## 1tonea2022001

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### EXECUTIVE SUMMARY — Context, Request for Fund Support, and Policy Recommendations
- Context:
  - Tonga experienced a double shock at the start of 2022: the Hunga Tonga–Hunga Haʻapai volcanic eruption (January 15, 2022) and the first local outbreak of COVID-19 (first community transmission reported on February 1).
  - Direct physical damages from the eruption and tsunami are estimated at 19.2 percent of FY2021 GDP (excluding potential economic losses due to disruptions in economic activity).
    - Estimated direct damages to capital stock (in millions of US$): Buildings—14.9; Residential—28.8; Nonresidential—20.9; Infrastructure—20.9; Agriculture—4.9; Ash Cleanup—90.4.
    - In percent of FY2021 GDP: Buildings—3.2; Residential—6.1; Nonresidential—4.4; Infrastructure—4.4; Agriculture—1.0; Total—19.2.
  - The undersea fiber-optic cable was severed for nearly a month, disrupting telecommunication services and remittance inflows.
  - About 2 percent of the population was displaced immediately following the disaster.
  - As of April 18, 56 percent of the eligible population (aged 18 or above or 34 percent of the total population) have received booster shots; authorities aim to administer booster shots to 70 percent of the eligible population by end-June 2022.
- Request for Fund support:
  - Authorities requested financial assistance under the Rapid Credit Facility (RCF) of 50 percent of quota: SDR 6.9 million (equivalent to US$9.4 million).
  - Tonga already has an outstanding RCF balance of 50 percent of quota (RCF-1) approved on January 25, 2021.
  - Purpose: meet urgent balance of payments (BOP) and government budget financing needs for reconstruction and social protection, alongside external grants from other development partners.
  - IMF staff support the RCF request.
- Policy recommendations:
  - Short term:
    - Fiscal policy: focus on supporting reconstruction and recovery with a larger budget envelope for FY2023, as envisaged by the authorities.
    - Monetary policy: current settings are appropriate under staff’s baseline inflation outlook, but the central bank should stay vigilant and stand ready to act given significant risks to inflation.
    - Financial sector: banks should be required to closely monitor credit risks and actively provision for loan losses.
  - Medium-to-long term:
    - Strengthen public finances through a combination of domestic fiscal measures―including rationalization of tax exemptions and reduction of the public wage bill―and continued donor support to meet development spending needs while reducing the risk of debt distress.
  - Structural reforms (priority areas):
    - (i) further liberalizing FDI;
    - (ii) easing access to credit;
    - (iii) expanding climate-resilient public infrastructure;
    - (iv) strengthening the AML/CFT and anti-corruption frameworks.

### RECENT ECONOMIC DEVELOPMENTS — FY2021 outcomes and near-term indicators
- Output and sectoral drivers:
  - FY2021: real GDP growth was -2.7 percent.
  - Contraction led by tourism-related sectors, wholesale and retail trade, and transport.
  - Drivers in FY2021: strong remittances and policy support partly offset border-closure impacts; construction activity remained robust due to reconstruction demand.
  - Remittance inflows increased by 36 percent in FY2021 in T$ terms.
- Inflation and reserves:
  - Headline inflation averaged 7.9 percent (y/y) from July 2021 to April 2022, above NRBT reference rate of 5 percent.
  - IMF staff estimate of core inflation (excluding food and energy) at end-April 2022: 4.3 percent.
  - FX reserves: US$318 million at end-FY2021 and US$360 million as of end-December 2021 (partly reflecting the IMF’s 2021 SDR allocation of US$18.7 million in August 2021).
- Fiscal outcomes:
  - Fiscal balance switched to a deficit in FY2021 due to COVID-related current expenditures.
  - Government fiscal package worth 5.3 percent of GDP on health care and social protection.
  - Fiscal balance moved from a surplus of 5.3 percent of GDP in FY2020 to a deficit of 1 percent in FY2021.
  - Public wage bill increased from 52.9 percent of domestic revenue in FY2020 to 57.3 percent in FY2021, breaching the authorities’ target ceiling of 53 percent; other fiscal anchors (domestic revenue floor of 21.5 percent of GDP and public sector wage bill ceiling of 45 percent of domestic revenue) were met in FY2021.
- Financial sector:
  - Banks were profitable and well-capitalized before the volcanic eruption, with declining NPLs due to loan write-offs and COVID-related loan relief measures.
  - Bank credit had gradually declined since mid-2020 after several years of double-digit increases.

### OUTLOOK AND RISKS — Growth, inflation, and balance of payments projections
- Growth projections:
  - FY2021: real GDP contracted by 2.7 percent.
  - FY2022: real GDP projected to contract by 1.9 percent (July 2021–June 2022).
  - FY2023: real GDP projected to rebound by 3.2 percent with gradual reopening of international borders led by reconstruction activity.
- Assumptions underpinning short-term outlook:
  - International borders planned to gradually reopen over FY2023; meaningful recovery in tourism expected to be delayed to FY2024.
  - Reconstruction of flagship infrastructure projects expected to accelerate in FY2023 after the border reopens in July.
  - Crop production expected to gradually recover over FY2023–FY2024 as soil contamination dissipates.
- Inflation forecast:
  - Average inflation projected at 8.4 percent (y/y) in FY2022, up from 1.4 percent in FY2021.
  - FY2023: inflation expected to decline to an average of 4.7 percent (y/y), slightly below NRBT reference rate of 5 percent, assuming international commodity prices stabilize in line with IMF April 2022 WEO forecasts.
- Key risks:
  - Frequent natural disasters; faster-than-expected rise in international food and energy prices; faster local community transmission of COVID-19 or new contagious virus; medium-term risk of loss of correspondent banking relationships (CBRs).

### MACROECONOMIC IMPACTS AND OUTLOOK — Current account, reserves, and medium-term trajectory
- Current account balance (CAB) projections:
  - CAB is projected to switch back to a deficit (-6.1 percent of GDP) in FY2022 and deteriorate further in FY2023 (-23.1 percent).
- Drivers of CAB deterioration:
  - Increased imports of food, imports of reconstruction-related materials, subdued tourism and agricultural exports, decline in remittances from exceptional levels during FY2021–FY2022.
- External financing and reserves:
  - Post-disaster increase in donors’ aids has not fully closed the external financing gap under current grant commitments.
  - International reserve coverage expected to trend down to around 3½ months of prospective imports in the medium term—but above NRBT’s minimum threshold of 3 months of imports—unless comprehensive efforts are made, including strengthening public finances and developing the private sector, together with continued strong financial support from development partners.
- Authorities’ views:
  - Authorities broadly agreed with staff’s assessment.
  - Authorities anticipate a FY2022 contraction of 2.5 percent and expect a strong rebound of about 3‒3½ percent in FY2023.

### FISCAL POLICY — Response, near-term stance, and medium-term adjustment
- Donor support and fiscal response:
  - Donors pledged grants: additional budget support worth 7 percent of GDP for FY2022 and 3.7 percent of GDP for FY2023.
  - Fiscal measures financed included tax reliefs, loan subsidies, and cash transfers worth a total of about 2.2 percent of projected FY2022 GDP during Q3:FY2022.
  - Reconstruction plan: 8 out of 20 high-priority projects already completed.
- Fiscal projections:
  - Staff expect fiscal deficit to widen from 1 percent of GDP in FY2021 to 2.1 percent in FY2022.
  - Envisaged expansionary fiscal stance in FY2023 is appropriate to meet urgent reconstruction and recovery spending needs.
- Medium-to-long term strategy and illustrative adjustment path:
  - Under an illustrative fiscal adjustment scenario, the present value (PV) of the public debt-to-GDP ratio could stabilize below the 70 percent threshold over the long term.
  - Fiscal adjustments could include a gradual increase of tax revenues and reduction of the public wage bill and current expenditure; new grant commitments in line with historical trends are essential.
  - Government strategy: pursue additional grants and avoid new non-concessional borrowing.
- Specific reform measures and quantitative impacts:
  - Authorities could increase revenues by about 3 percent of GDP by reducing tax exemptions and strengthening tax administration.
  - IMF TA estimate: additional revenue of 2½ percent of GDP could be collected by removing major tax exemptions (notably those related to electricity provision and consumption).
  - Revenue administration reforms could increase tax revenues by ½-1 percent of GDP through better tax compliance and lower tax arrears.
  - As of FY2020, collectable tax arrears estimated at 2.4 percent of GDP.
  - Lowering spending on wages and goods and services to peer levels could help improve the fiscal balance by about 1½ percent of GDP.
- Illustrative Fiscal Adjustment Path (selected figures, In percent of GDP):
  - Domestic fiscal measures (FY2025 to FY2030): 0.8, 1.6, 2.4, 3.2, 4.0, 4.5
  - Taxes (FY2025 to FY2030): 0.5, 1.0, 1.5, 2.0, 2.5, 3.0
  - Goods and services / Wage bill (FY2025 to FY2030): -0.3, -0.6, -0.9, -1.2, -1.5, -1.5
  - Additional Grants (FY2025 to FY2030): 1.9, 3.1, 4.2, 5.0, 5.0
  - Change in primary balance (FY2025 to FY2030): 0.8, 3.5, 5.5, 7.4, 9.0, 9.5
  - Memo. Projected primary balance (FY2025 to FY2030): -7.3, -5.3, -4.7, -4.3, -3.5, -2.2
  - Note: In the baseline scenario, grants would gradually decline to below 10 percent of GDP after FY2026. Grants averaged 18 percent of GDP between FY2016-FY2021.

### MONETARY AND EXCHANGE RATE POLICIES
- Current stance:
  - NRBT has maintained the policy rate at zero percent, the statutory reserve deposit (SRD) ratio at 10 percent, and the inflation reference rate at five percent.
  - Monetary conditions remain loose with abundant banking system liquidity due to large inflows of grants and remittances in FY2021.
- Inflation outlook and policy guidance:
  - Under the baseline, staff project inflation to gradually decline to below the reference rate in FY2023.
  - Current monetary policy settings are consistent with the baseline, but NRBT should stand ready to tighten if inflation is expected to stay above the reference rate for longer.
  - Monetary tightening options include increasing the SRD ratio or raising the policy rate.
  - Historical note: SRD ratio raised from 5 to 10 percent in FY2018, followed by reduction in average inflation from 6.8 percent in FY2018 to 3.3 percent in FY2019. The policy rate has not been adjusted for a decade.
- Exchange rate regime:
  - Tonga’s nominal exchange rate is pegged to a basket of currencies.
  - The real effective exchange rate (as of April 2022) has appreciated by 3.3 percent since January 2021.
  - Exchange rate stability maintained with currency basket weights set in 2018.

### FINANCIAL SECTOR POLICIES AND REFORMS
- Immediate supervisory guidance:
  - NRBT should encourage banks to actively provision for potential loan losses and monitor credit risks closely.
  - In case capital buffers become inadequate, NRBT should consider restricting dividend payouts and requesting capital injections from parent banks.
- Reforms to strengthen supervision and macroprudential framework (four priorities):
  - (i) Conduct risk-based offsite supervision after the natural disaster.
  - (ii) Expand NRBT’s regulatory remit to cover nonbank financial institutions (NBFIs), especially pension funds.
  - (iii) Establish a solvency stress testing framework that covers NBFI lending, with CD support from the IMF.
  - (iv) Develop macroprudential instruments to operationalize NRBT's financial stability mandate.
  - NRBT plans to establish a Financial Stability Unit based on earlier CD support recommendations from the IMF.
- Measures to support credit, financial deepening, and inclusion:
  - Near-term targeted concessional credit support to MSMEs in hard-hit sectors, including through the Government Development Loan (GDL) Scheme.
    - GDL funding increased from T$13 million to T$18.3 million in 2020 after TC Harold.
    - Subsidized interest rate reduced to 1 percent from 3 percent for new loans.
  - Consideration of a partial loan guarantee scheme temporarily as a crisis response with lenders bearing appropriate risk.
  - Long-term reforms: improve credit information systems, strengthen insolvency regimes and debt enforcement; plan to set up a credit registry within NRBT.
  - Promote financial solutions to cut transaction costs of remittances (example: Ave Pa’anga Pau voucher system).
- Financial landscape:
  - Tonga’s financial landscape mainly comprised of four banks (three subsidiaries of foreign-owned banks and a government development bank, with total assets of 95 percent of GDP at end-June 2021), and NBFIs including two major pension funds, 4 insurance companies, and a number of foreign exchange dealers.

