Tonga: Staff Report for the 2017 Article IV Consultation—Debt Sustainability Analysis
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
17 Jan 2018
eISBN:
9781484338032
Language:
English
Keywords:
ISCR; CR; current account; real GDP; GDP; GDP deflator; sustainability framework; service-to-revenue ratio; creating funding; debt-creating flow; debt distress rating; Public and publicly-guaranteed external debt; Public sector; Australia and New Zealand; Pacific Islands
Download PDF (440.9 KB)

2017 Article IV Consultation-Press Release; and the Staff Report for Tonga

Abstract

2017 Article IV Consultation-Press Release; and the Staff Report for Tonga

Background

1. Reconstruction costs after Cyclone Ian in 2014 and a legacy of large external loans have contributed to the accumulation of external debt in Tonga. The current Government’s policy of no non-concessional external debt has helped to keep the outstanding amount of debt under control. External debt was 41.8 percent of GDP in FY2017 decreasing from 44 percent of GDP in FY2016, thus remaining below the Government’s threshold of 50 percent.

2. The external debt distress rating is raised from moderate to high, to better account for the spending needed to finance reconstruction after future natural disasters. The medium-term baseline projections are adjusted to fully internalize the average effect of natural disasters on GDP growth, and on the current account and fiscal balances. The methodology used in this DSA is in line with the 2016 IMF Board Paper “Small States’ Resilience to Natural Disasters and Climate Change.” Given the elevated costs associated with reconstruction following natural disasters, the inclusion of additional spending in the medium-term projections is the main driver of worsened external debt dynamics for Tonga.

3. In the short-term, external debt remains stable in the baseline scenario, with a considerable increase in debt service ratios and utilization of FX reserves. Planned repayments of the China EXIM loans starting in FY2019 partially offset the financing requirements stemming from the government’s infrastructure spending. The repayments, though positive in terms of stabilizing the debt burden, will put considerable pressure on debt service ratios and on Tonga’s foreign exchange (FX) reserves in the upcoming years. Debt service is projected at 1.5 percent of GDP in FY2018 and, subsequently, to more than double to 3.8 percent of GDP from FY2019 onwards.

4. The Government of Tonga has a limited exposure to domestic public and private enterprises, through its on-lending of funds. As of end FY2017, total government loans outstanding stood at T$52.5 million, of which T$11.1 million or 1.2 percent of GDP are currently in arrears. The largest component of these arrears is on-lent funds to companies with majority of state ownership, which are currently under liquidation.

Methodology and Assumptions: Natural Disasters in the Baseline Scenario

5. Tonga is very vulnerable to natural disasters, in terms of both recurrence and average damage as a percent of GDP. The 2016 World Risk Index3 ranks Tonga as the world’s second most vulnerable country to natural disasters, while a recent IMF Board Paper4 ranked Tonga as eleventh most vulnerable Small Developing State to natural disasters.

6. The assumptions used to prepare the DSA are consistent with the macroeconomic framework of the Staff Report for the 2017 Article IV Consultation and are as follows:

  • Real GDP growth is projected to remain between 2.7 percent and 3.4 percent in FY2017 through FY2020, mainly due to strong construction activity and increasing exports of tourism and agriculture. For FY2020 through FY2022, growth is projected to gradually decline towards the long-term average of 1.8 percent, assuming no natural disasters. To incorporate the average effect of natural disasters on growth, consistently with IMF (2016), long-term GDP growth is lowered by 0.7 percentage points to 1.1 percent from FY2023 onwards.5,6

  • Inflation, measured as the GDP deflator growth, is projected to stabilize around 2.1 percent from FY2018 onwards, after an increase to 3.1 percent occurred in FY2017. The GDP deflator increased in FY2017 due to dry weather pushing up domestic food and kava prices. In the same period, the spike in CPI inflation was much larger reflecting a sharp increase of import taxes on fatty meat and tobacco products.

