclones could also take a toll on the economy (with average annual damage of around 4 percent of GDP—see Figure 1—indicating the level of risk).

Authorities’ Views

7. The authorities broadly concurred with the overall economic assessment, while stating that they expected higher growth over the medium term. They considered that the expected investment in a major hotel, the government’s reform efforts, and private sector development accompanied by accelerated credit growth would provide more impetus to economic activity. They forecast that near-term inflation could be temporarily negative, depending on energy price developments and offsetting effects from higher domestic food prices. On external risks, they agreed that spillovers could be expected through the remittance and trade channels, and are of the view that remittances will probably rise, albeit at a weaker growth rate of remittances, reflecting the favorable growth outlook of the U.S.

Tonga: The Macroeconomic Impact of Lower Oil Prices 1/

As a net oil importer, Tonga is expected to benefit from the recent decline in oil prices in the short term, with a favorable impact on growth, inflation, the trade balance and the fiscal balance. As a second round effect, remittances could also be positively affected as key host countries for expatriate Tongans are also net oil importers. However, if the price drops are sustained, prospective investment in renewable energies could be discouraged.

Growth. Lower fuel prices would stimulate domestic demand via a rise in private disposable income and corporate profitability. This would boost several activities, especially in the service sectors (e.g., distribution, transport), which could prop up the near-term growth rates.

Inflation. The lower import price of oil will ease inflationary pressures, mainly through driving down domestic costs of transportation. Electricity prices are also adjusted in line with the change in the import price of oil. This price effect would dominate the impact of higher domestic demand on inflation. The CPI inflation rate is expected to fall by 0.3 percentage point in 2014/15 and 0.2 in 2015/16.

Trade. Fuel imports account for almost 30 percent of total imports in Tonga. The value of fuel imports should fall since the effect of lower import costs should exceed the impact of possible increases in fuel demand. The lower fuel costs could also lower transportation costs deemed to be a significant portion of costs of imports, given the remoteness of Tonga. As a result, the current account is expected to improve in the near term.

A01ufig4

Pacific Small States: Oil Imports, 2012-13

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

1/ Average.Sources: Country authorities; IMF, WEO; and IMF staff estimates.

Fiscal. Revenues from import tariffs and VAT would be reduced through lower imports, while higher domestic demand may increase tax revenue. On the spending side, the authorities could save some fuel-related expenditure on the margin, while there is no fuel subsidy in Tonga. Overall, the fiscal balance could improve slightly by 0.1 percentage points both in 2014/15 and 2015/16.

Remittances. Key source countries for the remittances to Tonga are net oil importers including the U.S. and New Zealand. A boost to activity in these countries would favorably affect the inflow of remittances to Tonga, and thus help stimulate domestic demand.

Investment in mineral exploration and renewable energies. A prolonged period of low energy prices, however, could discourage future investment in deep-water mining as well as renewable energies.

1 Prepared by Yasuhisa Ojima (APD).

Policy Discussions: Navigating A Stable Course

Policy discussions centered on navigating a stable macroeconomic course in terms of fiscal, external, price and financial stability and on raising potential growth over the medium term.

A. Building a Sound Fiscal Position

8. Tonga’s fiscal position has improved, supported by large grant inflows, but spending pressures will remain high in the near term. The overall balance improved to a surplus of around 1 percent of GDP in 2013/14, partly due to grant inflows, but is expected to revert to a deficit in 2014/15. Spending pressures in the near-term include: i) cyclone-related reconstruction work; ii) wage pressures from the civil servants association; and iii) preparations for the 2019 South Pacific Games. Most of the reconstruction work, which contributes to the ramp up in capital expenditure in 2014/15, has so far been met by strong grant inflows mainly from World Bank and Asian Development Bank, but strong projected tax revenue performance in 2014/15 is also expected to play a funding role (text table).

Table.

Tonga: Summary of Government Operations, 2012/13-2015/16

article image
Sources: Tongan authorities; and IMF staff estimates.

9. Medium-term fiscal challenges center on maintaining prudent debt management and implementing public financial management reforms. Tonga’s public debt currently stands at around 50 percent of GDP, and given its vulnerability to external shocks, it is important to maintain a prudent debt policy. The staff welcomes the government’s conservative borrowing policy (that is, no external commercial borrowing and only limited concessional borrowing) and the agreement with China EXIM Bank to defer repayment of principal on previous loans for a period of five years. As a result, the mission’s debt sustainability analysis indicates that Tonga remains at moderate risk of debt distress. The authorities’ plan to finance the Pacific Games using non-debt creating funds (for example, the Pacific Games revenue, franchises, and donations) is fiscally prudent. Cost overruns could, however, necessitate borrowing, which could jeopardize fiscal sustainability. Tonga introduced a three-year budget framework in 2013 and adopted a roadmap for public financial management reform in 2014, but has not yet set a clear fiscal target for the medium-term.