### FINANCIAL STABILITY, BANKING SECTOR OVERSIGHT, AND STRUCTURAL REFORMS
- Financial stability and oversight:
  - NRBT acknowledged need to closely monitor potential loan losses and has undertaken stress testing and monthly NPL monitoring.
  - Stress testing results suggest banks’ capital adequacy ratios remain above minimum required even in worst-case scenario.
  - NRBT committed to setting up a solvency stress testing framework and a macroprudential framework with IMF TA assistance; a Financial Stability Unit is to be set up.
- Structural reforms — disaster resilience and climate:
  - Disaster Risk Management bill passed in 2021; effective implementation requires enhanced coordination.
  - Efficiency of climate-resilience capital spending could be improved by developing a comprehensive public asset register and expanding classification of capital spending to identify climate components.
  - Revisions to the Building Code and stronger enforcement recommended.
- Structural reforms — private sector development and public investment:
  - Inward FDI during 2016-2020 increased by only a modest 1.1 percent of GDP on average.
  - Proposed amendments to the reserved and restricted list under draft Foreign Investment Regulation 2021 are essential.
  - Priority initiatives: expand/upgrading physical and ICT infrastructure (including internet connections to remote islands), increase government spending on health/education/social protection, support conditional cash transfer program “SET”, and improve land leasehold market operations.
- Governance, AML/CFT, and anti-corruption:
  - Tonga acceded to UNCAC in February 2020.
  - Strengthening accountability and transparency and addressing weaknesses in revenue administration would mitigate governance and corruption risks.
  - Implementing the Anti-Corruption Commissioner Act remains essential; office not yet set up.
  - Recent AML/CFT improvements: establishment of the Financial Analysis and Supervision Coordinating Unit; enhanced FIU collaboration; NRBT setting up a national know-your-customer system and revising AML/CFT framework to be more risk-based and aligned with APG recommendations.
  - Concern: loss of correspondent banking relationships (CBRs) could have macro-critical impacts given heavy reliance on remittances.

### DEBT SUSTAINABILITY AND EXTERNAL SECTOR — DSA findings and implications
- RCF financing needs and capacity to repay:
  - Staff assess the RCF as the most appropriate financing instrument to meet Tonga’s urgent BOP need.
  - Estimated BOP need amounts to about US$134 million or 25 percent of FY2023 GDP.
  - Authorities requested emergency financing under the RCF worth 50 percent of quota.
  - Additional access of 50 percent of quota (equivalent to about 1.8 percent of GDP) is appropriate.
  - 50 percent of quota represents about 7 percent of total external financing needs in FY2023.
  - Financing plan: remaining FY2023 financing gap to be filled by donors’ aids and a drawdown from FX reserves; if donors’ aids do not fully materialize, further drawdown of FX reserves is expected.
  - If disbursed, RCF-2 would increase outstanding IMF credit to 100 percent of quota; total credit outstanding to the Fund would remain below 3.6 percent of GDP and peak at about 14.5 percent of gross reserves.
  - Under the baseline, total repayments to the Fund would peak at about 3.5 percent of exports and 0.6 percent of GDP.
- DSA key findings:
  - Tonga is assessed as being at high risk of debt distress.
  - Without additional grant commitments to staff’s baseline projection, PV of public debt-to-GDP ratio projected to rise above the 70 percent debt-distress benchmark in FY2032.
  - Debt obligations are largely external, with over half of total public debt to China Exim Bank.
  - Debt repayments expected to pick up in FY2024, mainly to Exim Bank, and stay elevated at over 3 percent of GDP until FY2027.
  - Under baseline, external debt-to-GDP and public debt-to-GDP paths show significant deterioration under various stress scenarios and natural disaster shocks.
- Public debt composition (end-June 2021):
  - Total PPG external debt: USD196 million (about 41 percent of GDP), accounting for 87 percent of total public debt.
  - Outstanding debt to multilateral creditors: USD75 million (about 15 percent of GDP).
  - China Exim Bank accounts for 58 percent of total external debt stock.
  - Domestic public debt: USD31 million (about 6 percent of GDP).
- Policy implications:
  - To rebuild fiscal buffers and enhance resilience, measures needed include stronger revenue mobilization, expenditure rationalization, and external donor support in line with historical trends.
  - Government commitments: strengthen debt management framework; seek grants and avoid non-concessional borrowing; continue to pursue debt relief from China Exim Bank.

### EXTERNAL SECTOR ASSESSMENT — CA, REER, reserves, and adequacy
- Current account and composition:
  - FY2014–FY2020: CA deficit averaged about 6 percent of GDP.
  - FY2021: CA estimated to have turned to a surplus of 3 percent of GDP driven by remittance inflows estimated at about 42 percent of GDP in FY2021.
  - CA projected: deficit of 6 percent of GDP in FY2022 and deficit of 23 percent of GDP in FY2023.
- REER and exchange rate:
  - Exchange rate regime: pa’anga determined by weighted-basket of USD, AUD, NZD, and FJD; basket weights unchanged since 2018 and reviewed in March 2022.
  - FY2021: REER depreciated by about 5.1 percent on average; April 2021–April 2022 both REER and NEER appreciated (REER 1.1 percent; NEER 3.6 percent).
- International reserves:
  - FY2021: US$318 million (about 10 months of the following year’s imports).
  - Optimal reserve levels: staff estimates 4.6 months (standard shock) and about 7.3 months (higher shock probability).
  - Staff project reserves to decline significantly in FY2023 and to about 3½ months of imports in FY2027 absent policy adjustments and donor support.

### RISK ASSESSMENT MATRIX — Key risks and policy responses (selected)
- Global risks:
  - Outbreaks of lethal and highly contagious COVID-19 variants: Likelihood: High; Expected impact: High.
    - Policy recommendation: Increase fiscal spending on health and social protection; keep monetary and macroprudential policies accommodative; accelerate structural reforms.
  - Rising and volatile food and energy prices: Likelihood: High; Expected impact: Medium-High.
    - Policy recommendation: Provide targeted fiscal support; tighten monetary policy using NRBT instruments if strong second-round effects materialize; increase public investment for productive capacity.
- Domestic risks:
  - Faster community transmission of COVID-19: Likelihood: High; Expected impact: Medium-High.
    - Policy recommendation: Accelerate booster vaccination; increase fiscal spending on health and social protection; require banks ensure adequate provisioning.
  - Partial withdrawal of CBRs due to AML/CFT gaps: Likelihood: Medium; Expected impact: High.
    - Policy recommendation: Strengthen AML/CFT framework; improve risk-based supervision and enforcement aligned with APG assessment.
  - Natural disasters related to climate change: Likelihood: High; Expected impact: Medium-High.
    - Policy recommendation: Prioritize expenditure to support affected households; provide fiscal stimulus if impact large; maintain easy monetary policy while monitoring banking sector debt service problems.

### STATISTICS, DATA ADEQUACY, AND REALISM TOOLS
- Data adequacy:
  - External sector source data have shortcomings in accuracy, completeness, timeliness, and classification; net errors and omissions were reduced but remain large.
  - Tonga participates in the e-GDDS; NSDP yet to be launched to disseminate 13 of 15 e-GDDS data categories.
- Realism tools:
  - Realism tools indicate the primary balance projections are reasonable; the fiscal forecasts between FY2022 and FY2025 are not overly optimistic.
  - Tonga's Composite Indicator (CI) index is 3.12, indicating debt-carrying capacity is "strong" per LIC-DSA framework.
- Selected indicators and projections (selected series reproduced exactly from source):
  - Real GDP (annual percent change): FY2019 0.7, FY2020 0.5, FY2021 -2.7, FY2022 -1.9, FY2023 3.2, FY2024 3.0.
  - Consumer prices (period average): FY2019 3.3, FY2020 0.4, FY2021 1.4, FY2022 8.4, FY2023 4.7, FY2024 3.4.
  - Gross official foreign reserves (millions of U.S. dollars): FY2019 212.8, FY2020 237.2, FY2021 317.9, FY2022 324.1, FY2023 231.8, FY2024 132.2.
  - Current account balance (In percent of GDP): FY2019 -0.9, FY2020 -4.0, FY2021 3.0, FY2022 -6.1, FY2023 -23.1, FY2024 -19.8.
  - Public sector total debt (In percent of GDP): FY2019 41.3, FY2020 43.6, FY2021 47.5, FY2022 47.6, FY2023 45.5, FY2024 47.9, FY2025 54.5, FY2026 62.2, FY2027 71.4.
  - External financing and reserves (Table 7, selected): Total requirement (In millions of U.S. dollars): FY2021 1.0, FY2022 91.3, FY2023 164.5; Total sources (In millions of U.S. dollars): FY2021 53.4, FY2022 39.0, FY2023 30.5; Financing gap / Additional financing sources (In percent of GDP): FY2021 -11.1, FY2022 10.5, FY2023 25.1.
  - IMF-related indicators (Table 8): Outstanding IMF credit (Millions of SDRs): FY2020 0.0, FY2021 6.9, FY2022 6.9, FY2023 13.8, FY2033 0.0.

### APPENDIX I — LETTER OF INTENT (selected commitments)
- Damages and urgent BOP need:
  - Damages to physical capital and estimated loss from the HTHH disaster amount to 37 percent of GDP (US$182 million).
  - Community transmission of COVID-19 began at start of 2022; national lockdowns implemented.
  - Urgent BOP need estimated at about US$121 million.
- Request for IMF support:
  - Government requests emergency financing of SDR 6.9 million (50 percent of quota) under exogenous shock window of RCF.
  - Development partners pledged additional budget support in grants worth about 7 percent of GDP for FY2022 and 4 percent for FY2023.
- Fiscal and debt commitments:
  - Strengthen debt management framework; seek grants and avoid non-concessional external borrowing; continue to pursue debt relief from China Exim Bank.
- Revenue and administration commitments:
  - Review and rationalize tax exemptions; improve approval process for exemptions; publish list of all exemptions and estimated foregone revenue; facilitate electronic filing; reduce processing time for tax dispute resolutions.
- Governance, transparency, and safeguards:
  - Commit to publishing an audit of COVID-19 related expenditures and pandemic-related procurement contracts on MOF website within 12 months following RCF approval.
  - First-time safeguards assessment of NRBT completed in December 2021; commitments to address recommendations (draft amendments to NRBT Act, fill Board vacancies, outsource audits of high-risk areas).
- Monetary and financial sector commitments:
  - NRBT to maintain accommodative monetary policy (policy rate at zero percent; SRD rate at 10 percent) and stand ready to tighten if inflation persists above reference rate.
  - Strengthen Financial Stability Unit capacity; develop macroprudential framework; draft legislation for licensing and supervision of pension funds, insurers, capital markets, credit information system, and payment systems.

*Source: EXECUTIVE SUMMARY (1tonea2022001), IMF staff.*

### EXECUTIVE SUMMARY

### EXECUTIVE SUMMARY

### Context
- Tonga experienced a double shock at the start of 2022: the Hunga Tonga–Hunga Haʻapai volcanic eruption (January 15, 2022) and the first local outbreak of COVID-19 (first community transmission reported on February 1).
- Direct physical damages from the eruption and tsunami are estimated at 19.2 percent of FY2021 GDP (excluding potential economic losses due to disruptions in economic activity).
  - Estimated direct damages to capital stock (in millions of US$): Buildings—14.9; Residential—28.8; Nonresidential—20.9; Infrastructure—20.9; Agriculture—4.9; Ash Cleanup—90.4.
  - In percent of FY2021 GDP: Buildings—3.2; Residential—6.1; Nonresidential—4.4; Infrastructure—4.4; Agriculture—1.0; Total—19.2.
- The undersea fiber-optic cable was severed for nearly a month, disrupting telecommunication services and remittance inflows.
- About 2 percent of the population was displaced immediately following the disaster.
- As of April 18, 56 percent of the eligible population (aged 18 or above or 34 percent of the total population) have received booster shots; authorities aim to administer booster shots to 70 percent of the eligible population by end-June 2022.

### Request for Fund support
- Authorities requested financial assistance under the Rapid Credit Facility (RCF) of 50 percent of quota: SDR 6.9 million (equivalent to US$9.4 million).
- Tonga already has an outstanding RCF balance of 50 percent of quota (RCF-1) approved on January 25, 2021.
- Purpose: meet urgent balance of payments (BOP) and government budget financing needs for reconstruction and social protection, alongside external grants from other development partners.
- IMF staff support the RCF request.

### Policy recommendations
- Short term:
  - Fiscal policy: focus on supporting reconstruction and recovery with a larger budget envelope for FY2023, as envisaged by the authorities.
  - Monetary policy: current settings are appropriate under staff’s baseline inflation outlook, but the central bank should stay vigilant and stand ready to act given significant risks to inflation.
  - Financial sector: banks should be required to closely monitor credit risks and actively provision for loan losses.
- Medium-to-long term:
  - Strengthen public finances through a combination of domestic fiscal measures―including rationalization of tax exemptions and reduction of the public wage bill―and continued donor support to meet development spending needs while reducing the risk of debt distress.
- Structural reforms (priority areas):
  - (i) further liberalizing FDI;
  - (ii) easing access to credit;
  - (iii) expanding climate-resilient public infrastructure;
  - (iv) strengthening the AML/CFT and anti-corruption frameworks.

