## cr1812

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### Tonga’s Housing Sector
- Housing credit continues to rise supported by lower interest rates and economic growth.
- Factors supporting housing credit growth:
  - low lending rates for housing loans;
  - revision of the Land Act (lease term shall not exceed 50 years and shall be renewable upon such conditions as to rent);
  - TDB home loan: 5 percent interest rate for new home loans during the first 2 years (introduced August 2015);
  - Retirement Fund Board home improvement loan facility (introduced July 2016).
- Market structure and risks:
  - A housing bubble is unlikely due to a rigid land tenure system with lengthy land registration and a very small and slow secondary market (approximately 10 house sale transactions per each year).
  - Most bank credit finances construction of owner-occupied dwellings and housing for personal use rather than investment.
  - Lending to households is collateralized where land is the only asset qualified as collateral by banks.
- Household credit quality:
  - Loan payments are salary-based and deducted directly from salaries.
  - NPLs declined from 6.7 percent in June 2016 to four percent in June 2017 (driven by a large write-off and high credit growth).
  - In FY2017, collateral held against delinquent loans was T$40.5 million versus total NPLs of T$16.9 million.
- Remittances (Total Remittances, In millions of Paanga):
  - FY2015: Private Transfer 186.3; Compensation of Employees 14.8; Private Capital Transfers 0.9; Social Benefits 0.4; Total 202.4
  - FY2016: Private Transfer 235.2; Compensation of Employees 17.5; Private Capital Transfers 1.6; Social Benefits 1.9; Total 256.2

### Macroeconomic developments and outlook (FY2016–FY2018 and medium term)
- Real GDP growth:
  - FY2016: 3.4 percent
  - FY2017: 2.7 percent (estimated)
  - FY2018: 3.4 percent (projected)
  - Medium-term growth: projected to moderate to around two percent
- Inflation:
  - Annual CPI inflation (FY2017): 7.2 percent (average)
  - Imported inflation (FY2017): 7.7 percent
  - Domestic component (FY2017): 5.8 percent
  - Inflation expected to decline to 5.3 percent on average in FY2018 and to decline further in the medium term
- External sector and reserves:
  - Current account deficit (FY2017): 12 percent of GDP
  - Reserves: US$169.9 million (or 5.9 months of imports) in FY2017
  - Net international investment position (NIIP): positive
  - Exchange rate: Tongan Pa’anga (T$) broadly unchanged versus U.S. dollar; CPI-based REER appreciated
  - Reserves projected to decline slightly in the medium term due to large principal loan repayments to China of approximately US$7.9 million per year
- Financial sector:
  - Private sector credit growth (FY2017): 18.9 percent
  - Credit-to-GDP remains below long-term average; most bank credit finances construction of owner-occupied dwellings
  - NRBT measures: minimum reserve requirements set to 10 percent of total deposits (July 2017); remuneration rate for RRs set to zero; minimum target for LTD ratio currently 80 percent
  - Banking system: well capitalized and profitable

### Fiscal sector, FY2018 Budget and budget projections (verbatim series preserved)
- Overall fiscal balance: -0.4 percent of GDP (over the last two years)
- FY2018 Budget characteristics: expansionary; fiscal position projected to weaken; spending pressures from wage increases, reform of public sector employment categories, and infrastructure strategy
- New revenue measures: increase of excise rates on alcohol, tobacco, and sugary drinks; replacing import duties on NCD related goods with excise taxes; a new income tax system
- Budget figures (Estimate/Budget/Projections, In percent of GDP):
  - Total Revenue: 44.5 54.4 53.5 52.6 51.6
  - Tax revenue: 21.3 24.9 24.0 23.1 23.8
  - Grants: 19.0 25.3 25.3 25.6 23.7
  - Other Revenue: 4.1 4.2 4.2 4.0 4.1
  - Total Expenditure: 44.9 55.8 55.8 54.5 56.0
  - Expense: 34.1 41.1 39.7 38.2 38.2
  - Wages: 13.1 13.7 13.7 12.9 12.4
  - Use of goods and services: 13.0 17.3 17.3 19.0 18.2
  - Other expense: 7.9 10.1 10.1 7.7 7.6
  - Transactions in Nonfinancial Assets: 10.8 14.8 14.8 14.8 17.7
  - Overall balance: -0.4 -1.3 -2.3 -1.9 -4.4
- Budget anchors introduced in the Budget document (verbatim excerpt preserved):
  - Domestic revenue (in percent of GDP)> 2225.429.128.2
  - Compensation of employees (in percent of domestic revenue)< 5357.751.352.9
  - (in percent of current expense)< 4547.543.643.5
  - Total external public debt outstanding (in percent of GDP)< 5041.842.343.2

### Fiscal strategy, scenarios and required adjustments (verbatim series preserved)
- Medium-term objective: achieve a primary surplus of one percent of GDP in the medium term to stabilize public debt at about 40 percent of GDP
- Two staff scenarios (both target constant public debt around 40 percent of GDP by achieving primary surplus of one percent of GDP by FY2022):
  - “Revenue and current expenditure adjustment” scenario:
    - Combination of revenue measures and reallocation of current expenditure (wages) into capital investment
    - Short-term GDP growth reduction of approximately 0.5 percentage points, but achieves necessary capital investments with positive long-run growth dividends
  - “Capital expenditure reduction” scenario:
    - Reduces capital expenditure to match effectively collected revenue
    - Lower short-term growth impact; smaller long-run growth improvement due to lower capital accumulation
  - Staff preference: revenue and current expenditure adjustment scenario
- Projection excerpts (Estimates/Projections, In percent of GDP; verbatim):
  - Baseline Revenue and grants: 44.5 53.5 52.6 51.6 49.0 49.5
  - Baseline Total Expenditure: 44.9 55.8 55.8 54.5 51.0 50.9
  - Baseline Primary balance: 0.4 -1.4 -1.0 -3.6 -1.2 -0.8
  - Baseline Total public debt: 48.0 49.2 50.3 52.0 51.9 51.3
  - Revenue and Current Expenditure scenario Primary balance: 0.4 -0.8 -0.7 -0.3 0.5 1.0
  - Revenue and Current Expenditure scenario Total public debt: 48.0 48.9 49.8 48.4 46.8 44.8
  - Capital Expenditure Reduction scenario Primary balance: 0.4 -0.7 -0.5 0.0 0.6 1.1
  - Capital Expenditure Reduction scenario Total public debt: 48.0 48.6 49.2 47.5 45.8 43.7
  - (2)-(1) Savings Required: 1 0.6 0.4 3.3 1.7 1.7

### Fiscal policy recommendations and indicative savings measures
- Revenue-side recommendations:
  - Amend PAYE reform to avoid shrinking tax base; staff caution that raising the minimum taxable income threshold currently leaves 60 percent of employees out of the tax net
  - Further boost excise revenue and increase consumption tax effectiveness
  - Replace FX levy with a non-distortionary tax; FX levy could remain until sunset in FY2020 if alternatives unavailable
- Expenditure-side recommendations:
  - Contain the wage bill back to around 12 percent of GDP
  - Rationalize capital spending and replace own-financing with donor grants where feasible
  - Maintain cash buffers (currently equivalent to 5.3 months of expenses) while calibrating fiscal consolidation to build resilience
- Indicative fiscal savings (as presented to authorities; magnitudes preserved):
  - Overall Savings: Up to 7.5
  - Total Revenue: up to 1.5
    - Modify PAYE reform: 1
    - 0.1
    - Increase excises on NCDs related goods: 0.2-0.6
    - Keep consumption tax rate at 15 percent and improve compliance: 0.7
  - Total Expenditure: Up to 6
    - Contain civil servants wage increases: 2
    - 1-3
    - Prioritize Capital Expenditure and/or obtain donor funding: Up to 3
  - PAYE/wage measure notes:
    - Keep minimum threshold unchanged at T$7400 (or raise it by a smaller amount) and lower the threshold for the maximum rate to T$50000
    - Freeze wage increases to bring the wage bill to around 12 percent of GDP, and limit increases to GDP growth thereafter