10. Against this backdrop, it is imperative to build sound fiscal positions to bolster resilience to shocks. A key fiscal policy recommendation is to gradually increase the primary fiscal surplus to about 1 percent of GDP over the medium-term, so that external debt stabilizes at about 35–40 percent of GDP (to provide a buffer to relative to debt distress thresholds, to allow the country to safely absorb external shocks). Since grant disbursements can fluctuate from one year to the next, staff also recommends monitoring the primary balance excluding grants as a key performance indicator. Measures to create such a primary surplus include: i) improving tax administration on consumption tax (for example, reducing the number of zero ratings and exemptions, undertaking a regular review of tax incentives); ii) restraining the wage bill in line with the authorities’ target (e.g., continuation of hire freeze, more efficient staffing); and iii) improving the quality and efficiency of spending through ongoing public financial management reforms (Appendix II). The Fund stands ready to provide technical assistance to support these fiscal reforms through the Pacific Financial Technical Assistance Center (PFTAC). Finalizing the debt management strategy, with technical assistance by the World Bank is also critical to lay a solid foundation for prudent debt management.

A01ufig5

Tonga: Tax Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Sources: Tongan authorities; and IMF staff estimates

11. The spending program for the Pacific Games needs to be carefully managed. Staff recommend that the authorities enhance controls on the spending program for the Pacific Games, and caution that the current proposal by the South Pacific Games Committee to raise funds by imposing a levy on foreign exchange transactions could give rise to exchange restrictions subject to Fund approval. Staff have requested further information from the authorities regarding the proposed levy in order to assess its jurisdictional implications. Another proposal to raise funds by imposing an additional departure tax should be carefully studied, in order to determine how much of an adverse effect such a tax would have on tourist arrivals. Against this backdrop, staff also stresses the importance of maintaining a prudent fiscal stance and building sound fiscal positions to bolster resilience to shocks.

Authorities’ Views

12. The authorities broadly agreed with staff’s views including the need for a medium-term fiscal anchor. They noted that the adoption of a roadmap for public financial management reform and the Debt Management Strategy could form the basis for a medium-term fiscal framework. The authorities aim to further broaden the tax base and strengthen administration, and plan to undertake an expenditure review of all government programs to improve the quality of public spending. They also concurred with the need to restrain the public sector wage bill, and noted that they would like to review technical issues (e.g., coverage of wages) before establishing an explicit monitoring benchmark. They also highlighted that more efficient inter-ministerial staff allocations would be helpful in this regard.

13. The authorities are aware of the potential cost overruns of the Pacific Games. They plan to control cost, for instance, by utilizing existing facilities for the Pacific Games (e.g., using school as accommodation facilities). The authorities confirmed their prudent stance of not using debt-creating flows to finance the Pacific Games, and that they would consult with the Fund on the possible introduction of foreign exchange levy and increasing the departure tax for overseas travel.

B. Safeguarding External Stability

14. Large grants and remittances in recent years have helped Tonga build up adequate international reserve buffers. The current account deficit is projected to be around 5 percent of GDP in 2014/15, and to move around 2-5 percent of GDP in the medium term, while international reserves are expected to remain above the NRBT’s comfort zone of 3–4 months of imports. The increase in foreign assets, largely due to grant inflows, has also contributed to the rise in domestic liquidity. Grant inflows have been relatively stable, reflecting Tonga’s favorable performance in policy reforms, and the remittance inflows have also been stable, reflecting diversified sources (e.g., the U.S., New Zealand and Australia).

15. Maintaining international reserves at the current level will help safeguard external stability. Overall, staff’s assessment indicates that reserve holdings (in months of imports) are adequate in light of the need to absorb frequent external shocks and the low opportunity cost of holding reserves in Tonga (Box 2). The pegged exchange rate within horizontal bands has served the country well. Staff’s exchange rate assessment suggests that the current level of the exchange rate is broadly in line with fundamentals (Box 3). In addition, other indicators (for example, tourist arrivals) continue to show no significant loss of competitiveness for Tonga.

Authorities’ Views

16. The authorities concurred with staff’s exchange rate assessments. On the foreign reserve adequacy, the authorities recognized the merit of the staff’s policy recommendation to safeguard external stability, but they believed that 3–4 months of import cover is a more realistic target for Tonga, partly because the high level of reserves in recent years was due to delays in implementation of donor-funded projects and hence may not be sustainable.

C. Ensuring Price Stability

17. Tonga has adopted an informal inflation reference range. Pursuing an inflation range in the context of a fixed exchange rate regime is challenging, although limited capital flows and the wide bands around the exchange rate target give the NRBT some room for maneuver. A weak transmission mechanism of monetary policy, the current accommodative monetary conditions, and Tonga’s sensitivity to external price shocks also complicate the task of controlling inflation. In fact, inflation has consistently been below the reference range (currently at 6 to 8 percent), raising questions about the usefulness of the band.