### Recent economic developments
- FY2021: real GDP growth was -2.7 percent, the first contraction since FY2009; contraction led by tourism-related sectors, wholesale and retail trade, and transport.
- Drivers in FY2021:
  - Strong remittances and policy support helped partly offset border-closure impacts.
  - Construction activity remained robust due to reconstruction demand.
  - Remittance inflows increased by 36 percent in FY2021 in T$ terms.
- Inflation developments:
  - Headline inflation averaged 7.9 percent (y/y) from July 2021 to April 2022, above the National Reserve Bank of Tonga’s (NRBT’s) reference rate of 5 percent.
  - IMF staff estimate of core inflation (excluding food and energy) at end-April 2022: 4.3 percent.
- External sector and reserves:
  - Current account balance estimated to have pivoted from -4 percent of GDP in FY2020 to 3 percent in FY2021.
  - FX reserves: US$318 million at end-FY2021 and US$360 million as of end-December 2021 (partly reflecting the IMF’s 2021 SDR allocation of US$18.7 million in August 2021).
- Fiscal developments:
  - Fiscal balance switched to a deficit in FY2021 due to COVID-related current expenditures.
  - Government fiscal package worth 5.3 percent of GDP on health care and social protection.
  - Fiscal balance moved from a surplus of 5.3 percent of GDP in FY2020 to a deficit of 1 percent in FY2021.
  - Public wage bill increased from 52.9 percent of domestic revenue in FY2020 to 57.3 percent in FY2021, breaching the authorities’ target ceiling of 53 percent; other fiscal anchors (domestic revenue floor of 21.5 percent of GDP and public sector wage bill ceiling of 45 percent of domestic revenue) were met in FY2021.
- Debt and risk:
  - Tonga is assessed as being at high risk of debt distress.
  - Without additional grant commitments to staff’s baseline projection, the present value of public debt-to-GDP ratio is projected to rise above the 70 percent debt-distress benchmark in FY2032.
  - Debt obligations are largely external, with over half of total public debt to China Exim Bank.
  - Debt repayments expected to pick up in FY2024, mainly to the Exim Bank, and stay elevated at over 3 percent of GDP until FY2027.
- Financial sector:
  - Bank balance sheets were strong before the volcanic eruption: banks were profitable and well-capitalized, with declining NPLs due to loan write-offs and COVID-related loan relief measures.
  - Bank credit had gradually declined since mid-2020 after several years of double-digit increases.

### Outlook and risks
- Growth projections:
  - FY2021: real GDP contracted by 2.7 percent.
  - FY2022: real GDP projected to contract by 1.9 percent (July 2021–June 2022) reflecting damages and COVID-19 containment measures.
  - FY2023: real GDP projected to rebound by 3.2 percent with a gradual reopening of international borders led by reconstruction activity.
- Assumptions underpinning the short-term outlook:
  - International borders planned to gradually reopen over FY2023; meaningful recovery in tourism expected to be delayed to FY2024 due to time required for repairs and reconstruction of tourism facilities.
  - Reconstruction of flagship infrastructure projects expected to accelerate in FY2023 after the border reopens in July, allowing entry of foreign engineers.
  - Crop production expected to gradually recover over FY2023–FY2024 as soil contamination from tsunami and volcanic ash dissipates.
- Inflation forecast:
  - Average inflation projected at 8.4 percent (y/y) in FY2022, up from 1.4 percent in FY2021, driven by geopolitical tensions on international commodity prices and domestic supply disruptions from the volcanic eruption.
  - FY2023: inflation expected to decline to an average of 4.7 percent (y/y), slightly below the NRBT’s reference rate of 5 percent, assuming international commodity prices stabilize in line with the IMF’s April 2022 World Economic Outlook forecasts.
- Short-term outlook is subject to large uncertainties and risks related to disaster recovery, COVID-19, and global commodity price shocks.

*Source: EXECUTIVE SUMMARY (1tonea2022001), IMF staff.*

### 14.      The catastrophic  impacts of the volcanic eruption and the COVID-19 outbreak have

### 14.      The catastrophic  impacts of the volcanic eruption and the COVID-19 outbreak have

### Macroeconomic impacts and outlook
- Current account balance (CAB) projection:
  - CAB is projected to switch back to a deficit (-6.1 percent of GDP) in FY2022 and deteriorate further in FY2023 (-23.1 percent).
- Drivers of CAB deterioration:
  - Increased imports of food―reflecting reduced domestic crop production.
  - Imports of reconstruction-related materials.
  - Subdued tourism and agricultural exports.
  - Decline in remittances from the exceptional levels during FY2021-FY2022.
- External financing:
  - Post-disaster increase in donors’ aids has not fully closed the external financing gap under current grant commitments (Table 7).
- Risks (balance of risks tilted to the downside; Annex II):
  - Frequent natural disasters.
  - Faster-than-expected rise in international food and energy prices due to geopolitical tensions, including the war in Ukraine, which could weaken private consumption and deteriorate the CAB.
  - Faster-than-manageable local community transmission of COVID-19 or a new contagious virus, given a high incidence of noncommunicable diseases and relatively weak health care capacity.
  - Medium-term risk of loss of correspondent banking relationships (CBRs), given Tonga’s heavy reliance on remittances.
- Medium-term outlook:
  - Growth potential expected to converge to long-term potential rate of 1½–2 percent without bold structural reforms.
  - CAB expected to gradually deteriorate relative to pre-pandemic levels due to heavy import dependence, weak competitiveness, and large infrastructure needs.
  - International reserve coverage expected to trend down to around 3½ months of prospective imports in the medium term—but above the NRBT’s minimum threshold of 3 months of imports—unless comprehensive efforts are made, including strengthening public finances and developing the private sector, together with continued strong financial support from development partners.

*Authorities’ views on outlook*
- Authorities broadly agreed with staff’s assessment of the outlook and risks.
- Economic projections by authorities:
  - After a 2.7 percent economic contraction in FY2021, authorities anticipate a further contraction in FY2022 by 2.5 percent due to volcanic eruption and COVID-19 impacts.
  - Authorities expect a strong rebound of about 3‒3½ percent in FY2023, driven by reconstruction activities and recovery in tourism following planned border reopening.
- Reserves:
  - Authorities noted reserves remain at record high levels due to recent large inflows of grants and remittances and stressed the need to maintain high reserves given vulnerability to natural disasters, external shocks, import dependence, and large external debt repayments coming due to the Exim Bank of China.

### Fiscal policy: response, near-term stance, and medium-term adjustment
- Donor support and fiscal response:
  - Donors pledged in grants additional budget support worth 7 percent of GDP for FY2022 and 3.7 percent of GDP for FY2023.
  - Fiscal measures financed included tax reliefs, loan subsidies, and cash transfers worth a total of about 2.2 percent of projected FY2022 GDP during Q3:FY2022.
  - Reconstruction plan: 8 out of 20 high-priority projects already completed.
- Fiscal outcomes and projections:
  - Staff expect fiscal deficit to widen from 1 percent of GDP in FY2021 to 2.1 percent in FY2022 due to lower tax revenues and additional spending needs after the volcanic eruption.
  - Envisaged expansionary fiscal stance in FY2023 is appropriate to meet urgent reconstruction and recovery spending needs.
- Medium-to-long term fiscal strategy and illustrative adjustment path:
  - Under an illustrative fiscal adjustment scenario, the present value (PV) of the public debt-to-GDP ratio could stabilize below the 70 percent threshold over the long term, even with large natural disaster shocks.
  - Fiscal adjustments could include a gradual increase of tax revenues and reduction of the public wage bill and current expenditure. New grant commitments in line with historical trends are essential.
  - Government strategy: pursue additional grants from development partners and avoid any new non-concessional borrowing from external creditors.
- Specific reform measures and quantitative impacts:
  - Revenues:
    - Authorities could increase revenues by about 3 percent of GDP by reducing tax exemptions and strengthening tax administration.
    - IMF TA report estimates additional revenue of 2½ percent of GDP could be collected by removing major tax exemptions, notably those related to electricity provision and consumption.
    - Revenue administration reforms could also increase tax revenues by ½-1 percent of GDP through better tax compliance and lower tax arrears.
    - As of FY2020, the amount of collectable tax arrears is estimated at 2.4 percent of GDP.
  - Expenditures:
    - Compensation of employees has exceeded the fiscal anchor of 53 percent of domestic revenue since FY2021.
    - Authorities aim to bring the public wage bill back to below the 53 percent ceiling in FY2024 onward—comparable to the FY2025 level projected by staff—via stricter controls on hiring and overtime pay.
    - Goods and services spending in Tonga is above the median level of Pacific Island countries (PICs), which stands at 12 percent of GDP, compared with a median level of 11 percent in other PICs.
    - Lowering spending on wages and goods and services to peer levels could help improve the fiscal balance by about 1½ percent of GDP.
- Fiscal transparency and donor support:
  - Enhanced transparency and accountability of government operations could strengthen the case for more donor support and debt relief.
  - Continued efforts to strengthen information systems for cash and financial management and improve internal audit processes are recommended, in line with the 2020 IMF Public Expenditure and Financial Accountability Assessment Report.
  - Authorities have published information on pandemic-related procurement contracts on the Ministry of Finance’s website and plan to publish an audit of pandemic-related spending by the Auditor General (Appendix I, ¶8).
  - Full implementation has been delayed by capacity constraints exacerbated by the volcanic eruption; authorities plan to seek CD support from IMF staff.

- Illustrative Fiscal Adjustment Path Relative to Baseline (In percent of GDP) — selected figures shown in source:
  - Domestic fiscal measures (FY2025 to FY2030): 0.8, 1.6, 2.4, 3.2, 4.0, 4.5
  - Taxes (FY2025 to FY2030): 0.5, 1.0, 1.5, 2.0, 2.5, 3.0
  - Goods and services / Wage bill (FY2025 to FY2030): -0.3, -0.6, -0.9, -1.2, -1.5, -1.5
  - Additional Grants (FY2025 to FY2030): 1.9, 3.1, 4.2, 5.0, 5.0
  - Change in primary balance (FY2025 to FY2030): 0.8, 3.5, 5.5, 7.4, 9.0, 9.5
  - Memo. Projected primary balance (FY2025 to FY2030): -7.3, -5.3, -4.7, -4.3, -3.5, -2.2
  - Note: In the baseline scenario, grants would gradually decline to below 10 percent of GDP after FY2026. Grants averaged 18 percent of GDP between FY2016-FY2021.

*Authorities’ views on fiscal policy*
- Authorities highlighted significant near-term spending needs for reconstruction and recovery but agreed on the need for fiscal adjustment over the medium term once recovery is on track.
- Actions to contain wage bill: improving hiring practices, limiting overtime allowances, and outsourcing some services.
- Authorities intend to seek new grant financing from donor partners and, in the near term, seek concessional loans from the IMF to help finance the budget deficit in FY2023.
- Emphasized importance of incorporating climate resilience into reconstruction.

### Monetary and exchange rate policies
- Current stance:
  - NRBT has maintained the policy rate at zero percent, the statutory reserve deposit (SRD) ratio at 10 percent, and the inflation reference rate at five percent.
  - Monetary conditions remain loose with abundant banking system liquidity due to large inflows of grants and remittances in FY2021.
- Inflation outlook and policy guidance:
  - Under the baseline outlook, staff project inflation to gradually decline to below the reference rate in FY2023 as base effects from higher commodity prices materialize and volcanic eruption impacts on domestic prices dissipate.
  - Current monetary policy settings are consistent with the baseline, but NRBT should stand ready to tighten if inflation is expected to stay above the reference rate for longer, possibly signaled by rapid credit growth or persistently high inflation expectations in major trading partners.
  - Monetary tightening options include increasing the SRD ratio or raising the policy rate if more decisive action is needed (Figure 3).
  - Historical note: The SRD ratio was raised from 5 to 10 percent in FY2018, followed by a reduction in average inflation from 6.8 percent in FY2018 to 3.3 percent in FY2019. The policy rate has not been adjusted for a decade.
- Exchange rate regime:
  - Tonga’s nominal exchange rate is pegged to a basket of currencies.
  - The real effective exchange rate (as of April 2022) has appreciated by 3.3 percent since January 2021, reflecting rising inflation relative to trading partners.
  - Exchange rate stability maintained with currency basket weights set in 2018.

*Authorities’ views on monetary policy*
- NRBT viewed the current monetary stance as appropriate to support recovery given weak economic activity and subdued credit growth.
- NRBT expects headline inflation to fall below the reference rate in FY2023 given base effects from current high global commodity prices.
- Noted large excess liquidity in the banking system could weaken monetary policy transmission; ongoing global monetary tightening could help contain Tonga’s imported prices.
- NRBT continues to evaluate available monetary policy tools should tightening be needed.

### Financial sector policies and reforms
- Immediate supervisory guidance:
  - NRBT should encourage banks to actively provision for potential loan losses and monitor credit risks closely.
  - Banks are well capitalized but economic disruptions could worsen balance sheets; NPLs could pick up significantly and impair banks’ ability to supply credit.
  - In case capital buffers become inadequate, NRBT should consider restricting dividend payouts by banks and requesting capital injections from parent banks.
- Reforms to strengthen supervision and macroprudential framework (four priorities):
  - (i) Conduct risk-based offsite supervision to assess banking sector health after the natural disaster.
  - (ii) Expand NRBT’s regulatory and supervisory remit to cover nonbank financial institutions (NBFIs), especially pension funds, which compete with banks in mortgage lending.
  - (iii) Establish a solvency stress testing framework that covers NBFI lending, with CD support from the IMF.
  - (iv) Develop macroprudential instruments to operationalize NRBT's financial stability mandate.
  - NRBT plans to establish a Financial Stability Unit based on earlier CD support recommendations from the IMF.
- Measures to support credit, financial deepening, and inclusion:
  - Near-term targeted concessional credit support to MSMEs in hard-hit sectors, including through the Government Development Loan (GDL) Scheme.
    - GDL funding increased from T$13 million to T$18.3 million in 2020 after TC Harold.
    - Subsidized interest rate reduced to 1 percent from 3 percent for new loans.
  - Consideration of a partial loan guarantee scheme to enhance access to credit, to be offered temporarily as a crisis response with lenders bearing appropriate risk.
  - Long-term reforms to reduce credit costs: improve coverage and quality of credit information systems, strengthen insolvency regimes and debt enforcement.
    - Plan to set up a credit registry within the NRBT; system should eventually be expanded to include NBFIs.
  - Promote financial solutions to cut transaction costs of remittances; example: Ave Pa’anga Pau voucher system could help cut associated costs.
- Financial landscape note:
  - Tonga’s financial landscape mainly comprised of four banks (three subsidiaries of foreign-owned banks and a government development bank, with total assets of 95 percent of GDP at end-June 2021), and NBFIs including two major pension funds, 4 insurance companies, and a number of foreign exchange dealers.