### Debt sustainability analysis (DSA) and public debt metrics (selected exact figures)
- DSA outcome: risk rating for external debt distress increased from moderate to high (DSA 2017) because of treatment of future spending related to natural disasters
- DSA assumptions and stress:
  - Average yearly natural disasters damages for Tonga amount to approximately three percent of GDP
  - One percent of GDP per year assumed as yearly reconstruction cost financed by government borrowing in baseline from FY2023
  - Debt service projections:
    - Debt service is projected at 1.5 percent of GDP in FY2018
    - Debt service is projected to more than double to 3.8 percent of GDP from FY2019 onwards
- Selected DSA table figures (verbatim series preserved where provided):
  - PV of external debt: 31.4, 33.8, 35.6, 36.0, 36.6, 35.7, 34.6, 35.9, 45.1
  - PV of PPG external debt (in percent of exports): 155.0, 156.2, 152.1, 153.0, 157.8, 154.6, 149.3, 147.0, 165.2
  - PV of PPG external debt (in percent of government revenues): 134.9, 133.2, 126.1, 133.2, 131.2, 138.6, 134.3, 139.6, 174.9
  - Total gross financing need (Millions of U.S. dollars): 25.8, 58.3, 48.2, 43.9, 41.9, 58.8, 55.3, 58.5, 60.3, 63.2, 94.8
  - Real GDP growth (in percent; Table 1 series): 2.1, 3.7, 3.4, 1.5, 2.8, 2.7, 3.4, 3.0, 2.9, 1.9, 1.9, 2.6, 1.1, 1.1, 1.1
  - Remittances: 27.4 percent of GDP in FY2017; Gross workers' remittances (Millions of US dollars): 102.7, 102.2, 112.2, 117.4, 124.3, 130.4, 136.0, 141.5, 147.2, 171.9, 229.4
- DSA conclusions:
  - PV of external debt-to-GDP plus remittances ratio hits the indicative threshold in FY2037
  - PV of external debt-to-GDP ratio (excluding remittances) breaches the indicative threshold in FY2032
  - Downside (natural disaster in FY2018) scenario: probability around 30 percent; assumes damage of 10 percent of GDP and a reduction of GDP growth of four percent in FY2018; sustainability threshold breached much sooner

### External sector assessment and reserves adequacy (Box 2 and FX metrics)
- External position: moderately weaker compared with fundamentals and desirable policies
- EBA-lite assessment (2016, verbatim metrics where provided):
  - CA-Actual: -13.2%
  - CA (Adjusted): -7.7%
  - CA-Norm: -6.2%  -9.8% (presented together in source)
  - Elasticity: -0.8  -0.8
  - CA-Gap (Adjusted): -1.5%  2.1%
  - o/w policy gap: -0.1%
  - REER Gap (Adjusted): 1.9%  -2.7%
- FX reserves and adequacy:
  - Gross FX reserves FY2017: US$169.9 million
  - Months of next year's goods and services imports (FY2013–FY2017): 6.9, 6.8, 6.3, 6.3, 5.9
  - FX reserves adequacy metrics (FY2017):
    - Actual Reserves (months of prospective imports): 5.9
    - Optimal level from reserves template: 6.3
    - Broad Money coverage: 136%
  - Capital grants–related imports: 5.5 percent of GDP in 2016 (used in CA adjustment)
- Policy guidance: should pressure on reserves emerge, NRBT should allow the pa’anga to depreciate against the basket of currencies to safeguard external stability

### Monetary policy, macroprudential measures and financial stability
- Monetary stance: accommodative and appropriate while no signs of overheating or credit misallocation; inflation moderating after one-off tax increase
- NRBT actions and tools:
  - Introduced remuneration rate on required reserves (currently set at zero)
  - Amendments to NRBT Act permit use of part of revaluation reserve to remunerate RRs
  - Staff recommends additional tools such as issuance of short-term NRBT securities and preparing legal documentation for reserves risk framework methodology
- Macroprudential recommendations:
  - limits to loan-to-value (LTV) ratio for property loans
  - diversification principles to avoid concentration to specific sectors or related borrowers
  - maximum LTD ratio
  - maintenance of adequate provision of NPLs
- Structural and supervisory reforms:
  - develop a domestic credit register
  - improve collateral framework
  - enhance insolvency frameworks
  - finalize new Banking Act and legislation for NBFIs; develop comprehensive supervision and disclosure frameworks
- AML/CFT and correspondent banking relationships:
  - Loss of CBR is a concern; NRBT preparing for Asia Pacific Group AML/CFT assessment in 2019 and strengthening AML/CFT laws

### Risks and Risk Assessment Matrix (selected entries and likelihood/impact)
- External risks:
  - Weak global growth — Likelihood: High; Impact: Medium/High; Policy response: Preserve fiscal and external buffers; boost public investment and structural reforms
  - Reduced correspondent banking services (“de-risking”) — Likelihood: High; Impact: Medium; Policy response: Maintain regulatory and supervisory compliance with AML/CFT standards
- Domestic risks:
  - Financial stability risks from high credit growth — Likelihood: Low; Impact: Medium; Policy response: Remain vigilant and intervene if overheating signs appear
  - Wage growth (public sector employment reform failure) — Likelihood: Medium/High; Impact: High; Policy response: Finalize reform and keep wage growth in check
  - Natural disasters — Likelihood: High; Impact: High; Policy response: Maintain fiscal buffers of 4-5 months of recurrent expenditure; invest in resilient infrastructure
- RAM methodology note: "low" below 10 percent; "medium" between 10 and 30 percent; "high" 30 percent or more

### Disaster preparedness, regional risk pooling and infrastructure priorities
- Tonga participates in PCRAFI regional insurance scheme
- A Climate Change Trust Fund established under the ADB-CRSP project funded by CIF
- Ex-post and preparedness measures:
  - Maintain capital budget realignment and donor assistance arrangements for relief and reconstruction
  - NEMO cluster activation (8 out of 10 coordinated clusters cited)
  - Enhance PFM systems; increase coral reef and mangrove resilience; upgrade evacuation and post-disaster access roads; enhance coastal protection; upgrade schools; rural electrification; disaster risk management training; complete specialized hazard maps

### Statistical capacity, data weaknesses and reporting
- Main weaknesses: timeliness, manual compilation, lack of consolidated financial statistics, under-recording (including capital expenditure financed by donors), large net errors and omissions in BOP
- Specific gaps and needs:
  - Improve coverage of financial account by enhancing IIS response rate and banks’ transaction data
  - Obtain data on compensation of employees, remittances, acquisition of goods and services by overseas workers
  - Resume compilation of the International Investment Position (stopped in 2013)
  - Strengthen GFS compilation and consider reporting annual GFS to IMF once follow-up is finalized
- Participation: GDDS since May 30, 2006; no data ROSC available

### Staff appraisal — key conclusions and policy priorities
- Recent performance: continued strong growth and moderating inflation; growth supported largely by construction
- Main vulnerabilities: external shocks, reliance on grants and remittances, exposure to natural disasters, fiscal slippage risk from wage growth and ambitious capital spending
- Policy priorities:
  - Preserve fiscal sustainability and buffers; target a primary surplus of one percent of GDP by FY2022
  - Prioritize own-financed capital expenditure toward education, health, roads, and resilience to natural disasters
  - Replace FX levy with non-distortionary tax and phase out by FY2020
  - Strengthen NRBT policy toolkit and finalize Banking Act and NBFI legislation
  - Develop macroprudential framework and credit monitoring indicators
  - Improve statistical capacity and timely reporting to IMF
- Article IV consultation periodicity: authorities suggested next Article IV on a 24-month cycle; staff finds Tonga satisfies criteria for 24-month cycle

*International Monetary Fund staff report (excerpts) contained in CR1812.*

### 1.  Tonga’s Housing Sector  ______________________________________________________________________ 18

### 1.  Tonga’s Housing Sector

### Context and structural characteristics
- Tonga is a small middle-income economy in the South Pacific, vulnerable to natural disasters, with geographical remoteness, high transportation costs, low diversification and connectivity, a narrow production base, and limited economies of scale.
- The economy is highly dependent on remittances flows and donor grants; agriculture and tourism are the main exports.
- Population: "around 100,000".
- Political developments: King Tupou VI dismissed the government on August 25, 2017; snap elections on November 16, 2017 resulted in the Democratic Party (DP) winning most seats.

