Public Information Notice No. 03/17

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Tonga

February 24, 2003

On February 5, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga.¹

Background

Economic activity rebounded modestly in 2001/02, as real GDP growth accelerated from about ½ percent in 2000/01 (fiscal year July-June) to 1½ percent in 2001/02 (Table 1). Conditions in agriculture improved owing to record-high prices for squash and vanilla. Construction rebounded sharply with the assistance provided by the international community to rebuild structures destroyed by Cyclone Waka. Tourism and the service sector have been sluggish during most of the past two years, partly owing to the unwinding of the stimulus from the new millennium celebrations and the impact of September 11 events, but tourism has been recovering markedly in recent months.

Knock-on effects from external shocks and competing demands on the budget have exerted extensive pressure on fiscal policy in 2001/02. Over the past two fiscal years, annual budget deficits estimated at around 1½ percent of GDP, reflected primarily increased support to public enterprises and rapid growth in current expenditures, as public wages were adjusted by 20 percent for cost of living in 2000/01. The deficit was primarily financed through bonds with the banking system and some external borrowing.

Credit has expanded at a very rapid pace. The ratio of private sector loans to deposits has risen sharply since November 2001 and stood close to a five year high in September 2002. Credit to public sector enterprises also expanded rapidly, but represented only 5 percent of total banking sector credit by September 2002. Interest rates remained largely stable in nominal terms and have become increasingly stimulatory with the acceleration of inflation. The NRBT introduced indicative quarterly ceilings on banks' credit to the non-financial private sector in June 2002.

Expansionary macroeconomic policies have resulted in a marked decline in net foreign assets, a weaker pa'anga, and higher inflation. Net foreign assets of the banking system declined from US$20 million in November 2001 to US$12 million in September 2002. Gross official reserves were temporarily boosted to US$18 million in June 2002, mainly reflecting the disbursement of the first tranche of the Economic and Public Sector Reform Program supported by the Asian Development Bank. However, with sustained demand pressures, reserves fell to US$13 million by end-September 2002. The exchange rate continued to depreciate relative to the basket peg and contributed to keep inflation high. Following the sharp real depreciation of the pa'anga between July 2000 and November 2001, the pa'anga appreciated by 1½ percent against the U.S. dollar, but since then, it depreciated by 3 percent through September 2002. Nonetheless, since November 2001, the exchange rate depreciated by 5½ percent in nominal effective terms against the basket and by 1¾ percent in real effective terms, primarily reflecting the weakening of the U.S. dollar vis-à-vis the New Zealand and Australian dollars. During 2002, inflation accelerated to about 10 percent, and price pressures have become broad based.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They expressed concern about the deterioration of macroeconomic performance in Tonga in recent years, which reflected limited progress in dealing with long-standing structural weaknesses, difficulties in preserving macroeconomic stability, and adverse weather and global economic shocks. Official reserves have been depleted, the pa'anga has depreciated markedly, and public indebtedness and inflation have increased rapidly. At the same time, economic growth has been sluggish, and unemployment has become a serious concern. Directors noted that the loss of most assets in the Tonga Trust Fund has further hampered the economy's ability to buffer adverse shocks and left the economy in a vulnerable condition.

Against this background, Directors stressed the need to take rapid and decisive action to restore macroeconomic stability. They urged the authorities to adopt fiscal measures, including better monitoring and elimination of some exemptions on import duties for personal and household goods and petroleum products, broadening the sales tax base and increasing the rate of the tax, and reducing current expenditures, particularly the public wage bill. They noted that continued support to ailing public enterprises would further undermine the much-needed improvement in the budget balance.

Directors recommended changes to the monetary policy framework to stem rapid credit growth, contain inflation, and help restore official reserves. They viewed greater reliance on indirect instruments as the most effective means of conducting monetary policy. Directors noted that, in the transition to a new framework, credit ceilings need to be enforced strictly through penalties on breaches by commercial banks, or otherwise replaced with alternative instruments, such as higher reserve requirements. Directors supported a prompt recapitalization of the National Reserve Bank of Tonga to restore its ability to effectively conduct open market operations, and encouraged the authorities to ensure that interest rates remain positive in real terms. Directors also saw a need to protect the National Reserve Bank of Tonga's financial position through strict limits on lending to the government.

Directors observed that exchange rate policy should aim at preserving competitiveness and ensuring external viability. They commended the authorities for increasing the flexibility of the pa'anga in recent years, and urged them to resist pressures to fix the value of the pa'anga against the U.S. dollar in light of the low level of official reserves and weak macroeconomic fundamentals.

Directors welcomed the recent enactment of legislation to improve public financial management, strengthen the efficiency of the public service and public enterprises, simplify business licensing, and reduce impediments to foreign investment. Implementation of these reforms would be critical to provide a more simple, transparent, and predictable framework for public and private sector activities, enhance the institutional framework and governance in Tonga, and strengthen long-term growth prospects.

Directors emphasized that efforts to strengthen the fiscal position would pave the way for a major reform of the tax regime. Directors endorsed the basic thrust of the proposed tax reform, aimed at broadening the tax base, shifting the burden of taxation away from foreign trade and toward domestic sources, simplifying the tax structure, reducing exemptions, and minimizing loopholes. They stressed, however, that the proposed reform should not compromise the fiscal position.

Directors expressed concern about the rise in the loan concentration ratio at commercial banks in recent years, particularly to sectors that may be vulnerable to external shocks. They encouraged the authorities to strengthen prudential supervision through more frequent meetings with domestic institutions and foreign supervisory authorities, tighter single borrower limits and the introduction of an aggregate limit on loans to connected parties. In this regard, an amendment of the Financial Institutions Act would be helpful. Directors welcomed the progress Tonga has made in dealing with anti-money laundering and other related initiatives, and urged them to take necessary further steps to combat terrorist financing.

Directors noted the critical need to improve the reliability of statistics to conduct policies and surveillance in an effective manner. Directors encouraged the authorities to coordinate and reconcile data among agencies in a more systematic manner and to strengthen efforts to provide key data to the Fund on a regular basis. In this regard, Directors welcomed Tonga's decision to participate in the General Data Dissemination System.