*Authorities’ views on financial sector policies*
- NRBT underscored the need to support recovery and noted subdued credit growth and excess liquidity in the banking system.
- NRBT evaluates pros and cons of available monetary and macroprudential tools and continues to consider actions should tightening or other interventions be required.

*Italic: IMF staff summary of Chapter 14 from the Tonga report (content unit 1tonea2022001).*

### 30.      The authorities broadly agreed with staff’s recommendations on financial stability.

### 1tonea2022001 - 30.      The authorities broadly agreed with staff’s recommendations on financial stability.

### Financial stability and banking sector oversight
- The NRBT acknowledged the need to closely monitor potential loan losses from the twin shocks earlier this year.
- Measures taken to ensure adequate provisioning include stress testing exercises and close monitoring of NPLs using monthly reports from banks.
- Stress testing results suggest that all banks’ capital adequacy ratio will remain above the minimum required risk-weighted capital ratio even in the worse-case scenario.
- The NRBT reiterated its commitment to:
  - setting up a solvency stress testing framework with IMF TA assistance;
  - establishing a macroprudential framework with IMF TA assistance.
- A Financial Stability Unit is to be set up to develop and implement macroprudential policies.

### Structural reforms — disaster resilience and climate
- Enhancing resilience to natural disasters and climate change is a top reform priority.
- The Disaster Risk Management bill passed in 2021 is an important first step, but effective implementation requires enhanced coordination across ministries and management of scarce resources.
- Efficiency of climate-resilience capital spending could be improved by:
  - developing a more comprehensive and regularly updated public asset register (IMF CD support on Tonga’s Asset Management Framework);
  - expanding classification of capital spending to better identify the climate component of public investment projects.
- Revisions to the Building Code to include climate resilience measures (construction materials, design, construction methods) and improving compliance through stronger enforcement are important.

### Structural reforms — private sector development and public investment
- Developing the small private sector is critical to boost Tonga’s long-term growth potential.
- Inward FDI during 2016-2020 increased by only a modest 1.1 percent of GDP on average.
- Proposed amendments to the reserved and restricted list under the draft Foreign Investment Regulation 2021 are essential to reap the benefits of the Foreign Investment Act of 2020.
- Priority policy initiatives recommended:
  - Expanding and upgrading physical and ICT infrastructure, including enhancing internet connections with remote islands (urgent after the HTHH disaster).
  - Increasing government spending on health, education, and social protection. An earlier IMF staff study estimates additional annual spending of 5 percent of FY2030 GDP would be needed to meet select SDGs.
  - Supporting the conditional cash transfer program (“SET”: Skills and Employment for Tongans) launched in 2018.
  - Improving land leasehold market operations; all lease contracts currently require Cabinet approval regardless of tenure, posing hurdles for private investment and relocation to safer areas after the HTHH disaster.

### Governance, AML/CFT, and anti-corruption
- Tonga acceded to the United Nations Convention Against Corruption in February 2020.
- Strengthening accountability and transparency and addressing weaknesses in revenue administration (e.g., tax dispute resolution and ease of paying tax) would mitigate governance and corruption risks.
- Implementing the Anti-Corruption Commissioner Act (enacted in 2017) remains essential; the office has not yet been set up nor a Commissioner appointed.
- Recent AML/CFT improvements:
  - Establishment of the Financial Analysis and Supervision Coordinating Unit.
  - Enhanced collaboration between the Financial Intelligence Unit (FIU) and regional AML/CFT supervisors and FIUs to improve information sharing and analytical capacity.
  - NRBT is setting up a national know-your-customer system and seeking to revise the AML/CFT framework to be more risk-based and aligned with Asia Pacific Group on Money Laundering (APG) recommendations, including strengthening regulation, enforcement, and financial and human resources.
- Concern noted that loss of correspondent banking relationships (CBRs) could have macro-critical impacts due to Tonga’s heavy reliance on remittances.

### International support and reconstruction coordination
- Continued financial support (cash and project grants) and technical assistance from development partners are critical given Tonga’s remoteness, narrow production base, and frequent natural disasters.
- Financial assistance should be aligned with Tonga’s development objectives and closely coordinated with authorities to avoid stretching limited administrative capacity.
- Example: Two small banks recently lost their USD accounts with the National Bank of Australia; one is now using a virtual platform for cross-border payments.

### Authorities’ views and policy actions
- Authorities concurred with the structural reform priorities and the need to develop the private sector.
- Key initiatives and plans:
  - Newly approved National Infrastructure Plan to improve project management and strengthen risk and hazard assessments.
  - Ongoing efforts to enhance education and training, including the SET Project (World Bank funded) and TVET programs.
  - Domestic Electronic Payment System (DEPS) project to upgrade the national payment system.
  - Augmented efforts to strengthen AML/CFT, including planned on-site bank visits to review compliance and enhanced customer due diligence for high-risk domestic politically exposed persons.
- Authorities emphasized the importance of continued support from development partners and the IMF for achieving SDGs under the Tonga Strategic Development Framework 2015-2025.

### Strengthening statistical capacity
- Improving the quality, timeliness, and coverage of macroeconomic statistics is a high priority.
- IMF CD support has been provided in national accounts, government finance, and balance of payments through CDOT and PFTAC missions.
- Authorities should continue disseminating better and timelier statistics, including publishing key macroeconomic and financial data regularly through a National Summary Data Page in the context of Tonga’s participation in the Enhanced General Data Dissemination System (e-GDDS).

### RCF — financing needs and capacity to repay
- Staff assess the RCF as the most appropriate financing instrument to meet Tonga’s urgent BOP need.
- The estimated BOP need amounts to about US$134 million or 25 percent of FY2023 GDP.
- The authorities requested emergency financing under the RCF worth 50 percent of quota to meet the urgent BOP need.
- An upper credit tranche quality Fund-supported program is not preferred now due to stretched administrative capacity after the volcanic eruption and COVID-19, and unreliable internet complicating program discussions.
- Access recommendation:
  - Additional access of 50 percent of quota (equivalent to about 1.8 percent of GDP) is appropriate, given public and publicly guaranteed debt is assessed as sustainable (DSA Annex).
  - 50 percent of quota represents about 7 percent of total external financing needs in FY2023.
- Financing plan:
  - Remaining FY2023 financing gap to be filled by donors’ aids (including those for the January 2022 volcanic eruption) and a drawdown from FX reserves.
  - If donors’ aids do not fully materialize, further drawdown of FX reserves is expected. Emphasis that Tonga should maintain higher reserves given natural disaster risk, large debt repayments from FY2024, the need to protect exchange rate credibility, and prepare for expected slowdown in remittances.
- Capacity to repay:
  - If disbursed, RCF-2 would increase outstanding IMF credit to 100 percent of quota.
  - Total credit outstanding to the Fund would remain below 3.6 percent of GDP and peak at about 14.5 percent of gross reserves.
  - Under the baseline, total repayments to the Fund would peak at about 3.5 percent of exports and 0.6 percent of GDP.
  - Overall debt service is expected to absorb a growing share of revenues and grants, peaking at about 31 percent in 2031, with sustained elevated levels afterwards.
  - Tonga’s debt service capacity would be improved by sustained revenue mobilization and fiscal consolidation.
  - Staff assess Tonga as being at high risk of debt distress, but public and public external debt is assessed as sustainable considering strong recent policy track record.
  - Downside risks to repayment capacity can be mitigated by reforms to develop the private sector and increase climate resilience.

### Use of RCF disbursement and safeguards
- The disbursement of RCF-2 to the NRBT will be used by the government as budget support for ongoing reconstruction and social protection measures targeted to the vulnerable.
- The Ministry of Finance and the NRBT have signed a memorandum of understanding on responsibilities for servicing the related financial obligations to the IMF.
- A first-time safeguards assessment of the NRBT was completed in December 2021 following RCF-1:
  - NRBT has maintained basic controls in key safeguards areas but faces challenges due to lack of capacity.
  - Governance weaknesses include lack of independent oversight and an incipient internal audit function.
  - Outstanding safeguards recommendations: drafting amendments to the NRBT Act to strengthen autonomy, filling Board vacancies, and outsourcing audits of high-risk areas.
  - Authorities have committed to implement recommendations, but little progress has been made to date; further efforts are needed to strengthen safeguards.

### Staff appraisal and outlook
- Economic shock and impact:
  - Tonga was severely hit by the HTHH volcanic eruption and a local COVID-19 outbreak in early 2022.
  - Real GDP is expected to decline by 1.9 percent in FY2022, following a contraction of 2.7 percent in FY2021.
  - Two national lockdowns in Q1 2022 brought virtually all activities to a halt.
- External balances:
  - FY2021 external balance preliminarily assessed as broadly in line with medium-term fundamentals and desirable policies, aided by remittance flows and COVID-19 related grants offsetting tourism losses.
  - External balances are set to markedly worsen in the near term due to reconstruction, reduced domestic crop production, and higher global commodity prices.
  - Current account deficits are expected to remain large over the medium term due to multi-year reconstruction, weak export competitiveness, and heavy import dependence.
  - Without reforms and continued donor support, reserve coverage is projected to decline in the medium term to below the optimal range estimated by staff—although still above the NRBT’s minimum threshold of 3 months of import cover.
- Growth outlook and risks:
  - Annual GDP growth is projected at 3.2 percent in FY2023, led by reconstruction and policy support.
  - Tourism recovery expected to contribute in FY2023, with a meaningful pickup likely in FY2024 after further repairs and reconstruction.
  - Downside risks include natural disasters, faster-than-expected rise in international food and energy prices, a new highly contagious and lethal COVID-19 variant or new virus, and the loss of CBRs.
- Policy stance:
  - Macroeconomic response since the global pandemic appropriately focused on protecting the vulnerable and maintaining stability.
  - FX reserves have been maintained at comfortable levels (over 9 months of import cover) since FY2020.
  - Staff support an expansionary FY2023 budget to facilitate reconstruction and recovery, noting significant near-term capital investment and continued fiscal support to vulnerable businesses and households are needed until recovery is firmly underway.

*IMF staff report content as provided in the source document.*

### 49.      Over the medium-to-long term, fiscal adjustment and additional donor support are

### 1tonea2022001 - 49.      Over the medium-to-long term, fiscal adjustment and additional donor support are

### Fiscal outlook and policy recommendations
- The risk of public and external debt distress is assessed to be high for Tonga.
- To reduce the risk of debt distress while achieving Tonga’s long-term development goals, gradual fiscal adjustment through both the expenditure- and revenue-side reforms will be essential, complemented by continued donor support in line with historical levels.
- Revenue-side recommendations:
  - Boost domestic revenues by rationalizing tax exemptions and strengthening tax administration.
- Expenditure-side recommendations:
  - Reinforce current spending controls—especially on the public wage bill—and provide targeted support to vulnerable groups.
- Climate resilience and public investment:
  - Significant public investment is needed to enhance Tonga’s climate resilience, with the aid of development partners.
- Transparency and accountability:
  - Greater transparency and accountability of government operations would help, including through the publication of audited pandemic-related expenditures and procurement documents.

### Monetary policy and inflation outlook
- The current monetary policy stance is appropriate under staff’s baseline inflation outlook, but the NRBT should stay vigilant.
- Headline inflation has remained above the NRTB’s reference rate of 5 percent since mid-2021, importantly reflecting higher global commodity prices and domestic supply-side disruptions following the volcanic eruption.
- Core inflation has been relatively modest, accompanied by continuing credit contraction since mid-2020.
- Staff project the average headline inflation in FY2023 to stabilize below the NRBT’s reference rate.
- The NRBT should stand ready to act given significant risks to inflation.

### Financial stability and banking sector
- While financial stability has been maintained, the NRBT should continue to closely monitor credit risks.
- Prior conditions:
  - Banks were profitable and well capitalized before the volcanic eruption, with declining NPL ratios.
- Near-term monitoring:
  - The NRBT should continue to monitor credit risks closely especially in hard-hit sectors such as tourism and wholesale and retail.
- Reforms needed:
  - Improve financial supervision, support credit growth, and promote financial deepening for Tonga’s financial development.
  - Continue ongoing efforts to strengthen the AML/CFT framework, given Tonga’s heavy reliance on remittances.

### Structural reforms to raise long-term growth potential
- Reform priorities comprise:
  - (i) improving the efficiency of climate-resilience capital spending;
  - (ii) streamlining the regulatory framework for FDI;
  - (iii) enhancing internet connectivity;
  - (iv) increasing government spending on health, education, and social protection; and
  - (v) improving land leasehold market operations.