  • Higher own-financed reconstruction spending in both the fiscal and current account balances. To quantify the additional burden on the fiscal expenditure of reconstruction costs, staff used data on natural disasters starting in 1980 to calculate (i) the probability that a natural disaster occurs in each year; and (ii) the average cost of damages associated with natural disasters. Using these data, the estimated average yearly damage is calculated as the multiplication of (i) and (ii), yielding for Tonga an approximate yearly damage of three percent of GDP. This DSA assumes that one percent of GDP from this damage is the yearly reconstruction cost that must be financed by government borrowing in the baseline scenario starting in FY2023.

  • The current account (CA) deficit has been wavering around 12 percent of GDP in the latest periods, notwithstanding a strong private remittances component. In the medium-term, the CA is projected to stabilize around 12 percent of GDP before the effect of natural disasters. To take these latter into account, this DSA assumes that reconstruction spending has a 100 percent import component and, consequently, the CA deficit is widened by one percent of GDP from FY2023 onwards.

  • The fiscal deficit is projected to widen to 2.3 percent of GDP in FY2018 and reach 4.4 percent of GDP in FY2020 due to increased infrastructure investments. It is then projected to stabilize at around 1.4 percent of GDP before the effect of natural disasters. From FY2023 onwards, the deficit is projected to widen by one percent of GDP, to account for average additional borrowing due to natural disasters.

  • Remittances flows in Tonga are large, mainly from a low skilled labor force of seasonal workers in Australia and New Zealand. Although the flows have recently been strong, they are volatile and subject to changes in the economic cycle of these two countries, which can affect the income of and the demand for low skilled workers. In Tonga, remittances are used by relatives of emigrants to finance consumption, mostly of imported goods. Finally, it is expected that future pressures on flows will stem from the increased costs of remittances associated with the de-risking and loss of correspondent banking relationship phenomena.

  • The financing requirements, which from FY2023 onwards include natural disasters spending, are assumed to be met mainly through additional external borrowing. The average grant element of this borrowing in the medium term converges to close to 40 percent. The calculation of the average grant element assumes that future financing from the ADB and IDA remains on a 50 percent grant and 50 percent loan basis, and that additional borrowings not covered by the ADB or IDA are on terms that are concessional but not as favorable as the ADB or IDA.7

uA03fig01

GDP Growth with Natural Disasters

(In Percent)

Citation: IMF Staff Country Reports 2018, 012; 10.5089/9781484338032.002.A003

Source: Tongan authorities; and IMF Staff calculations.

External DSA

7. The present value (PV) of external debt-to-GDP plus remittances ratio hits the indicative threshold in FY2037, while the PV of external debt-to-GDP ratio (excluding remittances from the denominator) breaches the indicative threshold in FY2032 (Figures 1a and 1b). At the end of the projection horizon in 2037, the PV of debt-to-GDP is 4.2 percentage points above the indicative threshold. These results are mainly driven by the incorporation of natural disasters, which have negatively affected Tonga’s economic growth and overall contribute to weaker and more volatile fiscal and external positions.8

Figure 1a.
Figure 1a.

Tonga: Indicators of Public and Publicly Guaranteed External Debt under Alternatives Scenarios Excluding Remittances, 2017–37 1/

Citation: IMF Staff Country Reports 2018, 012; 10.5089/9781484338032.002.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 2027. 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
Figure 1b.
Figure 1b.

Tonga: Indicators of Public and Publicly Guaranteed External Debt Including Remittances, 2017–37 1/

Citation: IMF Staff Country Reports 2018, 012; 10.5089/9781484338032.002.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 2027. 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 Combination shock and in figure f. to a One-time depreciation shock

8. Excluding private remittances from the denominator of the debt-to-GDP projections (and the associated thresholds) provides a more accurate reflection of the sustainability of Tonga’s external debt. Remittances, at 27.4 percent of GDP in FY2017, play a large role in Tonga’s macroeconomic framework. At the same time, remittances in Tonga are almost entirely used to finance consumption, which has a large import component. Remittances are also highly volatile. Furthermore, similar to a number of other Pacific Islands, Tonga has intermittently faced pressures on remittance channels as banks have responded to tightening AML/CFT standards by closing bank accounts of money transfer operators. Therefore, remittances—though large—should not be considered a mitigating factor in the debt sustainability assessment, as they are volatile and are not a reliable source of FX. Staff therefore assess Tonga’s debt sustainability using the alternative scenario which does not include remittances.