### Recent developments (FY2016–FY2017)
- Real GDP growth:
  - FY2016: 3.4 percent
  - FY2017: 2.7 percent (estimated)
  - Main growth drivers: construction (government infrastructure plan and sport facilities), agriculture, tourism, exports, and strong private consumption supported by remittances.
- Inflation:
  - Annual CPI inflation (FY2017): 7.2 percent (average)
  - Imported inflation (FY2017): 7.7 percent (linked to new import tax on fatty meat and tobacco introduced July 2016)
  - Domestic component of inflation (FY2017): 5.8 percent (due to dry weather)
- External sector:
  - Current account (CA) deficit (FY2017): 12 percent of GDP
  - Reserves: US$169.9 million (or 5.9 months of imports)
  - Net international investment position (NIIP): positive
  - Exchange rate: Tongan Pa’anga (T$) broadly unchanged versus U.S. dollar; CPI-based REER appreciated
- Fiscal sector:
  - Overall fiscal balance: -0.4 percent of GDP (over the last two years)
  - FY2017: tax revenue increased (higher excises and FX levy), but expenditures (higher wages and own-financed capital expenditure) more than offset gains
- Financial sector:
  - Private sector credit growth (FY2017): 18.9 percent
  - Credit-to-GDP remains below long-term average; most bank credit finances construction of owner-occupied dwellings
  - NRBT policy responses:
    - Raised minimum reserve requirements (RRs) for banks to 10 percent of total deposits in July 2017
    - Introduced a remuneration rate for RRs set to zero
    - Introduced a minimum target for the loan-to-deposit (LTD) ratio for banks, set currently at 80 percent
  - Banking system: well capitalized and profitable
  - Nonperforming loans (NPLs): declined from 6.7 percent in June 2016 to four percent in June 2017 (driven by a large write-off and high credit growth)

### Outlook and risks
- Macroeconomic projections:
  - FY2018 GDP growth: 3.4 percent (projected)
  - Medium-term growth: projected to moderate to around two percent
  - Inflation: expected to decline to 5.3 percent on average in FY2018 and to decline further in the medium term
  - CA deficit: projected to remain large in FY2018, mainly due to capital imports related to construction
  - Reserves: projected to decline slightly in the medium term due to large principal loan repayments to China of approximately US$7.9 million per year
- Risk assessment:
  - Overall balance of risks is tilted to the downside
  - External risks: weaker global growth, inward-looking policies reducing remittances, donor funds, and tourism; pressures on correspondent banking relationships (CBR) increasing remittance costs
  - Domestic risks: fiscal sustainability (if public sector employment reforms fail to contain wage growth), delays in grant disbursements and infrastructure building, large fiscal burden from future natural disasters if donor intervention falls short
  - Elections may slow growth momentum; upside risk: higher-than-expected short-term fiscal expansion boosting GDP growth
- Debt sustainability:
  - Risk rating for external debt distress increased from moderate to high (DSA 2017) because of the treatment of future spending related to natural disasters; natural disasters incorporated in baseline projections with two separate projection horizons

### Policy discussion: maintaining fiscal sustainability and resilience
- Priority policy objectives:
  - Boost resilience to shocks (climate change, natural disasters)
  - Preserve macrofinancial stability amid rapid credit expansion and limited policy instruments
  - Pursue structural reforms for sustained and inclusive growth
- Fiscal anchors introduced in the Budget document (first-time, reflecting past commitments and staff recommendations):
  - Anchors include a debt ceiling, a ceiling on compensation of employees as a percent of current expenses and domestic revenues, and a target for domestic revenue in percent of GDP
  - BudgetProjections excerpt (verbatim as in source):
    - Domestic revenue (in percent of GDP)> 2225.429.128.2
    - Compensation of employees (in percent of domestic revenue)< 5357.751.352.9
    - (in percent of current expense)< 4547.543.643.5
    - Total external public debt outstanding (in percent of GDP)< 5041.842.343.2
- FY2018 Budget characteristics and concerns:
  - Budget is expansionary; fiscal position projected to weaken
  - Spending pressures from wage increases, reform of public sector employment categories, and infrastructure development strategy
  - New revenue measures in FY2018:
    - Increase of excise rates on “sin goods” (alcohol, tobacco, and sugary drinks)
    - Replacing import duties on Non-Communicable Diseases (NCD) related goods with excise taxes
    - A new income tax system
  - Despite new revenues, higher expenditure results in a fiscal deficit until FY2020
- Budget figures and projections (verbatim table excerpts and projections as in source):
  - Estimate/Budget/Projections (In percent of GDP):
    - Total Revenue: 44.5 54.4 53.5 52.6 51.6
    - Tax revenue: 21.3 24.9 24.0 23.1 23.8
    - Grants: 19.0 25.3 25.3 25.6 23.7
    - Other Revenue: 4.1 4.2 4.2 4.0 4.1
    - Total Expenditure: 44.9 55.8 55.8 54.5 56.0
    - Expense: 34.1 41.1 39.7 38.2 38.2
    - Wages: 13.1 13.7 13.7 12.9 12.4
    - Use of goods and services: 13.0 17.3 17.3 19.0 18.2
    - Other expense: 7.9 10.1 10.1 7.7 7.6
    - Transactions in Nonfinancial Assets: 10.8 14.8 14.8 14.8 17.7
    - Overall balance: -0.4 -1.3 -2.3 -1.9 -4.4
- Assessment of revenue reforms and tax administration:
  - Authorities project a 3.6 percent of GDP increase in tax revenues, mainly from consumption and excise taxes
  - Staff is more conservative on consumption tax increases and recommends caution on the proposed PAYE/income tax reform, noting that raising the minimum taxable income threshold currently leaves 60 percent of employees out of the tax net
  - Staff acknowledged successful raising of T$5 million per annum revenue through the Foreign Exchange transactions tax (FX levy) but recommended replacing the FX levy with a non-distortionary tax; given lack of alternatives, the levy could remain until its planned sunset in FY2020
- Capital expenditure prioritization and PFM concerns:
  - Authorities should carefully prioritize own-financed capital expenditure and contain expenditures if revenues fall short
  - Prioritize projects that improve inclusive growth potential and resilience to natural disasters; postpone lower-return projects
  - Ensure assessment of future maintenance costs for sports facilities; focus donor funding on such projects
  - Technical assistance and Auditor General findings point to systematic under-recording of capital expenditure by up to 13 ministries outside MOFNP
- Medium-term fiscal strategy and scenarios:
  - Objective: achieve a primary surplus of one percent of GDP in the medium term to stabilize public debt at about 40 percent of GDP, providing a buffer for future natural disasters
  - Staff presented two scenarios to achieve sustainability (both target constant public debt around 40 percent of GDP by achieving primary surplus of one percent of GDP by FY2022):
    - “Revenue and current expenditure adjustment” scenario:
      - Combination of revenue measures and reallocation of current expenditure (wages) into capital investment
      - Short-term GDP growth reduction of approximately 0.5 percentage points, but achieves necessary capital investments with positive long-run growth dividends
    - “Capital expenditure reduction” scenario:
      - Reduces capital expenditure to match effectively collected revenue
      - Lower short-term growth impact; smaller long-run growth improvement due to lower capital accumulation
    - Staff preference: revenue and current expenditure adjustment scenario for its positive impact on longer-term growth
  - Projection excerpts (verbatim as in source):
    - Estimates/Projections (In percent of GDP):
      - Baseline Revenue and grants: 44.5 53.5 52.6 51.6 49.0 49.5
      - Baseline Total Expenditure: 44.9 55.8 55.8 54.5 51.0 50.9
      - Baseline Primary balance: 0.4 -1.4 -1.0 -3.6 -1.2 -0.8
      - Baseline Total public debt: 48.0 49.2 50.3 52.0 51.9 51.3
      - Revenue and Current Expenditure scenario Primary balance: 0.4 -0.8 -0.7 -0.3 0.5 1.0
      - Revenue and Current Expenditure scenario Total public debt: 48.0 48.9 49.8 48.4 46.8 44.8
      - Capital Expenditure Reduction scenario Primary balance: 0.4 -0.7 -0.5 0.0 0.6 1.1
      - Capital Expenditure Reduction scenario Total public debt: 48.0 48.6 49.2 47.5 45.8 43.7
      - (2)-(1) Savings Required: 1 0.6 0.4 3.3 1.7 1.7
- Recommended fiscal measures and expenditure priorities:
  - Revenue-side: amend PAYE reform to avoid shrinking tax base; further boost excise revenue; increase consumption tax effectiveness
  - Expenditure-side: aim to bring wage bill back to around 12 percent of GDP; rationalize capital spending and replace own-financing with donor grants where feasible
  - Maintain cash buffers (currently equivalent to 5.3 months of expenses) while calibrating fiscal consolidation to build additional resilience