### IMF assistance and external support
- Staff support the authorities’ request for emergency financial assistance under the RCF.
- The IMF’s assistance through the RCF equivalent to 50 percent of quote (SDR 6.9 million), together with additional aids expected from other donors, will help Tonga meet urgent BOP and budgetary needs and could catalyze additional external financing.

*International Monetary Fund — TONGA (excerpt).*

### 54.      It is recommended  that the next Article IV consultation for Tonga take place on a

### 1tonea2022001 - 54.      It is recommended  that the next Article IV consultation for Tonga take place on a

### Real Sector Development
- Net exports contracted due to the pandemic and the effect of the volcano eruption.
- Construction activities are supporting growth.
- Agricultural production and electricity consumption remain strong.
- Tourist arrivals were reduced to zero due to the border closure.
- Headline inflation is above the NRBT’s reference rate. Headline inflation is mainly driven by import prices.
- Contribution to Growth by Expenditure Category and by Sector (selected observations from figures):
  - Real GDP growth contributions displayed for FY2011–FY2022 (est./proj.) by Final Consumption Expenditure, Gross Fixed Capital Formation, Change in Inventories, Statistical Discrepancy, Net Exports.
  - Sectoral contributions include Manufacturing, Others, Construction, Services, Agriculture with FY2021 Est. and FY2022 Proj. noted in figures.

### External Sector Development
- Donors’ aids are boosting the capital account balance.
- The pandemic and the volcano eruption are expected to affect the trade balance.
- Remittances and grants are at record highs while travel receipts collapsed, thereby also supporting the current account balance.
- The REER has appreciated recently due to both nominal appreciation and high inflation.
- Reserves are at all-time highs due to donors’ aids and large inflows of remittances.
- Balance of Payments Forecast (In percent of GDP): Current Account Balance, Capital Account Balance, Financial Account Balance shown for FY2011–FY2022 (FY2021 Est., FY2022 Proj.).
- Trade and services dynamics highlighted:
  - Exports of Goods and Services and Imports of Goods and Services with Trade Balance (RHS) for FY2011–FY2022 (Proj.).
  - Remittances and Travel Receipts (In percent of GDP) for FY2011–FY2022 (Proj.).
- Reserves level: figures indicate reserves in millions of US dollar and months of GNFS, with reference lines for Optimal Reserves Level (7 ¼ Months of GNFS) and NRBT Minimum Reserves Threshold (3-4 Months of GNFS).

### Monetary Sector Development
- Monetary policy remains on hold.
- Broad money ticked up slightly.
- Unsterilized foreign inflows are the main drivers of liquidity.
- Liquidity in the banking system increased since the onset of the crisis.
- Credit to the private sector remains subdued. The loan-to-deposit ratio decreased due to both a decline in lending and an increase in total deposits.
- Key indicators from figures:
  - Required Reserves Ratio, Statuary Deposit Rate, Monetary Policy Instrument shown (Jan-11 to Jan-22).
  - Domestic Liquidity (Year-on-year percent change) includes Base Money (M1) and Broad Money (M2) with FY2011–FY2022 series (est./proj.).
  - Contribution to Total Liquidity: M3 from Net Foreign Assets and Net Domestic Assets (year-on-year percent) for FY2012–FY2022 (Proj.).
  - Central Government Demand Deposits in Commercial Banks and Excess Reserve Ratio (RHS) in Pa'anga and percentage points (Jan-11 to Jan-22).
  - Credit to Private Sector (year-on-year percent change) and Loan to Deposit Ratio with Minimum Requirement (FY2011–FY2021).

### Fiscal Sector Development
- The primary fiscal balance is expected to remain close to zero in FY2022.
- Tax revenues are expected to decline in FY2022 due to the volcanic eruption and COVID-related lockdown.
- Development partners have stepped up their grant support after the natural disaster.
- Current expenditure is expected to go up further for reconstruction and COVID responses.
- Existing capital grants can cover the increased capital expenditure needs after the volcanic eruption.
- Public debt has risen since the pandemic, while external debt remains below the fiscal anchor.
- Selected fiscal figures (Table 1 / Table 4 / Medium-Term Baseline):
  - Overall balance (In percent of GDP): FY2019 3.2, FY2020 5.4, FY2021 -1.0, FY2022 -2.1, FY2023 -4.8, FY2024 -5.2 (Table 1).
  - Total Revenue (In percent of GDP): FY2019 41.7, FY2020 44.2, FY2021 48.3, FY2022 51.5, FY2023 45.8, FY2024 39.9 (Table 4 / Table 5).
  - Grants (In percent of GDP): FY2019 18.3, FY2020 19.1, FY2021 22.4, FY2022 30.2, FY2023 20.5, FY2024 14.6 (Table 5).
  - Fiscal anchor on domestic revenue = 22 percent of GDP (noted in figures).
  - Public sector total debt (In percent of GDP) projections (Table 5): FY2019 41.3, FY2020 43.6, FY2021 47.5, FY2022 47.6, FY2023 45.5, FY2024 47.9, FY2025 54.5, FY2026 62.2, FY2027 71.4.

### Financial Sector Development
- Capital buffers remain above the PIC average.
- Bank income continues to rely on net interest income (58% net interest income; 23% net income from foreign exchange; 6% commission and charges; 13% other — Financial Sector Operating Income Components in 2020).
- Interest rate spreads remain wide; profitability has declined due to slow credit growth.
- NPLs ticked up slightly in FY2021. Bank lending remains concentrated in residential loans (Residential Real Estate Loans to Total Loans series shows high concentration).
- Key indicators (selected):
  - Capital Adequacy Ratio (In percent) for FY2012–FY2021 with PIC Average comparison.
  - Interest rates: Spread, Deposit Rates (3-month), Business Loan Rate series (2010Q1–2021Q3).
  - Return on Assets: Tonga vs PIC Average (2010–2021).
  - Non-performing Loans to Total Gross Loans and Net of Provisions to Capital (2012–2021).
  - Residential Real Estate loans to Total Loans (percent) series (2012Q1–2021Q3).

### Selected Economic Indicators and Projections (Tables summary)
- Population (2020): 106 thousands.
- Major exports: root crops, vanilla, squash, fish.
- Quota: SDR 13.2 million.
- Real GDP (annual percent change, Table 1 / Table 5):
  - FY2019 0.7, FY2020 0.5, FY2021 -2.7, FY2022 -1.9, FY2023 3.2, FY2024 3.0.
- Consumer prices (period average, Table 1): FY2019 3.3, FY2020 0.4, FY2021 1.4, FY2022 8.4, FY2023 4.7, FY2024 3.4.
- Gross official foreign reserves (millions of U.S. dollars, Table 1 / Table 5): FY2019 212.8, FY2020 237.2, FY2021 317.9, FY2022 324.1, FY2023 231.8, FY2024 132.2.
  - In months of next year's total imports: FY2019 8.3, FY2020 9.5, FY2021 10.0, FY2022 9.2, FY2023 6.2, FY2024 3.8.
- Current account balance (In percent of GDP, Table 5): FY2019 -0.9, FY2020 -4.0, FY2021 3.0, FY2022 -6.1, FY2023 -23.1, FY2024 -19.8.
- Remittances (in percent of GDP, Table 1 / Table 5): FY2019 27.4, FY2020 29.3, FY2021 42.3, FY2022 37.5, FY2023 30.1, FY2024 30.1.
- Tourism (in percent of GDP, Table 1): FY2019 11.1, FY2020 8.2, FY2021 0.8, FY2022 0.5, FY2023 1.0, FY2024 5.2.
- Nominal GDP (millions of US$ from Table 1): FY2019 511.3, FY2020 490.2, FY2021 470.5, FY2022 499.7, FY2023 534.9, FY2024 569.5.
- External financing and reserves (Table 7):
  - Total requirement (In millions of U.S. dollars): FY2021 1.0, FY2022 91.3, FY2023 164.5.
  - Total sources (In millions of U.S. dollars): FY2021 53.4, FY2022 39.0, FY2023 30.5.
  - Financing gap / Additional financing sources (In percent of GDP): FY2021 -11.1, FY2022 10.5, FY2023 25.1.
  - Use of IMF credit (net) / Disbursement (RCF): FY2021 9.7 (In millions of U.S. dollars).
- IMF-related indicators (Table 8):
  - Outstanding IMF credit (Millions of SDRs): FY2020 0.0, FY2021 6.9, FY2022 6.9, FY2023 13.8, FY2024 13.8, FY2025 13.8, FY2026 13.8, FY2027 12.4, FY2028 10.4, FY2029 7.6, FY2030 4.8, FY2031 2.1, FY2032 0.7, FY2033 0.0.
  - Outstanding IMF credit (Millions of T$): FY2021 22.3, FY2022 21.4, FY2023 43.2, FY2024 43.7, FY2025 44.1, FY2026 44.7, FY2027 40.6, FY2028 34.1, FY2029 25.2, FY2030 16.1, FY2031 6.9, FY2032 2.3.
- Medium-term baseline scenario summary (Table 5):
  - Real GDP growth projections: FY2025 2.5, FY2026 1.8, FY2027 1.8.
  - Consumer prices (end of period): FY2025 2.7, FY2026 2.6, FY2027 2.5.
  - Public sector total debt (in percent of GDP): FY2025 54.5, FY2026 62.2, FY2027 71.4.
  - Gross international reserves (end of period, millions of U.S. dollars): FY2025 132.2, FY2026 135.3, FY2027 137.5.

*Source: Tonga authorities; and IMF staff estimates and projections contained in the provided content.*

### 8. Decent Work & Economic Growth

### 8. Decent Work & Economic Growth

### External sector assessment — overview and key findings
- The external sector position for FY2021 is preliminarily assessed to be broadly in line with the level implied by fundamentals and desirable policies, but subject to large uncertainty due to estimated FY2021 data and volatility in Tonga’s external sector statistics.
- The assessment was heavily affected by: the pandemic; protracted border closure; sharp loss in foreign exchange earnings from tourism; and an unprecedented increase in remittances inflows.
- Higher public spending in the near term to support reconstruction and COVID response is expected to contribute to moving the current account back into a deficit.
- International reserves stood at a comfortable 10 months of prospective imports at end-FY2021 but are projected to decline to 3½ months over the medium term, below the adequate range assessed by staff.
- Policy priorities to mitigate reserve decline include strengthening public finances, promoting private sector development, and continued strong financial support from development partners.

### Current account — data and projections
- FY2014–FY2020: current account (CA) deficit averaged about 6 percent of GDP.
- FY2021: CA estimated to have turned to a surplus of 3 percent of GDP driven by:
  - Remittance inflows estimated to have increased by about 13 percentage points of GDP to reach about 42 percent of GDP in FY2021.
  - Some import compression associated with weaker domestic demand amid the pandemic.
- Projections:
  - CA balance projected to shift to a deficit of 6 percent of GDP in FY2022.
  - CA balance projected to further deteriorate to a deficit of 23 percent of GDP in FY2023, driven by:
    - higher import demand for reconstruction-related capital goods and food following the volcanic eruption in January 2022;
    - moderation in remittances from the unusually high level in FY2021;
    - slowdown in exports of agricultural products due to soil contamination from volcanic ash;
    - slow recovery in tourism due to damaged infrastructure and properties.

### Current account model estimates for 2021 (in percent of GDP)
- CA-Actual: 3.0
- Cyclical contributions (from model) (-): -0.9
- COVID-19 adjustor (+) 1/: -5.3
- Additional temporary/statistical factors (+): 0.0
- Natural disasters and conflicts (-): 1.1
- Adjusted CA: -2.5
- CA Norm (from model) 2/: -4.5
- Adjustments to the norm (+): 1.9
- Adjusted CA Norm: -2.6
- CA Gap: 0.02
  - of which Relative policy gap: 3.5
- Elasticity: -0.26
- REER Gap (in percent): -0.1

Notes:
- 1/ Additional cyclical adjustment to account for the temporary impact of the pandemic on tourism (+1.2 percent of GDP) and remittances (-6.7 percent of GDP).
- 2/ Cyclically adjusted, including multilateral consistency adjustments. The adjustments to the norm (1.9 percent of GDP) reflect Tonga's limited external financing capacity and low FDI inflows.

### Real effective exchange rate (REER)
- Exchange rate regime: Tonga pa’anga determined by a weighted-basket of the US dollar, Australian dollar, New Zealand dollar, and Fijian dollar; basket weights unchanged since 2018 and last reviewed in March 2022.
- FY2021: REER depreciated by about 5.1 percent on average; NEER depreciated by about 4.1 percent.
- April 2021–April 2022: both REER and NEER appreciated (REER 1.1 percent; NEER 3.6 percent) due to relatively higher inflation in Tonga over this period.
- Assessment: CA gap model implied a small REER undervaluation of about 0.1 percent, applying an estimated elasticity of -0.26. Large uncertainty remains due to pending official BOP data for FY2021, unusually large expected changes in grants/tourism/remittances, and swings in global commodity prices.

### Capital and financial accounts
- Recent CA deficits financed largely by capital account credits in the form of project support grants and grants in-kind.
- FDI inflows limited due to structural impediments (cumbersome land leasehold market operations and regulatory barriers).
- Recent external borrowings limited and exclusively on concessional terms, including the IMF’s RCF-1 disbursed in FY2021.
- Assessment: Authorities’ plan to pursue additional grants and avoid new non-concessional external borrowing is appropriate; reforms to promote FDI by reducing market entry barriers are ongoing and recommended.