18. The authorities should consider replacing the current inflation reference range with a lower reference rate. Setting it in line with Tonga’s medium term inflation forecast (e.g., using the IMF staff’s forecast of 3.5 percent) would help better clarify what would informally guide monetary policy. The new reference rate would need to be clearly communicated to the public, but should be reviewed periodically to ensure consistency with economic fundamentals (Appendix III).

Tonga: Assessing Reserve Adequacy 1/

Tonga’s international reserves have grown rapidly since the global financial crisis, mainly due to grants and remittance inflows. In 2013/14 reserve holdings peaked at US$153 million. This corresponds to more than 7 months of goods and service imports and is well in excess of the NRBT’s lower bound of 3 to 4 months of import cover (Figure 1). Tonga’s reserve position also exceeds levels recommended by standard “rules of thumb” such as coverage of 3 months of imports of goods and services, 100 percent of short-term debt and 20 percent of broad money in the economy (Table 1). The standard IMF formula for assessing reserve adequacy (IMF, 2011) yields minimum adequate reserves for Tonga of US$61 million or 14 percent of GDP, less than half of the NRBT’s actual reserve holdings in 2012/13.2 A comparison between actual reserves and benchmark metrics thus raises the question of whether reserve holdings in Tonga might be excessive.

Figure 1
Figure 1

Gross International Reserves

(In millions of US dollars)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Sources: Tongan authorities; and IMF staff calculations
Table 1

Rules of Thumb: Reserves Coverage in 2013/14

article image

A cost-benefit analysis developed by Dabla-Norris et al. (2011) allows for the determination of optimal levels of reserves specifically for low income countries.3 This framework maximizes the net benefit of holding international reserves by balancing the cost of reserves and the benefits of precautionary reserve holdings as insurance against adverse external shocks. Calibrating the model for Tonga yields optimal levels of reserves in the range of 5 to 10 months of import cover depending on assumptions about the cost of holding reserves (Figure 2). The opportunity cost of holding reserves can be approximated by the difference between real returns on short-term foreign currency assets and alternative domestic investments. For Tonga, the interest differential for government bonds and 3-month U.S. government treasury bills could be a proxy for the cost of holding reserves. The differential of roughly 3 percent implies optimal reserve holdings equivalent to 6 to 7 months of imports coverage.

Figure 2
Figure 2

Optimal Levels of Reserves

(Months of current imports)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Sources: IMF staff calculations.

Overall, reserve holdings are adequate in light of the large benefits of absorbing frequent external shocks and the low cost of holding reserves for Tonga.

1 Prepared by Eva Christiane Kneer (APD). 2 The standard IMF metric is based on a weighted average of short term external debt (STD), longer term debt arising from portfolio investment and other investment liabilities (OL), broad money (M2), and exports of goods and services (EX). 3 Dabla-Norris, E. et al., 2011. Optimal Precautionary Reserves for Low Income Countries: A Cost-Benefit Analysis. IMF Working Paper 11/249.

Tonga: Exchange Rate and Competitiveness 1/

Tonga’s real effective exchange rate is broadly in line with medium-term fundamentals. Other indicators suggest that the economy remains competitive.

Exchange rate

  • Tonga’s real effective exchange rate (REER) is broadly in line with medium-term fundamentals. The purchasing power parity approach suggests an undervaluation by around 6 percent, while the equilibrium real exchange rate approach indicates an overvaluation by 15 percent.

A01ufig6

New Zealand Tourists to Selected Pacific Islands

(In thousands)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Source: Statistics New Zealand.

Other indicators

  • Reserves. Gross international reserves are adequate and rising, and reached a level of 7 months of prospective imports in 2013/14.

  • Exports. Exports recovered quickly from a temporary slump during the global financial crisis, and have grown moderately in recent years. In the medium term, exports are projected to grow at an annual rate of 9 percent.

  • Number of tourists. The number of tourists has increased steadily as Tonga is becoming a more attractive tourist destination.

  • Costs of doing business. Tonga remains competitive compared with other PICs, according to the World Bank’s Doing Business 2015 report. Relative strengths include access to credit, contract enforcements and the low administrative burden involved in paying taxes and starting a business. There is room for improvement in terms of protecting investors and registering property.

A01ufig7

Ease of Doing Business, 2015

(Rank out of 189 economies) 1/

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Source: World Bank Doing Business (2015 Doing Business Report).1/ Higher rank indicates more costly. These indicators should be interpreted with caution due to a limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints and information availability.
A01ufig8

Tonga: Doing Business, 2015

(Rank out of 189 economies) 1/

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Source: World Bank Doing Business (2015 Doing Business Report).1/ Higher rank indicates more costly. These indicators should be interpreted with caution due to a limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints and information availability.
1 Prepared by Shi Piao and Eva Christiane Kneer (all APD).

