This paper discusses recent economic developments, economic outlook, risks, and challenges in Tonga. The Tongan economy has been rebounding since a contraction in FY2013. Growth accelerated from 2.1 percent in FY2014 to 3.7 percent in FY2015, supported by construction, tourism, strong remittances, and strong private credit, notwithstanding weather-related disruptions to agricultural production. The FY2016 real GDP growth is projected to remain relatively strong at 3.1 percent, driven by a recovery in agriculture and an increase in construction activity in preparation for the South Pacific Games. However, a protracted period of slower growth in advanced and emerging market economies, particularly in Australia and New Zealand, could weigh on Tonga via aid, remittances, and tourism channels.

Abstract

This paper discusses recent economic developments, economic outlook, risks, and challenges in Tonga. The Tongan economy has been rebounding since a contraction in FY2013. Growth accelerated from 2.1 percent in FY2014 to 3.7 percent in FY2015, supported by construction, tourism, strong remittances, and strong private credit, notwithstanding weather-related disruptions to agricultural production. The FY2016 real GDP growth is projected to remain relatively strong at 3.1 percent, driven by a recovery in agriculture and an increase in construction activity in preparation for the South Pacific Games. However, a protracted period of slower growth in advanced and emerging market economies, particularly in Australia and New Zealand, could weigh on Tonga via aid, remittances, and tourism channels.

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This is the second update of the debt sustainability analysis (DSA) conducted jointly by the IMF and the World Bank since 2014.1 The results for external debt indicate that Tonga remains at a moderate risk of debt distress, and the highest risk to debt sustainability emanates from a combination of shocks to GDP, exports, the U.S. dollar deflator and grants. Analysis of public debt points to risks stemming from strong wage growth.

Underlying Assumptions

Compared with the DSA update in 2015, the underlying assumptions remain broadly stable (Table 1) with growth converging to 1.8 percent in the medium-term to factor in downside effects of periodic shocks from natural disasters. The following highlights the main changes:

Table 1.

Tonga: DSA Update; Key Variables 1/

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

Data on fiscal year basis, with fiscal year beginning in July.

  • With the new global price outlook, the GDP and exports deflators have been revised downward, leading to lower nominal GDP and exports during the projection period.

  • The fiscal balance deteriorates versus the previous DSA, reflecting higher wage spending and lower grants from development partners, and assuming more financing to Tonga in the form of loans.

Tonga: Key Macroeconomic Assumptions

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Sources: national authorities; and IMF staff estimates.

The current account deficit also worsens, assuming larger non-debt creating inflows (capital grants cash and in-kind) in the run-up to the South Pacific Games (SPG).

External Dsa

Under the baseline scenario, all Tonga’s external debt distress indicators remain below their country-specific policy-based indicative thresholds (Figure 1). The rise in debt service ratios from 2019 to 2029 reflects mostly repayments of the two external loans from China EXIM Bank. The bound tests demonstrate that with a combined shock to GDP, exports, the U.S. dollar GDP deflator and non-debt creating inflows, three debt ratios (PV of debt-to-GDP+remittances, PV of debt-to-exports+remittances and debt service-to-revenue) breach their respective thresholds, two of which significantly and on a more sustained basis, suggesting a moderate risk of debt distress.

Figure 1.
Figure 1.

Tonga: Indicators of Public and Publicly Guaranteed External Debt under Alternatives Scenarios, 2016-2036 1/

Citation: IMF Staff Country Reports 2016, 178; 10.5089/9781498311816.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio on or before 2026. In figure b. it corresponds to a Combination shock; in c. to a Combination shock; in d. to a Combination shock; in e. to a Exports shock and in figure f. to a One-time depreciation shock

Additional risks arise from a potential shortfall of donor grants to finance the SPG and periodic spending to respond to natural disasters. To illustrate these risks, an alternative scenario has been prepared assuming about T$100 million being borrowed to finance the capital costs of the games during FY2016–19, on the terms of China’s EXIM Bank loan (2 percent interest, 20-year maturity, and 5-year grace period).2 It is also assumed that natural disasters once every 4 years, leading to a decline in GDP by about 2 percentage points and to additional spending on recovery, amounting to about one percent of GDP in the following years. Although past recovery efforts have been generously grant-financed by donors, the assumption is that financing will diminish going forward. Compared to the baseline scenario, debt ratios will increase, narrowing their distance to thresholds significantly but not breaching them. Hence, the moderate risk rating remains under this alternative scenario.