*International Monetary Fund staff report (excerpts) contained in CR1812.*

### 22.      The authorities fully concurred with staff assessment of the fiscal stance and risks to

### cr1812 - 22.      The authorities fully concurred with staff assessment of the fiscal stance and risks to

### Fiscal stance and risks
- Authorities concurred with staff assessment of the fiscal stance and risks to sustainability.
- Authorities acknowledged revenue projections are optimistic and may not be realized in full.
- Wage growth identified as the biggest fiscal risk, including further postponement of the civil servants’ employment framework reform.
- Authorities view development of sports and related facilities as a policy priority, expecting positive health effects and possible tourism boosts related to rugby.
- Authorities agreed on the need to continue building fiscal buffers and indicated some planned capital expenditure could be postponed or scaled down based on actual revenue collection.
- Discussion of possible adjustment strategies was well received, but authorities did not commit to specific measures.

- Fiscal savings measures and indicative magnitudes (as presented):
  - Overall Savings: Up to 7.5
  - Total Revenue: up to 1.5
    - Modify PAYE reform: 1
    - 0.1
    - Increase excises on NCDs related goods: 0.2-0.6
    - Keep consumption tax rate at 15 percent and improve compliance: 0.7
  - Total Expenditure: Up to 6
    - Contain civil servants wage increases: 2
    - 1-3
    - Prioritize Capital Expenditure and/or obtain donor funding: Up to 3

- Notes on PAYE and wage measures:
  - 1/ Measures to modify PAYE reform include keeping minimum threshold unchanged at T$7400 (or raising it by a smaller amount) and lowering the threshold for the maximum rate to T$50000.
  - 2/ Freeze wage increases to bring the wage bill to around 12 percent of GDP, and limit increases to GDP growth thereafter.

### External assessment
- The external position is moderately weaker compared with fundamentals and desirable policies; authorities should maintain adequate reserve buffers.
- EBA-lite CA model estimates:
  - adjusted CA gap of -1.5 percent of GDP
  - EBA-lite threshold of 1 percent of GDP
  - norm of -6.2 percent of GDP
- Reserves coverage:
  - projected at 5.9 months of imports in FY2017
  - estimated optimal level of 6.3 months
- Projected decline in reserves coverage driven by higher construction-related imports and principal repayments of the China EXIM bank loan.
- Exchange rate remains on the border of being broadly in line with fundamentals; no sign of deterioration in competitiveness.
- Policy guidance: should pressure on reserves emerge, the NRBT should allow the pa’anga to depreciate against the basket of currencies to safeguard external stability.
- Authorities’ view: saw external position as broadly in line with fundamentals; noted volatility of current account flows complicates model estimation and agreed current level of reserves is broadly adequate and should be maintained.

### Improving monetary policy and preserving financial stability
- NRBT progress:
  - Introduced the remuneration rate on required reserves (RRs), currently set at zero.
  - Following amendment of the NRBT Act, NRBT can use part of its revaluation reserve to remunerate RRs.
  - RR remuneration rate could become an effective policy rate by functioning as a floor to guide bank lending rates (currently not binding due to excess liquidity).
- Current monetary policy stance: accommodative and appropriate while no signs of overheating or credit misallocation; inflation moderating following dissipation of one-off tax increase.
- Recent credit growth supported by:
  - government-managed loan-subsidy scheme
  - lower lending rates
  - increase in construction
- Recommendations to enhance liquidity management and transmission:
  - Consider using more flexible tools in addition to RRs, such as issuance of short-term NRBT securities.
  - Prepare legal documentation underpinning reserves risk framework methodology and adopt as Executive Board decision.
- Concerns about minimum loan-to-deposits (LTD) ratio:
  - Could increase banking sector credit risk by incentivizing lending to substandard borrowers or inducing banks to stop accepting new cash deposits.
  - Staff doubts appropriateness of minimum LTD; recommends structural reforms instead.
- Structural reforms and credit access improvements recommended:
  - (i) developing a domestic credit register;
  - (ii) improving the collateral framework for borrowers;
  - (iii) enhancing insolvency frameworks;
  - (iv) closely monitoring provision of credit through the Government Loan Scheme to ensure creditworthiness.
- NRBT should develop credit growth indicators to monitor risks from potential credit booms.
- Regulatory and supervisory actions:
  - Finalize new Banking Act and legislation for NBFIs to enhance NRBT’s supervisory capacity.
  - Develop and implement comprehensive supervision and disclosure frameworks covering entire financial sector.
- Macroprudential policy recommendations:
  - (i) limits to loan-to-value (LTV) ratio for property loans;
  - (ii) diversification principles to avoid concentration to specific sectors or related borrowers;
  - (iii) maximum LTD ratio;
  - (iv) maintenance of adequate provision of NPLs.
- AML/CFT and correspondent banking risk:
  - Loss of CBR remains a concern; some Tongan money operators have had bank accounts closed.
  - NRBT should ensure regulations meet international AML/CFT standards.
  - NRBT preparing for a new AML/CFT assessment by the Asia Pacific Group on Money Laundering in 2019 and is strengthening AML/CFT laws and discussing mechanisms to reduce costs of money transfer services.
- Authorities’ views: agreed to safeguard financial stability, prioritize supporting credit growth while developing tools to monitor credit growth and stand ready to tighten policy if overheating emerges; welcomed TA on reserves management and interest in follow-up TA on monetary policy and macroprudential measures.