Authorities’ Views

19. The authorities agreed with staff’s views on the need to revisit the inflation reference range. They indicated that the range should be lowered and replaced by a rate, however, they would need to analyze the appropriate level over the medium term, partly because Tonga is a price taker and its inflation is susceptible to external shocks. They also noted that a lower reference rate would necessitate frequent revisions of the reference rate, should inflation rebound in the future due to an unexpected external shock. They emphasized the difficulty of having monetary policy influence the inflation rate, which is why the NRBT is not targeting inflation. The authorities expressed their interest in further developing their monetary policy framework and operational tools, with technical assistance from the Fund.

D. Fostering Financial Stability

20. Tangible progress has been made in repairing banks’ balance sheets and strengthening the legal framework, but challenges to financial stability remain. At present the financial system is bank-centered, comprising one government-owned bank (the Tonga Development Bank) and four commercial banks, one of which has only recently been established. Non-bank financial institutions (for example, provident funds, credit unions, microfinance institutions) are relatively small, and have been expanding only gradually. Key issues include:

  • Improvements in banks’ capital and credit quality. Asset quality in the banking system was deteriorated (e.g., higher non-performing loans (NPL)) during the global financial crisis, but most of Tonga’s banks subsequently improved their capital positions. While NPL ratios have declined to less than 13 percent in 2013/14 down from around 20 percent in 2008/09 (Table 6), the level remains high.

  • Excess reserves. Excess reserves have been large in recent years, hovering around 25 percent of total bank assets. The increase in international reserves and limited sterilization has led to a large injection of liquidity to the banking system.

    Legal framework. Efforts have rightly focused on strengthening regulations including amending the National Reserve Bank of Tonga Act and the Financial Institutions Act with technical assistance from the Fund. The thrust of updating these two laws lies in the authorities’ initiative to: i) bring all financial institutions in Tonga under the supervision of the NRBT; ii) strengthen the autonomy and accountability of the NRBT and reform its governance framework in line with best practices; and iii) provide the NRBT with the authority to issue binding regulations and entrust the NRBT with clear enforcement actions for any contraventions of its decisions.

A01ufig9

PICs: Excess Reserves

(In percent of total assets)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Sources: Country authorities; and IMF staff estimates

21. Banks’ excess reserves mirror weak private credit growth. Despite the authorities’ efforts to stimulate lending through accommodative monetary policies, credit growth has been sluggish due to constraints from both the supply and demand side (e.g., limited collateral, lack of investment opportunities) (Appendix IV). The authorities have embarked on different initiatives to support credit growth, through, for instance, an on-lending scheme administered by Tonga Development Bank designed to channel funds at favorable terms to selected sectors of the economy (e.g., agriculture, manufacturing). It is important that the authorities carefully examine the effectiveness of this on-lending scheme before scaling up its size. In addition, the establishment of Tonga Business Enterprise Center (TBEC) to assist private businesses with the development of business plans and loan applications is a welcome development.

22. Financial risks can be mitigated through active liquidity management, the introduction of macro-prudential tools, and improved bank supervision.

  • Managing macro-financial risks. Current high levels of excess liquidity do not pose an immediate risk to financial sector stability, but better tools to manage liquidity are needed to help avoid excessive credit growth in the future. Possible measures to absorb excess reserves include selling treasury bills and raising reserve requirements. Macro-prudential measures (e.g., loan-to-value ratios) could also play a role in safeguarding financial stability.

  • Improving banking supervision. Enhanced monitoring of banks’ asset quality (e.g., through risk-based on-site inspection to make sure that loan loss provisions are adequate) is important to ensure financial stability. This work could be strengthened in coordination with the PFTAC advisor on banking supervision.

Authorities’ Views

23. The authorities agreed on the need to absorb excess liquidity to help manage macro-financial risks. They recognized the importance of structural reforms to create an environment conducive to more investment opportunities. They were also mindful that higher statutory reserve deposit (SRD) requirements might increase lending rates and/or fees and charges, and reduce credit supply to the private sector, particularly small and medium sized enterprises (SMEs). Therefore, they plan to learn from other Pacific countries’ experiences (e.g., Fiji and Samoa) as to how to stimulate lending to the private sector especially for SMEs. The effectiveness of the government’s Managed Funds (e.g., Economic Growth Facility in the Tonga Development Bank) in stimulating credit growth will be assessed in conjunction with any other measures that may be introduced. The NRBT agreed to use macro-prudential tools to manage macro-financial risks, and noted that they will continue to closely monitor credit growth and examine its impact on monetary policy targets and financial stability.

24. The authorities committed to further strengthen banking supervision. This activity is currently assisted by the IMF PFTAC expert. They indicated that the supervision of non-bank financial institutions (NBFIs) (e.g., retirement fund, credit union, micro-credit institution) is a new challenge, and requested continued technical assistance support to help develop the legislative and regulatory framework for NBFIs.