Public Section Dsa3

Under the baseline scenario, the present value of public debt is projected to remain below the benchmark throughout the projection period (Figure 2), steadily decreasing to below 20 percent of nominal GDP. However, in the scenarios in which the primary balance remains at the level of 2016 throughout the projected period, or the public wage bill grows at an average rate of the past three years (7 percent) during the projection period, public debt becomes unsustainable.

Figure 2.
Figure 2.

Tonga: Indicators of Public Debt Under Alternative Scenarios, 2016-2036 1/

Citation: IMF Staff Country Reports 2016, 178; 10.5089/9781498311816.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio on or before 2026.2/ Revenues are defined inclusive of grants.

Conclusion

Compared to the DSA update of 2015,4 the risks to debt sustainability increased somewhat as demonstrated by the results of the most extreme shock simulations. Additional risks stem from the inability of the government to contain wage growth. However, the risk of external and public debt distress continues to be classified as moderate.

Authorities’ views

The authorities broadly agreed with the staff assessment of debt sustainability risks. They strive to maintain robust debt policies. To that end, they have recently finalized the Debt Management Policy and are taking steps to alleviate debt burden, including negotiating debt forgiveness with the Bank of China (T$8 million) and refinancing debt to the Pension Fund. They are concerned, however, that a higher share of loan financing by development partners (the World Bank and the Asian Development Bank) following Tonga’s upgrade to a moderate level of risk of debt distress in 2014 could undermine debt sustainability. They agree with the staff that other risks emanate from the pressure to raise public sector wages and to finance the SPG, and that it is important to maintain fiscal buffers for contingencies, such as natural disasters.

Table 2.

Tonga: External Debt Sustainability Framework, Baseline Scenario, 2013–36 1/

(In percent of GDP, Unless Otherwise Indicated)

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Sources: Country authorities; and staff estimates and projections.

Includes both public and private sector external debt.

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

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

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

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

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

Defined as grants, concessional loans, and debt relief.

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

Table 3.

Tonga: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2016–36

(In percent)

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Sources: Country authorities; and staff estimates and projections.

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

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

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

Includes official and private transfers and FDI.

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

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

Table 4.

Tonga: Public Sector Debt Sustainability Framework, Baseline Scenario, 2013–36

(In percent of GDP, Unless Otherwise Indicated)

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Sources: Country authorities; and staff estimates and projections.

Central government; gross debt.

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

Revenues excluding grants.

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

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

Table 5.

Tonga: Sensitivity Analysis for Key Indicators of Public Debt 2016–36

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Sources: Country authorities; and staff estimates and projections.

Assumes that real GDP growth is at baseline minus one standard deviation divided by the square root of the length of the projection period.

Revenues are defined inclusive of grants.

1

The last full DSA was prepared in June 2014 (SM/14/173, Sup.2). In line with the Staff Guidance Note on the Application of the Joint Bank-Fund Debt Sustainability Framework for Low-Income Countries in April 2016, Factsheet URL: http://www.imf.org/external/np/exr/facts/jdsf.htm, a full DSA is expected to be prepared every three years, or whenever circumstances have changed significantly since the previous DSA, such as a change in the external risk rating or overall risk assessment. Light updates should be prepared in intervening years. With the latest three-year average score of 3.47, Tonga is classified as a medium performer according to the World Bank Country Policy and Institutional Assessment (CPIA).

2

The most recent projections of the costs of the SPG range from T$80 million to T$100 million. This is down from previous estimates to reflect the authorities’ decision to utilize existing facilities rather than construct new accommodations.

3

The public sector comprises the central government and there is no local government in Tonga. The Country Policy and Institutional Assessment (CPIA) rating for Tonga remains at a medium level with a three-year average score of 3.47. The Tonga fiscal year starts in July.

4

See IMF Staff Report of the 2015 Article IV Consultation – Debt Sustainability Analysis Update.