9. The largest contributor to the combination shock to the PV of debt-to-GDP is a decrease in external transfers. This result highlights the large reliance of Tonga on external non-debt creating funding (e.g. grants in the case of official transfers) to finance fiscal expenditure. Although the scenario is unlikely, the shock shows how vulnerable are public finances should a significant shortfall in donor funding materialize.

10. The repayment of the EXIM loans in the coming fiscal years more than doubles the debt-service ratios. The servicing of these loans, particularly in terms of principal repayments, is expected to reduce Tonga’s FX reserves, and is subject to exchange rate risk. Thus, should existing buffers not be sufficient to meet the large payments, the additional debt service burden may lead to new financing needs in addition to the existing pressures from the government’s infrastructure spending, putting at risk the stabilization of debt that is currently projected in the baseline scenario.

11. Finally, the DSA considers a downside scenario, in which a natural disaster occurs in FY2018, sooner than the incorporation of the average annual effect into the projections. (Figure 1, green line). Under this scenario, which in accordance with staff estimates has a probability of around 30 percent, the sustainability threshold would be breached much sooner. For this scenario, a damage of 10 percent of GDP and a reduction of GDP growth of four percent are assumed in FY2018, both in line with historical averages.

Public DSA

12. The PV of public debt-to-GDP ratio does not breach the indicative threshold in the DSA projections (Figure 2). Nevertheless, the baseline scenario features an increasing debt burden from FY2023 onwards, reflecting the additional indebtedness due to spending on natural disasters.

Figure 2.
Figure 2.

Tonga: Indicators of Public Debt Under Alternative Scenarios, 2017–37 1/

Citation: IMF Staff Country Reports 2018, 012; 10.5089/9781484338032.002.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 2027.2/ Revenues are defined inclusive of grants.

Conclusion

13. The risk of external debt distress rating in the DSA 2017 is increased to high, due to Tonga’s fiscal fragility and the potentially large impact of natural disasters on debt sustainability. The reclassification is based on the model which does not include remittances. This notwithstanding, the current debt burden is still at a moderate level. Against this background, the authorities should focus fiscal efforts on maintaining fiscal sustainability by targeting a primary surplus of one percent of GDP in the medium term, while keeping buffers at a minimum of four-to-five months of recurrent expenditure, in view of future reconstruction efforts. The most extreme shock considered by the DSA framework highlights Tonga’s reliance on transfers, and shows the country is very vulnerable should a shortfall in non-debt creating financing materialize.

Authorities’ Views

14. The authorities agreed with staff’s DSA assessment, including on the reclassification to “high risk”. Staff delivered a presentation on the new DSA with natural disasters to officials from the NRBT and the MOFNP. The authorities welcomed the explicit account of natural disasters in the long run projections and potentially significant adverse effects on growth and fiscal accounts. In their view, the higher share of loans financing from development partners in the previous framework without natural disasters posed a threat to debt sustainability in the long run. The authorities agreed on the need for further research work to continue improving the quantification of the macroeconomic burden of disasters. Finally, they agreed with the need for a more prudent fiscal policy and to maintain sufficient buffers, in view of Tonga’s vulnerability to external shocks.

Table 1.

Tonga: External Debt Sustainability Framework, Baseline Scenario, 2014–37 1/

(In percent of GDP, unless otherwise indicated)

article image
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 2a.

Tonga: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt Excluding Remittances, 2017–37

(In percent)

article image
article image
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 assumingan 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 2b.

Tonga: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt Including Remittances, 2017–37

(In percent)

article image
article image
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 assumingan 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 3.

Tonga: Public Sector Debt Sustainability Framework, Baseline Scenario, 2014–37

(In percent of GDP, unless otherwise indicated)

article image
Sources: Country authorities; and staff estimates and projections.

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

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

Revenues excluding grants.

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

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