E. Raising Tonga’s Growth Potential

25. Raising potential growth remains a key challenge. Tonga’s per capita GNP growth over the past two decades was favorable when compared with other non-resource rich Pacific Islands peers, lifting Tonga to the ranks of middle-income countries. Tonga also compares favorably with other PICs in terms of living standards (e.g., high life expectancy at birth) and its business climate. Nevertheless, private sector activity and FDI remain relatively small. In the absence of reform measures over the medium term, longer-term growth would revert to its historical average of around 1¾ percent, once cyclone reconstruction work and Pacific Games-related activities are complete.

A01ufig10

Pacific Island Countries: Structural Indicators 1/

(Percentile ranks)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Sources: World Bank; and IMF staff calculations1/ The scale reflects percentile distributions in all countries for each respective data base/survey and is based on the latest available data.

26. There are several government initiatives to raise Tonga’s growth potential. Tonga’s Strategic Development Framework (TSDF), which is currently under the revision to TSDF II, aims to further develop the primary sector (agriculture, forestry and fishery) and tourism as key sources of growth. The Tonga Energy Road Map 2010-2020 aims to reduce Tonga’s vulnerability to oil price shocks and to improve the cost-effectiveness of energy use. Nonetheless, these efforts have yet to bear fruit. For instance, the initiative of the authorities to commercialize the Tonga Development Bank (TDB) and to revive the International Dateline Hotel has been challenging reflecting a shallow pool of investors. Key bottlenecks for private sector development include risks and investor uncertainty (for example, ambiguity in law and regulations), relatively high business costs (e.g., high electricity tariffs (chart)), and limited access to external markets (Appendix V).

A01ufig11

Industry Electricity Tariffs

(In U.S. dollars per kWh; 2011-2013)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Sources: Country authorities; and IMF staff estimates.

27. Business-enabling structural reforms to promote private sector development remain crucial. Promoting private sector development through further improvements in the business climate, together with more business-friendly laws and regulations (for example, revising the Foreign Investment Act, introducing new legislation on receivership bankruptcy) is critical. As in most small states, the contribution of the public sector to the economy will remain relatively large in Tonga. Therefore, enhancing public financial management with an appropriate medium-term fiscal framework would improve growth potential. Prioritizing expenditure toward growth enhancing and social spending categories (health, education, and infrastructure) would also promote greater inclusiveness.

Authorities’ Views

28. The authorities agreed that structural reforms are critical to raise growth potential. They noted that the revamped Tongan Strategic Development Framework has identified strategies for lifting potential growth rate to around 3 percent in the next 10 years. The authorities continued to see growth potential in the agricultural and tourism sector, and also indicated that new activities, such as call centers could be promising. The authorities expect to make significant progress in revising the Foreign Direct Investment Act and enacting the Receivership Bill to create more transparent business transactions later this year. They also intend to continue their efforts to make SOEs more efficient, including via commercialization of Tonga Development Bank (TDB).

Other Issues

29. Data issues. In staff’s view, Tonga’s macroeconomic statistics are broadly adequate for surveillance purposes, but improvements in data quality and data dissemination are needed (see the Statistical Issues in the Informational Annex). Better-quality statistics will be imperative to strengthen decision making by investors and policy makers. It is also important to implement previous TA recommendations, including the ones recently provided on national account statistics and external sector statistics.

Staff Appraisal

30. Tonga’s economy has rebounded and the outlook is favorable, while risks remain tilted to the downside. Growth is recovering and is expected to average 2–3 percent during the next five years, mainly supported by construction and tourism on the back of several large events (the coronation and the Pacific Games). Inflation is projected to remain low, reflecting the weak outlook for global commodity prices. International reserves are expected to stay comfortable at around 6 months of prospective imports largely, thanks to grants and remittances. The balance of risks is tilted to the downside. External risks involve spillovers from a protracted period of slower growth in advanced and emerging economies, which could weigh on Tonga, mainly through its close economic ties with Australia and New Zealand. On the domestic side, potential cost overruns related to the Pacific Games continue to pose downside risks.

31. The authorities should contain fiscal spending pressures in the near-term and build a sound fiscal position to bolster resilience to shocks over the medium term. Near-term fiscal pressures stem mostly from potentially large wage increases for civil servants, which can be contained by more efficient staff allocation in order to moderate the share of the wage bill in recurrent spending over the medium term. Controlling the spending program for the Pacific Games is also important to avoid cost overruns. The adoption of a roadmap for public financial management reform and the debt management strategy would lay the groundwork for a medium-term fiscal framework. Continued efforts to increase tax revenue by broadening the tax base and strengthening tax administration could create more room for priority social spending and public investment.

32. The current accommodative monetary policy stance is appropriate in view of the weak economy and low inflation, while large excess liquidity calls for better liquidity management to mitigate macro-financial risk. Preserving the current level of international reserves would help ensure external stability, and lowering the inflation reference rate would better anchor inflation expectations over the medium term. Although the presence of excess liquidity does not pose an imminent risk to financial sector soundness in the near term, the authorities should prepare to manage macro-financial risks by improving liquidity management and adopting macro-prudential tools. The progress in improving banks’ balance sheets and strengthening the legal framework in the financial sector is welcome.