### Supporting inclusive growth and building resilience to natural disasters
- Overarching goal: raise Tonga’s inclusive growth potential and reduce poverty.
- Constraints: limited business opportunities and difficult access to credit constrain private sector development, particularly for MSMEs.
- Government strategies:
  - Tonga Strategic Development Framework (TSDF II) focuses on resilient infrastructure, health and education, and diversification of domestic production (agriculture, manufacturing, tourism).
  - National Trade Framework (TNTF) strategy and MSME development strategy being developed to enhance export-oriented production and MSME support.
- Private sector development priorities:
  - Improve business climate, expand market access for exports, increase value added of domestic production by building manufacturing and packaging capacity.
  - Ensure inclusion of relevant international standards for exports to partner countries, particularly New Zealand and Australia.
  - Tonga joined PACER Plus in July 2017.
- Formalization of informal economy:
  - Formalization helps growth, access to finance, and broadens tax base.
  - Unemployment, particularly youth unemployment, remains high: approximately 40 percent in FY2016.
  - Formalization measures include introduction of a flat “small-business tax” in FY2015.
- Resilience to natural disasters:
  - Tonga ranked as the second most vulnerable country worldwide in the 2016 World Risk Index.
  - DSA 2017: risk of external debt distress increases to high due to recognition of long-term negative effects of natural disasters on GDP growth and macroeconomic balances.
  - Government infrastructure strategy mainstreams natural disaster resilience and climate proofing by increasing standards of newly built buildings, roads, and the electricity grid.
  - Ongoing priority projects include improving secondary school completion and job transitions for youth; upgrading road, aviation and maritime systems; and introducing technological advancements in government and health administrations.
- Authorities’ views: agreed promoting formalization and improving business climate are crucial; prioritized roads and transportation, followed by construction and upgrading of education facilities; noted improved resilience includes higher construction standards for new infrastructure.

### Strengthening statistical capacity
- Current weaknesses: statistical capacity weak due to insufficient resources at Tonga Department of Statistics (TDS) and MOFNP, causing delays in absorption of recent PFTAC TA, particularly for external sector and national accounts.
- Needs: development of labor and demographic statistics to effectively monitor unemployment, inequality, and inclusiveness of growth.
- TDS country-wide strategy for statistics:
  - Will recognize importance of good statistics and aim to reduce barriers to data sharing between institutions.
  - Staff emphasized achieving broad consensus to ensure buy-in and effectiveness.
- External sector statistics issues:
  - Quarterly and annual balance of payments compilation currently shared between NRBT (Overseas Transaction Exchange—OET) and TDS (integrating OET flows with other sources based on free-on-board—fob principle).
  - Need to clarify data sharing arrangements and resume compilation of the International Investment Position (IIP), which stopped in 2013.
  - Recent recruitment of new compilers welcomed; authorities encouraged to use IMF capacity building opportunities.
- Fiscal statistics:
  - More resources required for robust compilation of fiscal accounts; need to address discrepancies including underrecording of capital expenditure financed by donors.
  - Progress on implementing FAD and STA TA recommendations ongoing; authorities should consider reporting annual government finance statistics (GFS) to the IMF once follow-up is finalized.
- Authorities’ views: agreed on need to improve statistical compilation; TDS welcomed long-term strategy and foreseen budget increase and stressed urgent need to train newly hired staff due to increased demand for SDG- and TSDF-related indicators; MOFNP agreed to strengthen GFS compilation and address accountability and transparency issues in the Auditor General’s report.

### Staff appraisal (key conclusions)
- Recent performance:
  - Tonga has continued to experience strong economic growth and moderating inflation.
  - Economic growth projected to remain high in FY2018, slowing to the historic average over the medium term; inflation expected to moderate.
  - Growth supported largely by construction; authorities have developed agriculture and tourism sectors.
- Risks to outlook:
  - Tilted to the downside from external and domestic sources.
  - Global weaker growth and inward-looking policies could affect grant financing, private remittances, and tourism revenues.
  - Government infrastructure strategy may boost short-term growth but government must manage expenditures carefully and avoid fiscal slippage and non-concessional external borrowing.
- External sector assessment:
  - Moderately weaker than warranted by fundamentals and desirable policies.
  - Current account balance below estimated norm, reflecting reliance on grants and significant import share.
  - Exchange rate estimated in line with fundamentals.
  - Reserve adequacy strong in recent years but projected to decline due to increased prospective imports and loan repayments.
  - Recommendation: more prudent fiscal policy would help bring external position back in line with fundamentals.

*cr1812 - 22.      The authorities fully concurred with staff assessment of the fiscal stance and risks to*

### 46.      Staff supports more prudent fiscal management, while recognizing the need to build

### Staff supports more prudent fiscal management, while recognizing the need to build capital stock in Tonga

### Fiscal management and public investment
- Introduction of explicit fiscal anchors in the FY2018 Budget Document is welcome.
- Expected budget revenue are optimistic, even with the proposed tax revenue reforms.
- Authorities should contain the large wage bill to ensure fiscal sustainability is not compromised.
- For own-financed capital expenditure, prioritize projects likely to deliver long term returns, including:
  - education;
  - health;
  - roads;
  - building resilience to natural disasters.
- The FX levy should be replaced by a non-distortionary tax and be phased out no later than its sunset clause in FY2020.

### Medium-term fiscal framework and targets
- Maintain fiscal sustainability through prudent PFM and fiscal adjustment as needed to secure fiscal space for growth-enhancing spending.
- Authorities should target a gradual adjustment of the primary balance to approximately one percent of GDP by FY2022 to maintain the external public debt broadly unchanged.
- The required adjustment is achievable through several revenue and expenditure measures.
- PFM should be further strengthened to ensure appropriate medium-term planning, accountability, budget control, and efficient use of public funds.

### Monetary policy and central bank framework
- The stance of monetary policy is appropriate; the NRBT should stand ready to adjust should risks emerge.
- Current stance supports credit growth, consistent with financial deepening.
- NRBT efforts to modernize its monetary policy framework through the introduction of a policy rate and amendments of the NRBT Act are commendable.
- NRBT should consider using more flexible monetary policy tools in addition to the RRs.
- Reforms to the NRBT Act and the Banking Act are welcomed; the Banking Act still needs to be finalized to enhance NRBT’s supervisory powers.
- Loss of CBR may become an increasing source of concern; given the importance of remittances, the potential impact should be minimized through compliance with relevant international standards regarding AML/CFT.

### Macroprudential policy and financial stability
- Banking sector remains stable and profitable, but high credit growth merits continued monitoring.
- Staff encourages developing macroprudential policies, such as:
  - limits to LTV ratio for property loans;
  - loan diversification principles;
  - maximum LTD ratio.
- NRBT should develop credit monitoring indicators to catch early signs of potential distress.

### Structural reforms and poverty reduction
- Staff supports ongoing reforms aimed at raising Tonga’s growth potential and reducing poverty.
- In line with the TSDF II, authorities are focusing on:
  - investing in infrastructure;
  - enabling business climate improvements;
  - enhancing private sector development;
  - developing human capital;
  - improving access to finance.
- Formalizing the informal economy into MSMEs would promote inclusiveness and broaden benefits of economic growth.
- Staff supports expanding export market access and increasing the value added of domestic production.

### Macroeconomic statistics and data reporting
- Improving macroeconomic statistics is a priority.
- Although data are broadly adequate for surveillance, data quality and timeliness affect economic policy formulation and assessment.
- Efforts are needed to improve main macroeconomic datasets including BOP, fiscal accounts, and national accounts statistics.
- Staff encourages authorities to resume or initiate timely official reporting of all relevant datasets to the IMF.

### Article IV consultation periodicity
- At the authorities’ suggestion, the next Article IV consultation with Tonga is proposed to be held on the 24-month cycle.
- Tonga satisfies all relevant criteria to be moved to the 24-month cycle.

