Tonga -- 2010 Article IV Consultation, Preliminary Conclusions of the IMF Mission
April 2, 2010
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
The mission expresses its gratitude to all the government agencies and staff of the National Reserve Bank for generously providing their time and input to the meetings, and for their gracious hospitality.
1. It has been a challenging year for Tonga. Tonga has been hit hard as the global crisis spilled over to affect Tonga’s tourist industry, remittance flows, and agricultural exports.
• Growth. GDP contracted in FY2009/10 owing to a region-wide slump in tourism activity and falling remittances. At the same time, in large part due to rising nonperforming loans, bank balance sheets have weakened, restraining the availability of credit and tightening financial conditions despite the central bank’s efforts to stimulate demand. Compounding these downward pressures, part of the Tongan archipelago was hit by a tsunami on September 29, 2009 causing loss of life and significant material damages.
• Inflation. Consumer price inflation fell to 1½ percent y/y in September 2009, a combination of lower global fuel and commodity prices.
• External position. The trade deficit narrowed to an estimated 37¼ percent of GDP with exports declining by 5½ percent and imports falling by 11 percent. However, the current account deficit widened somewhat as a result of the decline in remittances. International reserves rose this year but largely as a result of one-off factors, including the recent allocation of SDRs by the IMF and the disbursement of donor grants.
2. Macroeconomic policies were appropriately loosened to support the real economy.
• Fiscal Policy. In FY2009/10, the government fiscal position posted an estimated deficit of about 4 percent of GDP, with the further deterioration in the fiscal balance from 2008/09 levels due to a 10 percent hike in civil servant wages, increased infrastructure spending, and weak revenues. Revenue performance was lackluster, falling short of the ambitious budget targets by about 6 percent of GDP, mainly due to lower trade and corporate income taxes.
• Monetary Policy. During the course of 2009 the National Reserve Bank of Tonga (NRBT) lowered reserve requirements (from 10 percent to 5 percent), reduced the interest rate on its repo facility (from 10 percent to 4½ percent), and stopped issuing central bank bills. Despite this, declining credit quality has taken a toll on bank profits and their willingness to lend. This has more than offset the effect of looser monetary policy on the real economy. Nevertheless, provisioning has risen ahead of write offs and profitability is expected to resume next year.
3. Activity is expected to rebound next year. Growth should reach 1¾ percent in FY2010/11 boosted by increased construction activity. As the global recovery takes hold, tourism and remittances should begin to pick up, albeit slowly. With the recapitalization of banks and most losses now realized, lending could resume. Inflation should rise in the coming months as a result of the expected recovery in domestic demand and a recent increase in electricity prices but should end the year at around 4 percent.
4. However, achieving reasonably high medium-term growth will be challenging. Public infrastructure spending should provide a temporary boost to activity in FY2010/11. However, once those projects wind down, it will be challenging to achieve growth in the 1 to 2 percent range. Prospects are constrained by Tonga’s geographic isolation, its narrow export base, the high cost of labor, an inability to retain skilled labor, and impediments to private sector activity. Government policies in the coming years will need to focus on mitigating these limitations.
5. The balance of risks is still tilted to the downside. In the near term, the strength of the global recovery is by no means assured and there are multiple risks that could weaken prospects in both Europe and the United States. If the global growth slows, this will take a direct toll on remittances, tourism, and exports which, in turn, will feed through to weaken domestic activity and put pressure on the balance of payments. A further rise in world commodity and food prices would also hit Tonga hard, feeding through to inflation, growth, and the current account deficit. Tonga’s high public debt now poses a considerable risk to economic prospects through its potential impact on the country’s external sustainability and ability to respond to shocks.
Calibrating Macroeconomic Policies in the Coming Year
6. The increase in Tonga’s both external and public debt over the past year has left the economy more vulnerable to shocks. Public and external debts are estimated to have reached 52½ percent of GDP and 44 percent of GDP in 2009/10, up from 39 percent of GDP and 32 percent of GDP in FY2008/09, respectively. The marked increase in Tonga’s indebtedness reflects primarily two renminbi loans from China’s EXIM bank, which together total over 30 percent of GDP. This has put Tonga into the range of “high risk of debt distress” according to the World Bank-IMF debt sustainability framework. Moreover, the government bears all the credit and currency risk associated with these new loans, including for the amounts on-lent to the private sector. Mitigating these debt vulnerabilities will necessitate continued progress on structural improvements to raise growth potential, continued support from donors, fiscal consolidation, and careful management of liabilities, reserves, and Tonga’s external position.
7. There is little scope for further fiscal stimulus in the coming fiscal year. The government will need to limit wage increases at most to the level of CPI inflation, carefully prioritize current spending, and further improve tax administration. Economic activity could be supported by bringing forward some donor-financed infrastructure spending, subject to capacity constraints. With revenue expected to recover partly from current slump and stepped up infrastructure spending, the deficit should be around 4¾ percent of GDP in 2010/11. This deficit should be financeable through construction loans.
8. In the coming years a sustained effort will be needed to put the public debt firmly on a downward path. The government should aim at a primary surplus target of around 1 percent of GDP to lower the debt and place the fiscal position on a more sustainable path. Achieving such an adjustment will require progress on multiple fronts over the medium term, including stepping up revenue administration and expenditure control, prioritizing expenditure, limiting loan drawdown to finance projects that are productive, as well as structural reforms. The government’s fiscal efforts will need to be supplemented by continued support from donors.