33. Structural reforms remain imperative to raising Tonga’s potential growth. Progress in updating Tonga’s strategic development framework (TSDF II) is welcome. Steadfast implementation of the authorities’ reform plan is crucial to make growth more sustainable and inclusive. Implementing key initiatives, such as revising the Foreign Investment Act, would help improve the business climate and promote private sector development.

34. Implementing TA recommendations are important for successful reforms. Improving the quality of data statistics will also help policy formulation and facilitate private sector decisions. In view of limited resources, better coordination and prioritization of Tonga’s prospective TA program is needed. The IMF/PFTAC would continue to provide the bulk of technical assistance, in coordination with other development partners.

35. It is recommended that the next Article IV Consultation takes place on the standard 12-month cycle.

Figure 4.
Figure 4.

Tonga: Financial Intermediation

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Table 1.

Tonga: Selected Economic Indicators, 2009/10-2015/161/

article image
Sources: Tongan authorities; and IMF staff estimates and projections.

Fiscal year beginning July.

Including preliminary data.

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

Table 2.

Tonga: Summary of Government Operations, 2009/10-2015/16

article image
Sources: Tongan authorities; and IMF Staff estimates.

Recurrent expenditure excludes one-off expenditure.

Table 2a.

Summary of Central Government Operations, 2009/10-2015/16 1/

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

Table reports central government operations in the GFSM 2001 format.

Table 3.

Tonga: Depository Corporations Survey, 2009/10-2015/161/

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Sources: Tongan authorities; and IMF 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, 2009/10-2015/16

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

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Sources: Tongan authorities; and IMF staff estimates.

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

Change in gross official foreign reserves.

Table 5.

Tonga: Medium-Term Scenario, 2010/11-2019/20 1/

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

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Sources: Tongan authorities; and IMF staff estimates and projections.

Fiscal year beginning July.

Table 6.

Tonga: Financial Soundness Indicators, 2007/08-2013/14 1/

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

Data as of end of fiscal years.

Table 7.

Tonga: Millennium Development Goals, 1990-2013

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Source: World Bank, World Development Indicators database.

Appendix I. Risk Assessment Matrix1

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Appendix II. Public Financial Management Reform1

A well-functioning Public Financial Management (PFM) system contributes to economic stability and growth by improving the use of public resources and strengthening governance. In the case of Tonga, where foreign aid plays an important role in economic development, effective PFM also provides assurance to donor countries that aid is used in a transparent and efficient manner.

PFM in Tonga has improved in the past decade, but considerable weakness still exists. In the 2007 Public Expenditure and Financial Accountability (PEFA) assessment, Tonga received 7 ratings of “A/B” of the 27 applicable performance indicators. This number increased to 12 in the 2010 assessment. The latest 2014 self-assessment showed further progress in improving some weak PFM areas and maintaining the areas that performed well. The table below compares the ratings of performance indicators from the 2010 PEFA assessment and 2014 PEFA self-assessment. Areas including revenue out-turn compared to budget, measures for tax assessment and taxpayer registration, and transparency of taxpayer obligations and liabilities continue to perform well. At the same time, areas including oversight of fiscal risks from public enterprises, composition of expenditure out-turn compared to budget, and quality and timeliness of in-year budget reports have been improved from ratings of “C/D” to “A/B”.

A01ufig12

Figure: PEFA Indicators changed in 2014 Assessment

(A=4, B=3, C=2, D=1)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Nonetheless, some PFM areas continue to be weak, such as the implementation of the three-year rolling medium-term budgeting framework, effectiveness of tax collection, and internal and external audit. In particular, performance in two areas has deteriorated since the 2010 assessment. They are processes for public procurement (from “C” to “D”) and effectiveness of payroll controls (from “B+” to ‘C+”).

The government of Tonga attaches high importance to PFM reform, which is considered critical to long-term growth. In October 2014, the Cabinet endorsed the PFM reform Roadmap which aims to improve critical PFM areas based on the 2014 assessment. The Roadmap proposes a total of 77 phased actions to be completed before 2019 and emphasizes the following priority areas:

  • strengthening the effectiveness of tax collection and internal audit;

  • enhancing and upgrading the Government Integrated Financial Management Information System (IFMIS);

  • better integrating planning, budgeting, and aid management functions; and

  • ensuring adequate staff capacity in all PFM units in line ministries and public agencies, through new recruitment or strengthening capacity of existing staff.