### Box 1 — Tonga’s Housing Sector: key points and statistics
- Housing credit continues to rise supported by lower interest rates and economic growth.
- A housing bubble is unlikely to develop due to:
  - rigid land tenure system with lengthy land registration;
  - very small and slow secondary market (approximately 10 house sale transactions per each year);
  - most bank credit finances construction of owner-occupied dwellings and housing for personal use rather than investment.
- Lending to households is collateralized, where land is the only asset that is qualified as collateral by banks.
- According to the “Land Act” the lease term shall not exceed 50 years and shall be renewable upon such conditions as to rent.
- Factors supporting housing credit growth include:
  - low lending rates for housing loans;
  - revision of the Land Act;
  - other initiatives.
- Specific initiatives:
  - In August 2015 TDB introduced a new loan, which offers 5 percent interest rate for new home loans during the first 2 years.
  - In July 2016, the Retirement Fund Board introduced a home improvement loan facility which contributed to the annual growth of personal loans from nonbank financial institutions.
- Higher payments for import of construction materials driven partially by removal of custom duty on construction materials also contributed to the increase of housing credit.
- Household credit quality is not a clear concern:
  - Loan payments are salary-based and deducted directly from salaries.
  - Remittances continue to increase, and consumer confidence and demand are on the rise.
  - On the supply side, NPLs continue to decline.
  - In FY2017, the value of collateral held against the delinquent loans reported by banks was T$40.5 million compared to total NPLs of T$16.9 million, indicating banks hold sufficient collateral to cover any shortfall in loan-loss provisions.
- Total Remittances (In millions of Paanga):
  - FY2015: Private Transfer 186.3; Compensation of Employees 14.8; Private Capital Transfers 0.9; Social Benefits 0.4; Total 202.4
  - FY2016: Private Transfer 235.2; Compensation of Employees 17.5; Private Capital Transfers 1.6; Social Benefits 1.9; Total 256.2

*International Monetary Fund — Excerpt from chapter text.*

### Box 2. Tonga: External Sector Assessment

### Box 2. Tonga: External Sector Assessment

### External balance assessment
- The external sector position is moderately weaker compared with fundamentals and desirable policies.
- The EBA-lite assessment, based on the CA and external sustainability (ES) approaches, estimates an adjusted current account gap of -1.5 percent (CA) and 2.1 percent (ES).
- Given Tonga’s reliance on grants, the CA deficit is adjusted to reflect a significant share of imports (5.5 percent of GDP in 2016) financed by capital grants, which are insensitive to changes in exchange rates.
- After adjusting the CA for capital grant related imports and notwithstanding the inherent volatility of Tonga’s BOP data, the external sector position is moderately weaker compared with fundamentals.
- The CA model is used for the assessment because external sustainability is not at risk in the baseline and the ES model estimates are affected by large and volatile transactions related to transfers.
- Key EBA-Lite figures (as reported):
  - CA-Actual: -13.2%
  - CA (Adjusted): -7.7%
  - CA-Norm: -6.2%  -9.8%  (presented together in source)
  - Elasticity: -0.8  -0.8
  - CA-Gap (Adjusted): -1.5%  2.1%
  - o/w policy gap: -0.1%
  - REER Gap (Adjusted): 1.9%  -2.7%

### FX reserves and outlook
- Tonga’s gross FX reserves stood at US$169.9 million in FY2017, boosted by grants and remittances inflows.
- Reserves coverage remained at a comfortable level of 6–7 months of prospective imports in FY2013–16, well above the NRBT’s target of 3–4 months.
- Coverage is projected to gradually decline, approaching around 5 months of prospective imports by FY2020, due to strong projected imports and large principal repayments of external debt starting in FY2018.
- Relevant balance sheet / BOP context noted: BOP data are inherently volatile, and large principal repayments of external debt begin in FY2018.

### Reserves adequacy
- When measured against its relatively high vulnerability to external shocks, Tonga’s level of foreign exchange (FX) reserves should be maintained between 6 and 7 months of prospective imports.
- The reserves template estimates an optimal level of reserves by comparing costs and benefits of holding reserves.
- The model for Tonga is calibrated using a higher-than-average risk of adverse external shock to reflect both vulnerability to natural disasters and the large current account deficit norm.
- Higher reconstruction spending or a shortfall in transfers could lead to a rapid decline in FX reserves and therefore a higher buffer is required to ensure external stability.

### FX reserves adequacy metrics (FY2017)
- Actual Reserves (months of prospective imports): 5.9
- Optimal level from reserves template: 6.3
- Broad Money coverage: 136%

### Additional empirical context from the assessment (selected figures)
- Capital grants–related imports: 5.5 percent of GDP in 2016 (used in CA adjustment).
- Nominal GDP FY2016: US$422.3 million (contextual figure reported elsewhere on the page).
- Gross official foreign reserves (selected series from tables):
  - FY2013: 147.6 (millions of U.S. dollars)
  - FY2014: 158.7 (millions of U.S. dollars)
  - FY2015: 142.5 (millions of U.S. dollars)
  - FY2016: 166.4 (millions of U.S. dollars)
  - FY2017: 169.9 (millions of U.S. dollars)
  - Months of next year's goods and services imports (FY2013–FY2017): 6.9, 6.8, 6.3, 6.3, 5.9 respectively.

_Prepared by Giovanni Ugazio; EBA-lite calculated for 2016; fiscal years in Tonga end in June. Source: IMF Staff Estimates._

### Appendix I. Risk Assessment Matrix

### Appendix I. Risk Assessment Matrix

### External risks
- Structurally weak growth in key advanced economies  
  - Likelihood: High  
  - Impact: Medium/High  
  - Assessment: Weak global growth could have a large adverse impact on Tonga via reduced remittances, donor funds and tourism. The impact may be more severe if it is compound with the implementation of inward looking policies.  
  - Policy response: Preserve fiscal and external buffers to cope with adverse shocks in the short term. In the longer term, boost public investment, and pursue structural reforms to improve potential growth and reduce dependence on aid and remittances.

- Significant China slowdown and spillovers  
  - Likelihood: Low/Medium  
  - Impact: Medium/High  
  - Assessment: China is a key development partner for Tonga, providing direct financing of several infrastructure projects.  
  - Policy response: (No separate policy response listed in the table for this row.)

- Reduced financial services by correspondent banks (“de-risking”)  
  - Likelihood: High  
  - Impact: Medium  
  - Assessment: De-risking could have a significant impact on money transfer operators (MTOs) and banks, potentially increasing the cost of inward remittances.  
  - Policy response: Maintain regulatory and supervisory up to date with international AML/CFT standards.

### Domestic risks
- Financial stability risks from high credit growth  
  - Likelihood: Low  
  - Impact: Medium  
  - Assessment: A prolonged period of high credit growth, especially if related to construction, may lead to lower lending standards, and/or excessive assets’ price increases.  
  - Policy response: Remain vigilant and be ready to intervene should signs of overheating appear.

- Wage growth (public sector employment reform risks)  
  - Likelihood: Medium/High  
  - Impact: High  
  - Assessment: Should the reform of public sector employment fail to contain wage growth in the coming years, there is a risk that the fiscal stance becomes unsustainable, possibly forcing the authorities to borrow externally.  
  - Policy response: Finalize the reform and keep wage growth in check.

- Natural disasters (regional)  
  - Likelihood: High  
  - Impact: High  
  - Assessment: Tonga remains vulnerable to large natural disasters, particularly cyclones, which have caused large damages to infrastructure and production base.  
  - Policy response: Maintain fiscal buffers of 4-5 months of recurrent expenditure. Invest in infrastructure that is resilient to disasters.