### International reserves — levels, projections, and adequacy
- Gross official reserves:
  - FY2021: US$318 million (about 10 months of the following year’s imports).
  - FY2020: US$237 million (9½ months of imports).
- Reserve projection: projected to decline significantly in FY2023 and to about 3½ months of imports in FY2027, reflecting:
  - moderation in remittances to pre-pandemic levels;
  - lower grants after current commitments are met;
  - rising debt repayments (notably to China Exim Bank).
- NRBT minimum threshold: 3 months of imports.
- Staff’s reserves adequacy findings:
  - Optimal level with standard shock probability (sample average 50 percent): 4½ months of imports (reported as 4.6 in staff table).
  - Adequate level incorporating Tonga’s high vulnerability to natural disasters: about 7½ months of imports (reported as 7.3 in staff table).
  - Additional reserve buffers may be needed to cover pickup in debt repayments from FY2024 onwards.
- International Reserve Adequacy Metric (FY2021, staff estimates):
  - Actual Reserves (months of prospective imports): 10.0
  - Optimal level with standard shock probability: 4.6
  - Optimal level with higher shock probability: 7.3
  - Broad Money coverage: 256%

### Risk Assessment Matrix — key risks and policy recommendations
- Global risks
  - Outbreaks of lethal and highly contagious COVID-19 variants
    - Likelihood: High
    - Expected impact: High (weaker remittance inflows; slower recovery in tourism; more stringent containment measures; higher poverty)
    - Policy recommendation: Increase fiscal spending on health and social protection while containing wage bill increases; keep monetary and macroprudential policies accommodative; accelerate structural reforms to promote private sector development.
  - Rising and volatile food and energy prices
    - Likelihood: High
    - Expected impact: Medium-High (larger import bill and CA deficit; lower FX reserves; higher domestic inflation; weaker private consumption)
    - Policy recommendation: Provide targeted fiscal support to the vulnerable; tighten monetary policy using NRBT instruments if strong second-round effects materialize; increase public investment to expand productive capacity in the long term.
- Domestic risks
  - Faster community transmission of COVID-19
    - Likelihood: High
    - Expected impact: Medium-High (lower GDP growth; rise in nonperforming loans; slower reconstruction; larger economic scarring)
    - Policy recommendation: Accelerate booster vaccination campaign; increase fiscal spending on health and social protection; adapt to new COVID-19 norms (e.g., digital infrastructure); keep monetary policy accommodative and require banks ensure adequate provisioning.
  - Partial withdrawal of Correspondent Banking Relationships (CBRs) due to AML/CFT gaps
    - Likelihood: Medium
    - Expected impact: High (lower remittance inflows; weaker private consumption; larger CA deficit)
    - Policy recommendation: Strengthen AML/CFT framework; improve risk-based supervision and enforcement aligned with Asia-Pacific Group assessment.
  - Natural disasters related to climate change
    - Likelihood: High
    - Expected impact: Medium-High (disruptions in economic activity; lower GDP growth; damages to properties and infrastructure)
    - Policy recommendation: Prioritize expenditure to support affected households; provide fiscal stimulus if economic impact is large; maintain easy monetary policy while monitoring potential banking sector debt service problems.

### Recommendations from 2021 Article IV Consultation — status updates
- Fiscal policies
  - Improve targeting of exemptions and broaden tax base
    - Action since 2021: FY2022 fiscal policy focused on pandemic and volcanic eruption recovery; authorities reiterated commitment to rationalize tax exemptions post-pandemic.
  - Improve efficiency of government spending, including containing public sector wages
    - Action since 2021: Reforms underway to contain the public sector wage bill by improving hiring practices, limiting overtime allowances, and outsourcing some services; authorities committed to bringing the public wage bill back to below the 53 percent ceiling in FY2024 onward.
  - Further enhance transparency and accountability of government operations
    - Action since 2021: Authorities published a summary table of COVID-19-related procurements on the MOF website.
- Monetary policy and financial sector
  - Maintain supportive monetary policy and ensure adequate liquidity
    - Action since 2021: NRBT has remained on hold, maintaining accommodative monetary policy; staff projects inflation to fall below NRBT's reference rate of 5 percent by end-FY2023.
  - Accelerate improvements in financial supervision
    - Action since 2021: Measures taken to ensure adequate provisioning, including stress testing and close monitoring of NPLs monthly; NRBT plans solvency stress testing and macroprudential frameworks with IMF TA.
  - Strengthen AML/CFT framework
    - Action since 2021: NRBT setting up a national know-your-customer system and revising AML/CFT framework to be more risk-based and aligned with Asia Pacific Group recommendations; established a Financial Analysis and Supervision Coordinating Unit to strengthen AML/CFT supervision and collaboration with the Financial Intelligence Unit (FIU) and regional counterparts.
- Structural policies
  - Improve the business environment and develop the private sector
    - Action since 2021: Government continued funding MSMEs through the Government Development Loan (GDL) Scheme; subsidized interest rate for new loans reduced to 1 percent from 3 percent to help MSMEs rebound after the volcanic eruption.
  - Invest in climate-resilient infrastructure
    - Action since 2021: After January 2022 volcanic eruption, government drafted a recovery plan focusing on climate resilience, including stricter application of building codes for new residential houses.

*Source: Tonga — staff report and annexes (Voluntary National Review 2019 and IMF staff estimates).*

### Appendix I. Letter of Intent

### Appendix I. Letter of Intent

### Impact of Hunga Tonga Hunga Ha'apai (HTHH) eruption and COVID-19
- Damages to physical capital and estimated loss from the HTHH disaster amount to 37 percent of GDP (US$182 million).
- Community transmission of COVID-19 began at the start of 2022; national lockdowns and strict containment measures have been implemented.
- The HTHH disaster and COVID-19 outbreak, together with the surge in global food and energy prices following the war in Ukraine, have generated an urgent balance of payments need.

### Macroeconomic outlook and key projections
- Current account deficit expected to widen to about 6 percent of GDP in FY2022 (July 2021–June 2022) and 23 percent in FY2023, reflecting higher imports of food, energy, and reconstruction-related materials, and weaker agricultural exports.
- Real GDP projected to contract by 1.9 percent in FY2022, before rebounding by 3.2 percent in FY2023 led by reconstruction activity.
- Urgent BOP need estimated at about US$121 million.

### Request for IMF support and external assistance
- Government requests emergency financing of SDR 6.9 million (50 percent of our quota) under the exogenous shock window of the IMF's Rapid Credit Facility (RCF).
- Funds disbursed under the previous RCF in 2021 were SDR 6.9 million.
- Development partners have pledged additional budget support in grants worth about 7 percent of GDP for FY2022 and 4 percent for FY2023 to help cover emergency spending.
- The IMF assistance, together with drawdown from foreign exchange reserves and additional financing from other partners, will help meet the urgent BOP need.

### Fiscal stance, debt outlook, and policy commitments
- Overall risk of public and external debt distress remains high despite pre-pandemic fiscal consolidation over FY2016–FY2020.
- Debt repayments, especially to China Exim Bank, are expected to rise sharply from FY2024 onwards.
- Government commitments:
  - Strengthen debt management framework.
  - Seek grants from development partners and avoid any non-concessional borrowing from external creditors.
  - Continue to pursue debt relief from China Exim Bank, in addition to the debt service suspension received under the G-20 Debt Service Suspension Initiative.

### Revenue measures and tax administration reforms
- Commitment to undertake reforms to broaden the tax base and strengthen tax administration, with capacity development (CD) support from the IMF.
- Specific measures on tax exemptions:
  - Review and rationalize current tax exemptions.
  - Improve the process for approving new tax exemptions by setting clear eligibility criteria and limited time frames.
  - Allow the Minister of Finance (MOF) to have the ultimate authority to grant exemptions.
  - Publish the list of all exemptions and the estimated foregone revenue on a regular basis, with CD support from the IMF.
- Commitments to enhance tax compliance, including facilitating electronic filing of taxes and reducing processing time for tax dispute resolutions.

### Budget prioritization and public sector wage policy
- Priority to reduce poverty, strengthen climate resilience, and promote private sector development.
- Commitment to gradually bring down public sector wage bill to below the fiscal anchor of 53 percent of domestic revenue, including by strengthening controls on overtime and non-permanent staff costs, and curb increases in spending on goods and services.
- Accelerate implementation of climate- and development-related investments through more consistent prioritization, better sequencing, and improved cross-governmental coordination.

### Governance, transparency, and procurement commitments
- Commit to publishing on the MOF website:
  - An audit of COVID-19 related expenditures by the Auditor General, and
  - Pandemic-related public procurement contracts and related documents, including owners of awarded companies,
  - Within 12 months following the approval of the RCF request by the IMF Board.
- Some procurement contracts have been published on the MOF website, including names of contracting government agencies and awarded legal entities, contract amounts, and nature of goods and services procured.
- Implementation of these commitments from the 2021 RCF has been delayed due to capacity constraints exacerbated by the HTHH disaster and COVID-19; IMF CD support will be sought.

### Monetary policy and inflation
- Headline inflation has remained elevated since December 2021, well above the NRBT's reference rate of five percent, largely reflecting global commodity price increases following the war in Ukraine and supply-side disruptions from the HTHH disaster and local COVID-19 spread.
- The NRBT expects inflation to decline below the reference rate by end-March 2023.
- NRBT plans to maintain an accommodative monetary policy stance:
  - Policy rate kept at zero percent.
  - Statutory reserve deposit rate at 10 percent.
- NRBT stands ready to tighten if inflation is expected to stay above the reference rate for longer.
- Commitment to improve monetary policy transmission via better liquidity management, communication, and financial market reforms, with CD support from the IMF.

### Financial sector resilience and regulatory reforms
- Financial sector assessed to be resilient to HTHH disaster and COVID-19 impacts, while acknowledging increased credit risks.
- Banks were well-capitalized before the events; will monitor loan quality deterioration and provisioning.
- Strengthen Financial Stability Unit capacity to:
  - Develop and implement macroprudential policy framework.
  - Conduct more robust risk assessments and stress testing.
  - Improve data collection for systemic risk indicators.
  - Prepare a financial stability report.
- NRBT developing regulatory framework for non-bank financial institutions:
  - Consultations on draft legislation for licensing and supervision of pension funds and insurance are in progress.
  - Legislation being drafted for licensing and supervision of capital markets, credit information system, and payment systems including digital financial services.
  - Implementing newly enacted legislation for licensing and supervision of credit unions.

### AML/CFT framework improvements
- Given the importance of remittances, government will strengthen legal compliance and effectiveness of AML/CFT framework to address weaknesses identified by the 2021 Mutual Evaluation Report of the Asia Pacific Group.
- Reform measures include:
  - Amending legal framework to establish risk-based supervision and enhance enforceability of regulations.
  - Strengthening regulations and enforcement through increased awareness of AML/CFT risks by reporting entities.
  - Provisioning adequate financial and human resources to the AML/CFT supervisor.
  - Implementing appropriate measures in relation to beneficial ownership and politically exposed persons.

### Safeguards assessment and IMF procedures
- A first-time safeguards assessment of the NRBT was completed in December 2021.
- Commit to addressing recommendations from the safeguards assessment, including:
  - Drafting amendments to the NRBT Act to strengthen NRBT autonomy.
  - Filling NRBT Board vacancies.
  - Outsourcing audits of high-risk areas.
- Since RCF funds will be received by the NRBT as fiscal agent and used for budget financing, government will prepare a memorandum of understanding between the MOF and the NRBT on respective responsibilities for servicing related financial obligations to the IMF.

### Engagement with the IMF and policy assurances
- Reaffirm willingness to remain engaged with the IMF and to benefit from policy advice and CD support.
- Commit to ensuring continued macroeconomic stability and to avoid measures that may compound difficulties.
- Do not intend to introduce or intensify exchange and trade restrictions or other measures that would compound Tonga's balance of payments difficulties; will comply with IMF Articles of Agreement and Article VIII provisions.
- Authorize the IMF to publish this letter, along with the staff report and related documents for the 2022 Article IV consultation and the request for disbursement under the RCF.