The Roadmap recognizes the importance of effective communication with stakeholders and proper sequencing of the reform actions. However, potential areas of weakness exist:

  • the timing for the IFMIS upgrade is ambitious, and the Roadmap appears more focused on equipment updates than on business process redesign to improve internal management;

  • actions may not be adequate to address the effectiveness of payroll controls, a PFM area which has deteriorated in the 2014 assessment; and

  • the discussion of devolution of PFM responsibilities needs to be managed carefully to avoid unintended consequences (for example, less coordinated budgeting and lack of consistency)

Table.

Comparison between 2010 PEFA and 2014 Self-assessment

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Table.

Comparison between 2010 PEFA and 2014 Self-assessment

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Appendix III. Moving to Inflation Point Reference System1

The NRBT uses an inflation reference range of 6 to 8 percent, which has remained unchanged since 2011, despite a fall in Tongan inflation after the global financial crisis. Actual inflation has been consistently below the reference range since then, raising questions about the usefulness of the range. The NRBT could introduce an inflation reference rate along the following lines:

  • Introducing an inflation reference rate. A benchmark for inflation would be useful for facilitating internal policy discussions and coordination, including with the Ministry of Finance and National Planning (MOFNP). A reference rate rather than range would be more suitable for this purpose. The rate could be set equal to the medium-term inflation forecast (e.g., use IMF staff’s forecast of 3.5 percent), which should be reviewed periodically to ensure consistency with economic fundamentals.

  • Policy coordination and discussion. The central bank could use the reference rate in their assessment of economic developments and outlook during their periodic review of monetary policy setting. The central bank should share their assessment with the Ministry of Finance and National Planning (MOFNP) and discuss policy coordination.

  • Improve communication. The rationale for choosing an inflation reference rate and the use of it should be clearly communicated to the public. The NRBT could also mention that the inflation reference rate reflects what the NRBT sees as consistent with medium-term fundamentals of the Tongan economy. The NRBT’s Monetary Policy Statement could also explain deviation from the reference rate, as well as the authorities’ intended policy reaction.

A01ufig13

Tonga: Headline Inflation

(In annual percentage change)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

Sources: Tongan authorities; and IMF staff estimates.

Appendix IV. Impediments to Credit Growth1

Despite accommodative monetary policy and ample liquidity in the banking sector, credit to the private sector has declined since the global financial crisis and remained weak in recent years. To implement effective policies for reviving credit growth, it is important to identify whether banks are reluctant to lend (supply-side constraint) or whether firms and households are unwilling to borrow (demand-side constraint). In Tonga, both demand- and supply-side constraints seem to limit credit growth, but supply-side constraints might be easier to address by policymakers.

  • Demand-Side Constraints. A moderate growth outlook, limited investment opportunities and low expected returns are important constraints to credit demand in Tonga. High interest rates and unattractive lending conditions also reduce borrowing. Although lending rates for both households and businesses have gradually fallen in recent years, they remain elevated at roughly 8 percent. The requirement to pledge land as collateral entails risks that small borrowers are unwilling to take. Furthermore, many businesses and households still struggle to service past debt obligations. The availability of alternative funding sources might also have reduced the demand for bank credit. While Tonga does not have a corporate bond market, lending by micro-finance institutions, retirement funds, credit cooperatives and money lenders has gained in importance in recent years.

  • Supply-Side Constraints. Several commercial banks in Tonga experienced large loan losses during the global financial crisis, and focused on repairing their balance sheets in the following years, thus limiting their ability to expand lending. Partially as a result of this experience, lending practices by banks have become more conservative after the crisis. Banks typically require borrowers to pledge collateral or to make an equity contribution to the business project. Small borrowers often lack the means to contribute equity to the project. Land tends to be the only asset that could qualify as collateral, but a lengthy land registration process and a limited secondary market for land reduce the value of land as collateral to banks. Furthermore, information provided by Tonga’s credit bureau is perceived as incomplete, complicating the process of screening borrowers. As a result, banks tend to concentrate on extending credit to larger established businesses, and shy away from lending to SMEs.

Appendix V. Challenges to Growth1

Tonga faces considerable challenges to achieving higher economic growth, many of which are shared with its Pacific island neighbors. Nations that move up from Tonga’s level of income most often do so by exporting competitive manufactures or building industries to serve large domestic markets.2 Neither are viable growth strategies for Tonga. The South Pacific islands countries, including Tonga, are the most distant in the world from markets (on a GDP-weighted basis).3 This, on its own, heightens frictional trade costs. With scale, such costs could be lowered but Tonga is also unable to exploit the economies of scale required to bring down production costs because of its small size—a population of 100,000. Small size and economic remoteness combine to produce more formidable barriers to growth than either would on its own. For example, it is hard to service Tonga by large container vessels, which are the standard in international shipping, thus increasing the cost of long-distance logistics.4