### Risk assessment methodology note
- The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff).  
- Likelihood definitions used by staff: "low" is meant to indicate a probability below 10 percent, "medium" a probability between 10 and 30 percent, and "high" a probability of 30 percent or more.  
- The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

*Source: IMF staff (Appendix I. Risk Assessment Matrix).*

### 5. Enhance preparedness and invest in smart infrastructure

### 5. Enhance preparedness and invest in smart infrastructure

### Regional risk pooling (Risk Transfer)
- Tonga is one of the five Pacific countries taking part in the Pacific Catastrophe Risk Assessment and Financing Initiative (PCRAFI) regional insurance scheme which aims to provide coverage in times of natural disasters.
- A Climate Change Trust Fund has been established under the ADB-CRSP (Climate Resilience Sector Projects) project funded by (Climate Investment Fund) CIF.

### Ex-post response — Coping (Emergency response and reconstruction)
- Maintain financial tools and arrangements such as capital budget realignment, bilateral and multilateral donor assistance for relief and reconstruction, flash appeals.
- The National Emergency Management Office (NEMO) has pursued to activate 8 out of the 10 coordinated clusters:
  - Water and Sanitation
  - Food Security and Livelihood (FSL)
  - Safety and Protection
  - Economic and Social Recovery
  - Communications
  - Logistics
  - Essential Services
  - Education
  - shelter
  - transport
- Enhance PFM systems
- Increase ability of coral reefs to recover after climate related events
- Improving management of mangroves for climate adaptation
- Upgrading evacuation and post disaster access roads
- Enhancing coastal protection
- Upgrading schools
- Rural electrification program to improve energy efficiency
- Disaster risk management training and improving communication with districts and communities
- Completion of specialized hazard maps and detailed analysis

### Risk assessment and risk reduction
- Continued emphasis on completing specialized hazard maps and conducting detailed analysis to inform preparedness and infrastructure investment decisions.
- Risk reduction measures focus on ecosystem-based adaptation (coral reef recovery, mangrove management), structural measures (coastal protection, evacuation and access road upgrades), and social infrastructure resilience (upgrading schools, emergency communication and training).

*Prepared from: cr1812 - 5. Enhance preparedness and invest in smart infrastructure*

### 2017. Timeliness and ease and efficiency in reporting remain an   issue. Source data are often available with a signific

### TONGA: STAFF REPORT FOR THE 2017 ARTICLE IV CONSULTATION—DEBT SUSTAINABILITY ANALYSIS

### Data and statistical weaknesses
- Timeliness, ease, and efficiency in reporting remain an issue; source data are often available with a significant time lag and in-year sub-annual reporting requires considerable manual intervention.
- Financial accounting system has not been upgraded and cannot capture all transactions; much of the government’s financial business processes and data collection are completed manually.
  - Budget is compiled manually.
  - Debt management is conducted outside of the financial accounts.
  - Aid revenue data are not included in the financial accounts.
  - Payments and receipts are processed and recorded on a manual basis.
- Reconciliation with monetary and BOP data requires enhancement; published data are often subject to significant revisions.
- Consolidated financial statistics for the general government are not published due to lack of source data and capacity and up until now no data are reported for publication in the GFS Yearbook (GFSY).
- Monetary and Financial Statistics:
  - NRBT reports data for the central bank, other depository corporations, and monetary aggregates using the standardized report forms (SRFs).
- Financial Sector Surveillance:
  - Tonga compiles FSIs for deposit takers and reports them to STA on a regular quarterly basis.
- External Sector Statistics: source data shortcomings in accuracy, completeness, timeliness, and classification; large net errors and omissions remain due to under-reporting of components.
  - Data gaps could be addressed by: enhancing the IIS response rate; gathering more accurate banks’ financial transactions data; obtaining data on compensation of employees, remittances, and acquisition of goods and services by overseas workers; capturing capital transfers related to donor-funded construction projects.
  - Key challenges for TSD and NRBT: (1) improve coverage of items in financial account by enhancing IIS response rate and gathering more accurate banks’ financial transactions data, (2) obtain not captured data e.g. compensation of employees, remittances and acquisition of goods and services by overseas workers and incorporate them into BOP statistics, (3) capture capital transfers accompanied by main construction projects and incorporate them into BOP statistics, and (4) maintain adequate staff resources for compiling and disseminating balance of payments and IIP in accordance with the international standards.
- Participation and metadata:
  - The country has been participating in the GDDS since May 30, 2006.
  - No data ROSC is available.

### Background and current debt position
- Reconstruction costs after Cyclone Ian in 2014 and legacy large external loans contributed to external debt accumulation.
- Government policy of no non-concessional external debt helped contain outstanding debt.
- External debt levels:
  - External debt was 41.8 percent of GDP in FY2017, decreasing from 44 percent of GDP in FY2016.
  - Government’s threshold for external debt is 50 percent.

### Methodology and key assumptions (natural disasters incorporated)
- DSA incorporates effects of natural disasters in the baseline with two projection horizons: baseline assumes no disaster until FY2023; alternative scenario considers a disaster in FY2018.
- Long-term assumptions:
  - Potential growth without natural disasters: 1.8 percent.
  - To incorporate average effect of natural disasters, long-term GDP growth is lowered by 0.7 percentage points to 1.1 percent from FY2023 onwards.
  - Average yearly natural disasters damages for Tonga amount to approximately three percent of GDP.
  - One percent of GDP per year is assumed as yearly reconstruction cost financed by government borrowing in the baseline from FY2023.
- Macroeconomic projections & assumptions:
  - Real GDP growth projected to remain between 2.7 percent and 3.4 percent in FY2017 through FY2020.
  - Growth for FY2020 through FY2022 projected to gradually decline towards 1.8 percent, assuming no natural disasters.
  - Inflation (GDP deflator growth) projected to stabilize around 2.1 percent from FY2018 onwards after an increase to 3.1 percent in FY2017.
  - Current account (CA) deficit has been wavering around 12 percent of GDP in the latest periods; projected to stabilize around 12 percent of GDP before natural disasters.
  - To account for reconstruction import content, CA deficit is widened by one percent of GDP from FY2023 onwards.
  - Fiscal deficit projections:
    - Widen to 2.3 percent of GDP in FY2018.
    - Reach 4.4 percent of GDP in FY2020 due to increased infrastructure investments.
    - Stabilize at around 1.4 percent of GDP before natural disaster effects.
    - From FY2023 onwards, deficit is projected to widen by one percent of GDP to account for average additional borrowing due to natural disasters.
  - Remittances:
    - Remittances are large and volatile; used mainly to finance consumption of imported goods.
    - Remittances are vulnerable to de-risking and loss of correspondent banking relationships.
  - Financing assumptions:
    - From FY2023 onwards additional external borrowing meets reconstruction financing requirements.
    - Average grant element of borrowing in the medium term converges to close to 40 percent.
    - Assumes future financing from ADB and IDA remains on a 50 percent grant and 50 percent loan basis; additional borrowings not covered by ADB or IDA are concessional but less favorable.

### External DSA findings and scenarios
- PV of external debt-to-GDP plus remittances ratio hits the indicative threshold in FY2037.
- PV of external debt-to-GDP ratio (excluding remittances from the denominator) breaches the indicative threshold in FY2032.
- At the end of the projection horizon in 2037, the PV of debt-to-GDP is 4.2 percentage points above the indicative threshold.
- Main drivers: incorporation of natural disasters lowers growth and weakens fiscal and external positions.
- Remittances:
  - Remittances were 27.4 percent of GDP in FY2017.
  - Staff assess debt sustainability using an alternative scenario that excludes remittances because remittances finance consumption, are very volatile, and are not a reliable source of FX.
- Vulnerabilities highlighted:
  - Largest contributor to the combination shock to the PV of debt-to-GDP is a decrease in external transfers, showing reliance on external non-debt creating funding.
  - Repayment of EXIM loans starting in FY2019 more than doubles debt-service ratios, puts pressure on FX reserves, and introduces exchange rate risk.
  - Debt service projections:
    - Debt service is projected at 1.5 percent of GDP in FY2018.
    - Debt service is projected to more than double to 3.8 percent of GDP from FY2019 onwards.
- Downside scenario (natural disaster in FY2018):
  - Staff estimate probability of around 30 percent.
  - Assumes damage of 10 percent of GDP and a reduction of GDP growth of four percent in FY2018.
  - Under this scenario the sustainability threshold would be breached much sooner.