_Appendix I. Letter of Intent (Ref. M.F. 180/1, 18 June 2022) — Government of Tonga_

### 8.10 of the Sustainable Development Goals.

### 8.10 of the Sustainable Development Goals.

### Data adequacy and statistics compilation
- Financial Sector Surveillance: Tonga compiles financial soundness indicators for deposit takers and reports them to STA on a quarterly basis.
- External Sector Statistics:
  - Source data have shortcomings in accuracy, completeness, timeliness, and classification, affecting timely dissemination of quarterly balance of payments statistics.
  - An October 2020 technical assistance mission assisted authorities in reducing delays and improving data on goods and services, current and capital transfers to the government, direct investment, and international reserves.
  - Net errors and omissions were reduced but remain large.
  - A 2021 mission assisted authorities in developing international investment position statistics.
- Data dissemination:
  - Tonga participates in the Enhanced General Data Dissemination System (e-GDDS).
  - An e-GDDS mission in October 2020 assisted authorities in publishing key economic data through a National Summary Data Page (NSDP), which is yet to be launched, aiming to disseminate 13 of the 15 e-GDDS data categories according to a regular schedule.
  - No data ROSC is available.
- Table of Common Indicators Required for Surveillance (As of June 14, 2022):
  - Exchange Rates — Date of Latest Observation: 3/2022; Date Received: 5/2022; Data Frequency: M; Reporting Frequency: M; Frequency of Publication: M.
  - International Reserve Assets and Reserve Liabilities of the Monetary Authorities — 3/2022; 5/2022; M; M; M.
  - Reserve/Base Money — 3/2022; 5/2022; M; M; M.
  - Broad Money — 3/2022; 5/2022; M; M; M.
  - Central Bank Balance Sheet — 3/2022; 5/2022; M; M; M.
  - Consolidated Balance Sheet of the Banking System — 3/2022; 5/2022; M; M; M.
  - Interest Rates — 3/2022; 5/2022; M; M; M.
  - Consumer Price Index — 3/2022; 5/2022; M; M; M.
  - Revenue, Expenditure, Balance and Composition of Financing — General Government — 2020/21; 4/2022; A; A; A.
  - Revenue, Expenditure, Balance and Composition of Financing — Central Government — 2020/21; 4/2022; A; A; A.
  - Stocks of Central Government and Central Government-Guaranteed Debt — 2020/21; 4/2022; A; A; A.
  - External Current Account Balance — Q2/2021; 4/2022; Q; Q; Q.
  - Export and Import of Goods and Services — Q2/2021; 4/2022; Q; Q; Q.
  - GDP/GNP — 2020/21; 4/2022; A; A; A.
  - Gross External Debt — 2020/21; 4/2022; A; A; A.
  - International Investment Position — Q2/2021; 4/2022; Q; Q; Q.

### Debt Sustainability Assessment (Joint Bank-Fund DSA)
- Risk ratings:
  - Risk of external debt distress: High
  - Overall risk of debt distress: High
  - Granularity in the risk rating: Sustainable
  - Application of judgment: No
- Context and recent shocks:
  - Before the pandemic, indebtedness declined from FY2015 to FY2019 due to fiscal consolidation.
  - Since 2020, shocks include the COVID-19 pandemic, tropical cyclone Harold in April 2020, and the volcanic eruption in January 2022.
  - Public debt-to-GDP rose in 2020 and 2021 reflecting increased reconstruction and COVID-19 response expenditures.
- Key DSA findings:
  - The present value (PV) of the external debt-to-exports ratio is expected to breach the indicative threshold in FY2022-23, mainly due to the decline of exports from external shocks.
  - Under the baseline scenario, the PV of the external debt-to-GDP ratio is expected to breach the threshold starting in FY2032.
  - The PV of the public debt-to-GDP ratio is expected to breach the benchmark starting from FY2032 under the baseline scenario.
  - A tailored one-time large natural disaster shock would imply significant deterioration in debt sustainability.
  - Long-term debt sustainability depends on fiscal adjustment and continued donor grant inflows to finance climate resilience and SDGs.
- Policy implication summary:
  - To rebuild fiscal buffers and enhance resilience, measures needed include stronger revenue mobilization, expenditure rationalization, and external donor support in line with historical trends.
- Tonga Composite Indicator:
  - Tonga Composite Indicator (CI) index is 3.12, indicating Tonga’s debt-carrying capacity is strong.

### Public debt coverage and contingent liabilities
- Public debt coverage:
  - Tonga’s public debt includes obligations of the central government and central bank; the central bank’s debt is borrowed on behalf of the government.
  - Local governments do not incur debt, nor do other entities in the general government.
  - As of end-June 2021, government-guaranteed debt was about 1 percent of GDP.
  - DSA coverage excludes debt of guaranteed and non-guaranteed state-owned enterprises due to data limitations; an additional 2 percent of GDP is added to the contingent liability test.
  - Contingent liabilities include a standard 5 percent of GDP cost to the government of a financial crisis.
  - The DSA is conducted on a residency basis.
- Public debt composition and magnitudes (end-June 2021):
  - Total public and publicly guaranteed (PPG) external debt: USD196 million (about 41 percent of GDP), accounting for 87 percent of total public debt.
  - Outstanding debt to all multilateral creditors: USD75 million (about 15 percent of GDP), about 41 percent of total external debt stock.
  - Export-Import Bank of China (China Exim Bank) accounts for 58 percent of total external debt stock.
  - Loans from China Exim Bank are denominated in Chinese renminbi.
  - Domestic public debt: USD31 million (about 6 percent of GDP), accounting for 13 percent of total public debt.
  - Domestic financial institutions hold about half of total domestic debt; the rest held mainly by domestic pension funds.
- Debt service and DSSI treatment:
  - Tonga started repayments to China Exim Bank in FY2019 with larger repayments coming due starting in FY2024.
  - Tonga’s request for temporary suspension of calendar year 2020 debt service to China Exim Bank under the G20 Debt Service Suspension Initiative (DSSI) was accepted; rescheduled repayments are included in the baseline scenario.
  - Under the DSSI, debt deferral amounts to 1.4 percent of GDP in FY2021 and 0.7 percent of GDP in FY2022.
  - The DSSI extension to end-2021 is incorporated into the baseline with rescheduled repayments during that period.
- Public debt policy constraint:
  - Government's fiscal anchors (introduced in FY2018) limit total public external debt-to-GDP to a maximum of 50 percent.
  - Other than the RCF, Tonga has not contracted external loans since 2018, though it is receiving disbursements from prior loan commitments (remaining loan commitment about 0.4 percent of GDP).
- Contingent liability defaults used in DSA:
  - Other elements of the general government not captured: 0.0 percent of GDP.
  - SoE's debt (guaranteed and not guaranteed): 2.0 percent of GDP.
  - PPP: 0.0 percent of PPP stock.
  - Financial market shock default value: 5.0 percent of GDP.
  - Total contingent additions: 7.0 percent of GDP.

### Background on macroeconomic forecasts and baseline assumptions
- Baseline scenario assumptions align with the Staff Report for the 2022 Article IV consultation and second RCF disbursement.
- Authorities’ reform commitments under Strategic Development Framework (SDF) 2015–2025 include:
  - Enhancing trade facilitation and access to credit.
  - Building climate-resistant public infrastructure (National Infrastructure Plan).
  - Boosting domestic revenues through tax administration reforms and rationalization of tax exemptions.
  - Containing public sector wage bill within fiscal target while strengthening social protection and targeted support for the vulnerable.
- Real GDP growth projections:
  - Real GDP growth is projected at 1.7 percent on average during FY2022–32.
  - Economic activity expected to contract by 1.9 percent in FY2022 due to the volcano eruption and the war in Ukraine.
  - GDP growth expected to pick up in FY2023–24 with gradual reopening of borders and reconstruction activities; post-reconstruction, trend to potential growth rate of 1.8 percent over medium- to longer-term.
- Risks to projections:
  - Downside risks: new COVID-19 variants, faster-than-expected increases in fuel and food prices, extended supply chain disruptions, delays in tourism resumption, deglobalization reducing remittances and donor funds, natural disasters, rising sea levels, disruptions in correspondent banking relationships.
  - Upside: earlier resumption of tourism, stronger global recovery boosting remittances, higher capital spending on climate-resilient infrastructure.
- Natural disaster assumption:
  - Baseline incorporates effect of natural disasters and climate change over the longer-term; FY2023–25 assumed disaster-free.
  - From FY2026 onwards, baseline lowers annual GDP growth by 0.16 percentage points to reflect average long-term effects of natural disasters and climate change (based on IMF staff analysis).
- Inflation:
  - Inflation (measured by GDP deflator in USD terms) projected to average 3 percent during FY2022–32.
  - Inflation expected to peak in FY2022 due to commodity price increases induced by the war in Ukraine and domestic supply disruptions following the volcanic eruption in January 2022, then trend down in the medium term.
- Current account and FDI:
  - Non-interest current account deficit projected to reach 22.7 percent of GDP in FY2023 due to rising food and fuel prices, reconstruction imports, slow tourism recovery, and decline in remittances.
  - Over FY2022–32 the non-interest current account deficit projected to average over the period reflecting weak export competitiveness, import reliance, reconstruction imports in FY2023, and lower official transfer inflows after current commitments are met.
  - Net FDI inflows expected to stand at 0.1 percent of GDP over FY2022–32.
- External borrowing and reserves:
  - Except for the IMF’s second RCF-supported financing and rescheduled China Exim Bank repayments under the DSSI, new external borrowing expected to commence in FY2024 and increase gradually to refinance debt repayments and the primary deficit expected to reach double digits over FY2028–2032.
  - Even if authorities relied only on grants, they would still need to borrow to meet existing loan repayments under the baseline.
  - International reserves expected sufficient to cover external debt repayments until FY2023; large repayments to China Exim Bank beginning in FY2024 (annual payments of about 2.6 percent of GDP in FY2024–29 on average) would exhaust cash buffers unless authorities borrow or drawdown reserves.
- Fiscal outlook and projections:
  - Primary deficit projected to increase from 1.6 percent of GDP in FY2022 to 4.2 percent in FY2023 and then to 11.9 percent of GDP in FY2032.
  - Higher deficit in FY2023 reflects larger budget envelope for reconstruction and recovery despite higher domestic revenues.
  - Long-term deterioration driven by lower grant inflows after commitments are met and large spending needs for infrastructure, climate resilience, and SDGs.
  - Domestic revenues expected to improve over time via revenue administration and tax arrears collection.
  - Public sector wages projected to decline gradually to a level below the fiscal target of 53 percent of domestic revenue in FY2025.
  - Fiscal deficit as share of GDP expected to decline beyond 2032 as capital spending moderates after completion of multi-year reconstruction and accumulation of climate-resilient capital.

### Baseline macroeconomic projection table (selected series, percent unless stated)
- Historical FY2011-21 average and FY2022–32 averages (selected):
  - Real GDP growth (in percent): Historical: -1.9; FY2022: 3.2; FY2023: 3.0; FY2024: 2.5; FY2025: 1.8; FY2026: 1.8; FY2027: 1.8; FY2028: 1.8; FY2029: 1.8; FY2030: 1.8; FY2031: 1.8; FY2032: 1.3; FY2022-32 average: 1.7.
  - GDP deflator in US dollars (change in percent): FY2022: 8.3; FY2023: 3.7; FY2024: 3.4; FY2025: 2.6; FY2026: 2.0; FY2027: 1.5; FY2028: 1.6; FY2029: 2.2; FY2030: 2.6; FY2031: 2.6; FY2032: 2.6; FY2022-32 average: 3.0.
  - Non-interest current account deficit: FY2022: 5.8; FY2023: 22.7; FY2024: 19.3; FY2025: 8.1; FY2026: 13.8; FY2027: 13.8; FY2028: 16.1; FY2029: 9.9; FY2030: 10.6; FY2031: 9.9; FY2032: 9.6; FY2022-32 average: 12.7.
  - Net FDI (negative = inflow): FY2022: 1.2; FY2023: 1.2; FY2024: 0.8; FY2025: 1.0; FY2026: 1.0; FY2027: 0.9; FY2028: 0.0; FY2029: -1.0; FY2030: -1.0; FY2031: -1.0; FY2032: -1.2; FY2022-32 average: 0.1.
  - Primary deficit: FY2022: 1.6; FY2023: 4.2; FY2024: 4.4; FY2025: 8.1; FY2026: 8.8; FY2027: 10.2; FY2028: 11.7; FY2029: 12.5; FY2030: 11.7; FY2031: 11.5; FY2032: 11.9; FY2022-32 average: 8.8.
  - Grants: FY2022: 30.2; FY2023: 20.5; FY2024: 14.6; FY2025: 12.7; FY2026: 11.2; FY2027: 9.3; FY2028: 7.4; FY2029: 6.5; FY2030: 5.0; FY2031: 4.9; FY2032: 4.1; FY2022-32 average: 11.5.

_Staff report prepared by the staffs of the International Monetary Fund and the International Development Association, June 29, 2022._

### 6.      The realism tools indicate that the primary balance projections are reasonable (Figure 4). The

### 1tonea2022001 - 6.      The realism tools indicate that the primary balance projections are reasonable (Figure 4). The

### Realism tools and fiscal projections
- The realism tools indicate that the primary balance projections are reasonable (Figure 4).
- The fiscal forecasts between FY2022 and FY2025 are not overly optimistic as the projected three-year adjustment lies in the left section of the distribution of past adjustments of the primary fiscal deficit (Figure 4).
- The real growth forecast for FY2022 is within the range calculated by the model.
- A strong rebound is expected in FY2023 as the economy emerges from the twin shock in FY2022.
- The realism of projections for public and private investment rates and their contribution to real GDP could not be calculated due to the unavailability of data.

### Country classification and tailored stress tests
- Tonga's Composite Indicator (CI) index is 3.12, calculated based on the October 2021 WEO and the 2020 CPIA, indicating that the country's debt-carrying capacity is "strong" according to the revised LIC-DSA framework.
- Given the severity and frequency of natural disasters in Tonga, a tailored one-time stress test for natural disaster shocks was conducted.
- EM-DAT shows the country’s largest damage from natural disasters during 1980–2016 was 28.2 percent of GDP.
- The DSA assumes a one-off shock of 14 percentage points (ppts) to the debt-to-GDP ratio in FY2023, with real GDP growth and exports lowered by 3 and 7 ppts, respectively, in the year of the shock (Lee et al., 2018).

