IMF Executive Board Concludes 2008 Article IV Consultation with TongaPublic Information Notice (PIN) No. 08/96
July 31, 2008
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2008 Article IV Consultation with Tonga is also available.
On July 2, 2008, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga.1
Tonga's economy has shown resilience in the aftermath of the November 2006 riots and is now on a path to recovery. The key factor underpinning this resilience has been private investment. Donor-supported government reconstruction loans are expected to add further momentum to the recovery. However, the global upswing in fuel and food prices has intensified pressure on inflation and external reserves, the latter mitigated to a large extent by strong inflows of remittances.
Real GDP contracted by about 3¼ percent in FY06/07 (ending June), following the November 2006 riots, but the private sector quickly relocated businesses and replenished lost inventories. Preliminary indicators for the first half of FY07/08 suggest that the economy is on a path to recovery led by the services sector.
Adverse terms of trade shocks contributed to inflation pressures. Major increases in external food and fuel prices, combined with a nominal depreciation of the pa'anga against the currencies of major trading partners, have led to a marked increase in CPI inflation, which reached 12½ percent at end-March 2008 (from 6¾ percent at end- December 2007).
Tonga's external position is expected to weaken, reflecting mainly the impact of rising food and fuel prices. The current account deficit is projected to remain high in FY07/08 at about 10 percent of GDP, as sharp increases in imports, reflecting the economy's heavy reliance on oil imports, are matched by increases in remittances. External reserves have declined somewhat since last June, but are expected to stabilize at around 3-months of imports at end-FY07/08 on account of the projected improvements in official and private capital inflows.
Significant efforts have been made to achieve a balanced budget in FY07/08. During the first nine months of FY07/08, revenue performance remained buoyant, boosted by a recovery of arrears and a containment of the public wage bill and nonwage spending. The authorities have proposed a balanced budget in FY08/09 to limit domestic and nonconcessional external borrowing. The budget proposes over 20 percent growth in tax revenue to support higher maintenance and capital spending. At the same time, the budget also propose a reduction of maximum tariff rates and increase in the individual income tax exemption threshold, together with a reduction in the corporate tax rate for large taxpayers.
Monetary policy was eased in several steps in early 2007 to support economic recovery. At the time, inflation was less of a concern. The impact of monetary easing has only started to materialize recently. Private sector credit growth picked up gradually. It reached 16½ percent (y/y) at end-February 2008, from 6½ percent at end-March 2007. Banks' business loans, however, grew at a faster pace (to almost 30 percent by end-December 2007), while growth in housing loans has been relatively slow.
Tonga's total public debt stock declined to 45¼ percent of GDP in FY06/07 from 48½ percent of GDP in FY05/06. External debt to GDP fell as donor financing declined in real terms, while fiscal consolidation to limit domestic budget financing also contributed to a downward trend in domestic public debt to GDP. Following the civil unrest in November of 2006, the government made a significant effort toward securing financing for the reconstruction of the capital city of Nuku'alofa; the government contracted a long-term soft loan of about US$63 million (or 23 percent of GDP in FY07/08), but disbursements of this loan have been postponed.
Executive Board Assessment
Executive Directors welcomed the resilience of the Tongan economy in the aftermath of the November 2006 riots. With political stability now restored, private investment is picking up and near-term growth prospects have become more favorable, especially in the tourism and construction sectors. Directors considered that attention should now turn to rebalancing the economic policy mix, in order to address the inflationary risks and external vulnerabilities arising from increases in world food and fuel prices.
Directors commended the authorities for the progress they have made in ensuring fiscal prudence, including the recovery of tax arrears and the containment of the public wage bill and nonwage spending. They welcomed the planned balanced budget in FY07/08, which is evidence of strengthened fiscal discipline, and considered it to be essential to maintain a tightened fiscal stance in FY08/09 in order to help fight inflation. Directors called for a more orderly public sector wage policy to reduce fiscal vulnerability.
Directors recommended an early monetary tightening to support fiscal policy in the effort to contain inflation and anchor inflation expectations. This should be achieved through the increased use of market-based instruments, including the issuance of reserve bank notes. Directors encouraged the authorities to step up prudential measures to help monitor the fast growth in business loans.
Directors agreed that Tonga's current balance of payments position appears broadly sustainable, and considered that external price competitiveness has been generally preserved. However, in light of the sustained rise in international fuel and food prices, they recommended monitoring trade performance closely. Directors took note of the staff assessment that the real effective exchange rate of the Tongan pa'anga is close to its equilibrium level. At the same time, they observed that allowing some greater exchange rate flexibility, underpinned by appropriately tight fiscal and monetary policies, would help ensure external stability and safeguard external reserves, although it was recognized that the potential inflationary impact of such a move would need to be monitored carefully.
Directors stressed the importance of assessing the debt sustainability implications of the reconstruction loan contracted with a major donor. They cautioned that the loan, as currently structured, could increase Tonga's risk of debt distress, although the large remittance inflows could help mitigate this risk. Directors therefore welcomed the authorities' decision to review the size of the loan to ensure that it is consistent with Tonga's medium-term fiscal framework, its implementation capacity, and real sector business needs, and to best utilize this loan over a suitable longer time horizon. They called on the authorities to strengthen their public debt management policy and limit the recourse to non-concessional borrowing to ensure debt sustainability over the medium term.
Directors commended the authorities for the progress made in the corporatization and privatization of public enterprises, as well as the measures to improve governance. The Procurement Bill has been implemented, which will make government contracting more transparent, and a task force has been set up to review administrative impediments to business. Directors recommended revisiting plans for the government to purchase the electricity company, bearing in mind the financial burden and the quasi-fiscal and governance risks of such a step. A better alternative would be to seek private investors to acquire the company.
Directors encouraged the authorities to work closely with technical assistance providers to improve further Tonga's statistical capacity, particularly in the areas of national accounts and price statistics.