### Public DSA findings
- The PV of public debt-to-GDP ratio does not breach the indicative threshold in the DSA projections.
- Baseline shows an increasing public debt burden from FY2023 onwards reflecting additional indebtedness due to spending on natural disasters.

### Conclusions and policy recommendations
- External debt distress rating increased from moderate to high in DSA 2017 due to fiscal fragility and potential large impact of natural disasters; reclassification is based on the model which excludes remittances.
- Current debt burden remains at a moderate level despite the reclassification.
- Policy priorities recommended for the authorities:
  - Preserve the policy to cap external debt and borrow externally only in exceptional circumstances and on highly concessional terms.
  - Contain fiscal expenditure to maintain fiscal buffers.
  - Target a primary surplus of one percent of GDP in the medium term.
  - Keep buffers at a minimum of four-to-five months of recurrent expenditure to prepare for future reconstruction efforts.
- The DSA underscores Tonga’s reliance on transfers and vulnerability to a shortfall in non-debt creating financing.

*Prepared by the staff of the International Monetary Fund (IMF) and the International Development Association (IDA); December 19, 2017.*

### 14.      The authorities agreed with staff’s DSA assessment, including on the reclassification to

### cr1812 - 14.      The authorities agreed with staff’s DSA assessment, including on the reclassification to

### Agreement with staff DSA and policy stance
- The authorities agreed with staff’s DSA assessment, including on the reclassification to “high risk”.
- The authorities welcomed the explicit account of natural disasters in the long run projections and potentially significant adverse effects on growth and fiscal accounts.
- The authorities agreed on the need for a more prudent fiscal policy and to maintain sufficient buffers, in view of Tonga’s vulnerability to external shocks.
- The authorities agreed on the need for further research work to continue improving the quantification of the macroeconomic burden of disasters.

### Engagement and capacity building
- Staff delivered a presentation on the new DSA with natural disasters to officials from the NRBT and the MOFNP.

### DSA projections and indicators (selected exact figures from tables and figures)
- PV of external debt: 31.4, 33.8, 35.6, 36.0, 36.6, 35.7, 34.6, 35.9, 45.1 (as presented in Table 1 PV of external debt 4/ row).
- PV of PPG external debt (in percent of exports): 155.0, 156.2, 152.1, 153.0, 157.8, 154.6, 149.3, 147.0, 165.2 (Table 1).
- PV of PPG external debt (in percent of government revenues): 134.9, 133.2, 126.1, 133.2, 131.2, 138.6, 134.3, 139.6, 174.9 (Table 1).
- Debt service-to-exports ratio (in percent): 8.9, 8.9, 7.6, 7.2, 6.6, 17.2, 17.0, 16.8, 16.2, 14.3, 10.4 (Table 1).
- PPG debt service-to-revenue ratio (in percent): 7.3, 6.8, 6.6, 6.2, 5.5, 14.9, 14.2, 15.1, 14.6, 13.6, 11.1 (Table 1).
- Total gross financing need (Millions of U.S. dollars): 25.8, 58.3, 48.2, 43.9, 41.9, 58.8, 55.3, 58.5, 60.3, 63.2, 94.8 (Table 1).
- Non-interest current account deficit that stabilizes debt ratio: 8.2, 10.9, 16.0, 8.1, 8.7, 11.1, 9.3, 11.1, 11.6, 9.1, 11.7 (Table 1).

### Key macroeconomic assumptions (exact series)
- Real GDP growth (in percent): 2.1, 3.7, 3.4, 1.5, 2.8, 2.7, 3.4, 3.0, 2.9, 1.9, 1.9, 2.6, 1.1, 1.1, 1.1 (Table 1).
- GDP deflator in US dollar terms (change in percent): -3.3, -5.3, -6.2, 2.6, 9.0, -1.4, -4.3, 0.6, 2.1, 2.0, 1.8, 0.1, 1.8, 1.8, 1.8 (Table 1).
- Effective interest rate (percent): 1.7, 1.6, 1.6, 1.6, 0.4, 1.6, 1.6, 1.7, 1.9, 1.9, 1.8, 1.8, 2.0, 2.0, 1.9 (Table 1).
- Grant-equivalent financing (in percent of GDP): 6.2, 5.7, 5.5, 5.5, 7.1, 7.0, 6.7, 6.3, 6.5 (Table 1 entries shown).
- Gross workers' remittances (Millions of US dollars): 102.7, 102.2, 112.2, 117.4, 124.3, 130.4, 136.0, 141.5, 147.2, 171.9, 229.4 (Table 1 memorandum).

### Stress tests and sensitivity analyses (select exact stress outcomes)
- The most extreme stress test is defined as the test that yields the highest ratio on or before 2027; across figures the most extreme shocks correspond to Combination shock (figures b, c, d, and e) and One-time depreciation shock (figure f).
- Table 2a (Excluding remittances) and Table 2b (Including remittances) present scenario outcomes such as:
  - PV of debt-to-GDP ratio (Baseline and scenarios): Baseline series examples include 34, 36, 36, 37, 36, 35, 36, 45 (Table 2a header series).
  - PV of debt-to-exports ratio (Baseline and scenarios): Baseline series examples include 156, 152, 153, 158, 155, 149, 147, 165 (Table 2a series).
  - PV of debt-to-revenue ratio (Baseline and scenarios): Baseline series examples include 133, 126, 133, 131, 139, 134, 140, 175 (Table 2a and 2b series).
  - Debt service-to-revenue ratio and Debt service-to-exports (and +remittances) ratio series are presented across scenarios and bound tests with exact numbers in Tables 2a and 2b (select entries include 7, 6, 15, 14, 15, 14, 11, etc.).

### Public sector debt metrics (exact figures)
- Public sector debt (in percent of GDP): 47.1, 51.4, 49.2, 51.2, 53.5, 54.2, 55.6, 55.4, 57.4, 59.7, 71.5 (Table 3).
- PV of public sector debt: 38.8, 40.0, 41.6, 41.7, 42.2, 41.1, 39.8, 40.3, 48.4 (Table 3).
- Gross financing need: -4.9, 4.2, 1.9, 1.3, 3.1, 5.1, 4.9, 4.9, 4.3, 5.3, 5.3 (Table 3).
- PV of public sector debt-to-revenue and grants ratio (in percent): 133.5, 131.4, 130.0, 137.5, 136.0, 133.7, 129.3, 133.1, 159.2 (Table 3).
- Debt service-to-revenue and grants ratio (in percent): 8.5, 8.5, 8.2, 5.6, 5.4, 13.9, 13.3, 13.2, 12.8, 12.1, 10.0 (Table 3).

### Policy implications highlighted
- Natural disasters significantly increase long-run fiscal and growth vulnerabilities, warranting their explicit inclusion in DSA frameworks.
- Higher share of loans financing from development partners in frameworks that exclude natural disasters poses a threat to debt sustainability in the long run.
- Need for continued research to improve quantification of the macroeconomic burden of disasters.
- Need for more prudent fiscal policy and maintenance of sufficient buffers given Tonga’s vulnerability to external shocks.

*Source: IMF staff and Tonga authorities as presented in the DSA material (figures and tables quoted).*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr1812.pdf_