• Improving revenue administration. The introduction of a new customs management system and efforts to improve arrears collection should help raise revenues. However, there is a need for further sustained improvements in revenue administration, including ensuring the proper classification of goods at customs, and increasing compliance through the use of the unique tax identification number recently assigned to corporate tax payers. In addition, with the introduction of self-assessment, completing the automation of customs processing will provide resources to strengthen auditing and tax collection. These measures will provide sufficient fiscal space for the government to maintain basic public services while still allowing for medium-term fiscal consolidation.
• Strengthening fiscal management and medium-term budgeting. At present, fiscal decision-making is hampered by limited economic and policy analysis and an inadequate budget reporting system. There is a need to adopt a medium-term framework that aims at achieving a sustainable fiscal path in outer years, as well as integrates the annual budget, corporate plans of line ministries, and the medium-term development objectives laid out in the government National Strategic Planning Framework. This will help guide the direction of medium-term fiscal policies, better prioritize expenditure, provide an anchor for expectations, and reduce debt distress risks through greater fiscal discipline. A successful implementation of such a strategy will however require better reporting by line ministries, as well as improved capacity, fiscal control, and communication between different agencies involved in the budget process.
• Debt management. Given the large credit and currency risks in the government balance sheet, we recommend establishing a comprehensive debt management strategy that aims at limiting these vulnerabilities. In this regard, the mission encourages the authorities to proceed with the selection of eligible private sector construction projects on a commercial basis to limit the credit risk to the government balance sheet and also risk of excess capacity in some sectors of the economy. Limiting the credit risk will free resources for development priorities set out in the National Strategic Planning Framework. The mission welcomes the government request for IMF technical assistance on debt management.
9. Monetary policy should maintain a neutral stance in the months ahead. The loosening of monetary policy in FY2009/10 was appropriate but failed to fully translate into looser monetary conditions as banks maintained a tight lending stance to restore the health of their balance sheets. As a result, there is now ample liquidity in the banking system and little need for a further loosening of monetary policy. However, there is a risk that, as conditions normalize, the expansionary monetary stance of the past year could feed through to higher inflation and downward pressure on international reserves.
10. If higher inflation than expected in the baseline scenario, or downward pressures on reserves were to materialize, the monetary policy stance will need to be tightened. The NRBT should use the wide range of tools at its disposal, including raising reserve requirements, resuming the issuance of central bank paper, and raising interest rates on its repo facility. Such a tightening stance could begin once the recovery in Tonga’s main remitting countries is firmly established since a recovery in those economies typically leads to stronger remittances and imports, and ultimately exerts downward pressure on the reserve coverage ratio.
11. Making use of the flexibility afforded by the current exchange rate arrangement remains critical for safeguarding external stability. The team assesses the currency to be moderately overvalued. This leaves little scope to tighten monetary conditions through a nominal appreciation of the currency, but the NRBT should stand ready to gradually depreciate against the basket in order to safeguard external stability. However, to be effective, this will need to be accompanied with further fiscal restraint. We welcome the NRBT’s decision to review the current weights in the basket to better reflect economic circumstances and NRBT’s objectives, and the IMF’s Pacific Financial Technical Assistance Center (PFTAC) will soon provide technical assistance on this issue.
12. Further stepping up prudential regulations and supervision will promote financial stability and improve intermediation. We welcome the NRBT’s steady strengthening of bank supervision, as well as the recent decision requiring banks to improve the disclosure to their customers about the full costs of new loans (including all fees, interest, and charges). We encourage the NRBT to continue improving the supervision and monitoring of banks, including through more on-site visits, and to follow up with PFTAC’s recommendation to improve banks’ prudential reporting requirements.
13. Improving the legal framework for collateralized borrowing has the potential to lower financial intermediation costs and restart bank lending. The lack of collateral and the difficulties of foreclosing on defaulters are significant impediments to business lending. There is significant scope to improve the institutional framework for lending in order to increase access to finance and lower the cost of borrowing. Potential changes could include instituting a centralized credit bureau and strengthening creditor rights, including through changes to the legal framework to ensure the timely registering and recovery of collateral. Enacting the planned secured property and bankruptcy protection laws should further expand access to finance. In addition, further improvements to transparency and disclosure for financial services would also afford greater protections to bank borrowers. Such measures will ultimately lower credit spreads toward those in other regions. In this regard, the pressure to begin administering the level of interest rates should be resisted. Bank profitability in Tonga, including interest rate spreads, does not appear to be excessive when compared to other South Pacific jurisdictions and administering interest rates would hamper banks’ ability to price risk and reduce the availability of credit for riskier borrowers.
14. Finally, additional efforts are needed to promote private drivers of growth. Improving efficiency in the delivery and generation of utilities, as currently envisaged, will reduce the cost of doing business. We encourage the government to swiftly proceed with the execution of its National Strategic Planning Framework, which holds the promise of increasing private sector-led development over the longer term. The central part of this program includes lengthening land leases for all businesses to over 99 years in order to encourage private construction and investment and increase the availability of collateral for secured lending. At the same time, while some progress had been made in streamlining the approval process for investment, improvements could still be made in increasing access to land for development, reducing the number of licenses needed for development and making them more quickly available, and removing restrictions on the areas where foreign investment is not permitted.