Despite the considerable challenges of size and location, there are viable growth strategies that countries such as Tonga can and have successfully pursued to support growth and shared prosperity. Industries that trade on the natural assets of the country, such as sustainable tourism, fisheries, agriculture and possibly seabed mining are areas of potential. Tourism in particular offers the prospect of growth in supporting industries including better use of domestic production base (e.g., agriculture), substituting for costly imported products. Tonga has already taken significant steps towards creating a conducive environment for growth. The figure below shows that Tonga performs better than the East Asia Pacific (EAP) average in 7 of the 10 measured areas, but significant constraints persist in registering property, investor protection and insolvecy resolution.5

Tonga has made considerable infrastructure investments, including a new national fiber-optic cable, renewable energy capacity and road network in the capital island. At the same time, the most often-cited constraints to private sector development in Tonga remain, namely: i) risk and uncertainty; ii) high cost of doing business; and iii) lack of access to markets. Growth-enhancing initiatives include:

  • First, there is scope to improve the predictability and certainty for business to support long-term planning by reducing ambiguity, discretion and gaps in law and regulation, by putting in place clear, unambiguous and appropriate legislation built on consultation and which is clearly communicated to the public. Areas of importance are in labor market regulation, trade taxation, discretionary tax exemptions and foundational law for formal credit markets to function properly. Work underway on the Foreign Investment Act and supporting legislative revisions will also be important.

  • Second, using a combination of development partner-supported infrastructure investment, targeted policy reforms and effective regulation could reduce business costs such as energy and logistics.

  • Third, Tonga could seek to strengthen external partnerships that support improved market access and promote collective (regional) solutions to public goods provision and facilitate cross-border economic activity. Pro-development relationships with donor countries need to prioritize the economic benefit for Tonga by facilitating and lowering the barriers to much larger markets. Regional partnerships could aim to solve collective action problems by fostering strong cooperative action, which will yield greater benefits for all.

Figure.
Figure.

Doing Business 2014/15: Distance to Frontier Scores for Tonga Relative to EAP Average

(In annual percentage change)

Citation: IMF Staff Country Reports 2015, 107; 10.5089/9781475518375.002.A001

1. starting a business; 2. construction; 3. getting electricity; 4. registering property; 5. getting credit; 6. protecting investors; 7. paying taxes; 8. trading across borders; 8. enforcing contracts; 9. resolving insolvency1/ These indicators should be interpreted with caution due to a limited number of respondents, a limited geographical coverage, and standardized assumptions on business constraints and information availability.
1

Fiscal years in Tonga run from July to June.

2

The reconstruction of the business district in the capital city was completed in 2011/12.

1

The Risk Assessment Matrix (RAM) shows events that could materially after the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff's subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

1

Prepared by Fei Liu (SEC) and Ronald Lee Hacket (PFTAC).

1

Prepared by Yasuhisa Ojima (APD).

1

Prepared by Eva Christiane Kneer (APD).

1

Prepared by David Knight (WB) and Johannes Wolf (ADB).

2

Bulman, D. et al, 2014, Transitioning from Low-Income Growth to High-Income Growth, World Bank Policy Research Working Paper 7104.

3

World Bank, 2014, East Asia and Pacific Economic Update October 2014, World Bank: Washington DC.

4

UNCTAD, 2014, Review of Maritime Transport, United Nations: New York and Geneva.

5

World Bank, 2014, Doing Business 2015: Going Beyond Efficiency, World Bank: Washington DC.

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Cover IMF Staff Country Reports
Tonga: 2015 Article IV Consultation-Staff Report; and Press Release
Author:
International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2015: Issue 107
Publisher:
International Monetary Fund
ISBN:
9781475518375
ISSN:
1934-7685
Pages:
69
DOI:
https://doi.org/10.5089/9781475518375.002
Figure 1.

Tonga: Stylized Facts

Population vs GDP-Weighted Distance 1/

Tonga: Key components of GDP

(In percent of GDP)
Figure 2.

Tonga: Recent Economic Developments
Figure 3.

Tonga: External and Monetary Developments

Real GDP Growth - Decomposition

(In percent)

Pacific Small States: Oil Imports, 2012-13

(In percent of GDP)

Tonga: Tax Revenue

(In percent of GDP)
Figure 1

Gross International Reserves

(In millions of US dollars)
Figure 2

Optimal Levels of Reserves

(Months of current imports)

New Zealand Tourists to Selected Pacific Islands

(In thousands)

Ease of Doing Business, 2015

(Rank out of 189 economies) 1/

Tonga: Doing Business, 2015

(Rank out of 189 economies) 1/

PICs: Excess Reserves

(In percent of total assets)

Pacific Island Countries: Structural Indicators 1/

(Percentile ranks)

Industry Electricity Tariffs

(In U.S. dollars per kWh; 2011-2013)
Figure 4.

Tonga: Financial Intermediation

Figure: PEFA Indicators changed in 2014 Assessment

(A=4, B=3, C=2, D=1)

Tonga: Headline Inflation

(In annual percentage change)
Figure.

Doing Business 2014/15: Distance to Frontier Scores for Tonga Relative to EAP Average

(In annual percentage change)