### External debt sustainability (baseline and stress scenarios)
- Under the baseline scenario:
  - External debt-to-GDP ratio is expected to decline from 41 percent in FY2021 to 32 percent in FY2024.
  - External debt-to-GDP ratio will breach the authorities’ fiscal anchor of 50 percent in FY2027.
  - The PV of the external debt-to-GDP ratio is expected to breach the threshold of 55 percent starting from FY2032.
- Drivers:
  - Near-term decline reflects large repayments to China Exim Bank and a shift to domestic debt financing and the second RCF.
  - From FY2025 onwards, new external debt is expected to finance large investment needs for SDGs and climate resilience.
- Under a combination of diverse shocks (most extreme scenario), the PV of external debt-to-GDP ratio would breach the threshold earlier in FY2028.
- Due to a narrow export base and temporarily depressed export levels, the debt service-to-exports ratio will breach the threshold in the near and medium term.
- The PV of the external debt-to-exports ratio will breach its threshold in the next two years and again after FY2029.
- Under an export shock, the PV of the external debt-to-exports ratio will remain breached in all future years.
- The tailored natural disaster shock would:
  - Significantly worsen the external debt path.
  - Cause the PV of external debt-to-GDP ratio to jump up in FY2023 and breach the threshold two years earlier in FY2030.
  - Note: multiple severe natural disasters within a ten-year timeframe could have larger cumulative negative effects.

### Public debt sustainability (baseline and stress scenarios)
- Under the baseline scenario:
  - The PV of the public debt-to-GDP ratio would breach 70 percent from FY2032 onwards.
  - Nominal public debt-to-GDP ratio is higher in FY2023 due to reconstruction activity, while the ratio improved after FY2024 with more grants assumed in the baseline.
- Standardized sensitivity analysis:
  - The PV of the public debt-to-GDP ratio would cross 70 percent of GDP in FY2028 under a multi-year GDP growth shock.
  - The PV of the public debt-to-GDP ratio would breach the threshold in FY2029 under a capital inflow shock.
- Tailored one-time natural disaster shock:
  - The PV of public debt relative to both GDP and exports is higher compared to the baseline.
  - The PV of the public debt-to-GDP ratio would cross 70 percent of GDP in FY2029.
- Combined contingent liability shock:
  - The trajectory of the PV of the public debt-to-GDP ratio shifts upwards by 4 percentage points from the baseline.

### Risk rating and vulnerabilities
- The 2022 DSA under the LIC-DSF suggests Tonga's risk of external debt distress remains high.
- Under the baseline:
  - The indicative threshold for the PV of the external debt-to-GDP ratio is expected to be breached starting from FY2032.
  - The PV of the external debt-to-exports ratio will breach its threshold in the next two years and again after FY2029.
  - The external debt service-to-export ratio is expected to breach the threshold from FY2022 to FY2028.
- Overall risk of debt distress is also high:
  - PV of the public debt-to-GDP ratio is projected to breach the indicative benchmark from FY2032 onwards, reflecting large investment needs and declining capital grant commitments over the medium-to-long term.
  - Tonga is highly vulnerable to natural disaster, growth, and exports shocks.

### Policy recommendations and fiscal strategy
- Short-term:
  - Adopt an expansionary fiscal stance in FY2023 focused on reconstruction and social protection.
  - Implement well-targeted financial assistance measures, including cash transfers and concessional loans, to protect vulnerable households and businesses affected by border closures, the volcanic eruption, COVID-related mobility restrictions, and high inflation driven by global commodity prices and disruptions in domestic supply conditions following the volcanic eruption.
  - Accelerate reconstruction of damaged infrastructure, improve build quality, and relocate away from high-risk areas to strengthen climate resilience.
  - Tonga’s FY2023 budget is consistent with these priorities.
- Medium-to-long term:
  - Public debt could be put on a sustainable path with feasible domestic fiscal measures and additional external donor support.
  - Under an illustrative fiscal adjustment scenario, the PV of public debt-to-GDP ratio could stabilize below the 70 percent threshold over the long term, even with a large natural disaster shock.
  - Fiscal adjustments could include a gradual increase of tax revenues and reduction of current expenditure to levels similar to other PICs, post-reconstruction.
  - New grant commitments consistent with historical trends are essential to fund capital investment projects for SDGs and climate resilience.
  - Government strategy recommended: improve revenue administration, collect tax arrears, contain public wage bill within the fiscal target, pursue additional grants from development partners, and avoid any new non-concessional borrowing from external creditors.

*Source: Excerpt from IMF DSA chapter on Tonga contained in the supplied content unit.*

### 20.      The authorities agreed with the debt sustainability assessment and stressed the need for

### 1tonea2022001 - 20.      The authorities agreed with the debt sustainability assessment and stressed the need for

### Authorities' assessment and policy commitments
- The authorities agreed with the debt sustainability assessment and stressed the need for continued donor support in the medium-to-long term.
- They recognized the need to build adequate fiscal buffers over the medium term after the recovery is firmly underway.
- Policy commitments and priorities:
  - Rationalize tax exemptions.
  - Improve the targeting of economic support.
  - Further enhance revenue administration.
  - Implement spending controls in line with recommendations from IMF and World Bank technical assistance.
  - Continue to seek new concessional and grant financing commitments from bilateral donors and international financial institutions to contain external debt levels.
  - Refrain from non-concessional borrowing (consistent with Tonga’s compliance with a non-concessional external borrowing ceiling as part of the World Bank’s Sustainable Development Finance Policy, SDFP).
  - Use the government’s medium-term debt strategy to guide fiscal policy and debt management decisions.
  - Revise public financial management (PFM) legislation (currently under preparation) to improve debt management.
- The debt strategy and PFM legislation are supported by the World Bank’s SDFP.

### Illustrative fiscal adjustment path (relative to baseline, In percent of GDP)
- Note: In the baseline scenario, grants would gradually decline to below 10 percent of GDP after FY2026. The adjustment path assumes additional grants as shown above. Grants averaged 18 percent of GDP between FY2016–FY2021.
- Domestic fiscal measures (FY2025–FY2030):
  - FY2025: 0.8
  - FY2026: 1.6
  - FY2027: 2.4
  - FY2028: 3.2
  - FY2029: 4.0
  - FY2030: 4.5
- Taxes (FY2025–FY2030):
  - FY2025: 0.5
  - FY2026: 1.0
  - FY2027: 1.5
  - FY2028: 2.0
  - FY2029: 2.5
  - FY2030: 3.0
- Goods and services / Wage bill (FY2025–FY2030):
  - FY2025: -0.3
  - FY2026: -0.6
  - FY2027: -0.9
  - FY2028: -1.2
  - FY2029: -1.5
  - FY2030: -1.5
- Additional Grants (FY2025–FY2030):
  - FY2025: 1.9
  - FY2026: 3.1
  - FY2027: 4.2
  - FY2028: 5.0
  - FY2029: 5.0
  - FY2030: (blank in source)
- Change in primary balance (FY2025–FY2030):
  - FY2025: 0.8
  - FY2026: 3.5
  - FY2027: 5.5
  - FY2028: 7.4
  - FY2029: 9.0
  - FY2030: 9.5
- Projected primary balance (FY2025–FY2030):
  - FY2025: -7.3
  - FY2026: -5.3
  - FY2027: -4.7
  - FY2028: -4.3
  - FY2029: -3.5
  - FY2030: -2.2

### External Debt Sustainability Framework — selected indicators (Baseline Scenario)
- External debt (nominal), selected entries (In percent of GDP):
  - 2019: 36.4
  - 2020: 37.4
  - 2021: 41.2
  - 2022: 39.3
  - 2023: 35.8
  - 2024: 32.0
  - 2025: 38.5
  - 2026: 46.2
  - 2027: 55.2
  - 2032: 101.2
  - 2042: 133.6
- Change in external debt (selected):
  - 2019: -4.2
  - 2020: 1.0
  - 2021: 3.9
  - 2022: -2.0
  - 2023: -3.5
  - 2024: -3.8
  - 2025: 6.6
  - 2026: 7.7
  - 2027: 9.0
  - 2032: 8.6
  - 2042: 3.8
- Identified net debt-creating flows (selected):
  - 2019: -1.5
  - 2020: 6.3
  - 2021: 0.1
  - 2022: 8.1
  - 2023: 23.2
  - 2024: 19.6
  - 2025: 8.6
  - 2026: 14.6
  - 2027: 14.4
  - 2032: 7.8
  - 2042: -16.0
- Non-interest current account deficit (selected):
  - 2019: 0.0
  - 2020: 3.4
  - 2021: -3.1
  - 2022: 5.8
  - 2023: 22.7
  - 2024: 19.3
  - 2025: 8.1
  - 2026: 13.8
  - 2027: 13.8
  - 2032: 9.6
  - 2042: -13.9
- Deficit in balance of goods and services (selected):
  - Exports (selected): 22.0, 19.1, 4.7, 1.6, 4.1, 11.6, 12.5, 13.7, 15.1, 17.7, 40.3, 18.4, 12.8 (series present in table)
  - Imports (selected): 64.0, 62.8, 63.8, 76.1, 79.0, 78.6, 68.9, 68.9, 68.9, 66.7, 67.4, 62.5, 70.8 (series present in table)
- Net current transfers (negative = inflow) (selected):
  - 2019: -33.4
  - 2020: -31.2
  - 2021: -48.9
  - 2022: -58.3
  - 2023: -42.1
  - 2024: -38.4
  - 2025: -39.9
  - 2026: -33.0
  - 2027: -31.6
  - 2032: -31.6
  - 2042: -33.4
  - of which: official (selected): -8.8, -4.1, -7.0, -22.0, -14.4, -10.6, -12.2, -5.2, -4.2, -4.1, -4.0, -6.9, -8.2
- PV of PPG external debt-to-GDP ratio (selected):
  - 27.8, 26.7, 24.7, 21.4, 24.3, 27.5, 31.6, 58.6, 79.5 (values shown under "Sustainability indicators")
- PV of PPG external debt-to-exports ratio (selected):
  - 590.4, 1624.7, 605.4, 184.3, 195.2, 200.2, 209.1, 331.4, 197.3 (values shown)
- PPG debt service-to-exports ratio (selected):
  - 9.1, 7.9, 15.6, 86.6, 50.9, 35.0, 30.5, 27.0, 23.6, 13.8, 14.5
- PPG debt service-to-revenue ratio (selected):
  - 8.6, 6.0, 2.8, 6.7, 8.2, 16.1, 15.2, 14.8, 14.2, 9.1, 21.6
- Gross external financing need (Million of U.S. dollars) (selected):
  - 10.4, 27.8, -4.2, 42.0, 138.9, 138.0, 76.9, 114.8, 117.2, 84.3, -104.9

### Key macroeconomic assumptions (selected series as reported)
- Real GDP growth (in percent):
  - 0.7, 0.5, -2.7, -1.9, 3.2, 3.0, 2.5, 1.8, 1.8, 1.8, 1.8, 1.3, 1.7
- GDP deflator in US dollar terms (change in percent):
  - 5.6, -4.6, -1.4, 8.3, 3.7, 3.4, 2.6, 2.0, 1.5, 2.6, 0.9, 0.2, 3.0
- Effective interest rate (percent):
  - 2.3, 1.4, 0.4, 0.9, 1.3, 1.3, 1.2, 1.2, 1.2, 1.2, 1.1, 1.5, 1.2
- Growth of exports of G&S (US dollar terms, in percent):
  - 9.2, -16.6, -76.4, -62.9, 165.7, 203.6, 12.9, 14.2, 13.9, 9.0, 5.9, -2.8, 35.0
- Growth of imports of G&S (US dollar terms, in percent):
  - 3.2, -5.9, -2.5, 26.7, 11.2, 5.9, -7.8, 3.8, 3.3, 4.5, 1.4, 1.7, 5.5
- Grant element of new public sector borrowing (in percent) (selected):
  - 20.1, 41.0, 41.0, 46.5, 45.9, 44.8, 44.2, 44.5 (values as shown)
- Government revenues (excluding grants, in percent of GDP) (selected):
  - 23.4, 25.1, 25.9, 21.2, 25.3, 25.3, 25.0, 25.0, 25.1, 27.0, 27.0, 22.7, 25.3
- Aid flows (in Million of US dollars) (selected):
  - 516.6, 512.0, 517.6, 551.2, 490.4, 421.9, 396.5, 357.1, 307.0, 189.5, 158.9
- Grant-equivalent financing (in percent of GDP) (selected):
  - 18.3, 19.1, 22.4, 30.2, 20.5, 15.4, 17.4, 16.8, 15.4, 10.3, 9.1, 15.9
- Grant-equivalent financing (in percent of external financing) (selected):
  - 100.0, 100.0, 100.0, 98.0, 92.1, 93.0, 72.0, 72.0, 68.0, 57.5, 58.6, 72.6
- Nominal GDP (Million of US dollars) (selected):
  - 511, 490, 470, 500, 535, 570, 599, 622, 643, 786, 1,125
- Memorandum: PV of external debt (in percent of GDP) (selected):
  - 27.8, 26.7, 24.7, 21.4, 24.3, 27.5, 31.6, 58.6, 79.5
- Total external debt service-to-exports ratio (selected):
  - 9.1, 7.9, 15.6, 86.6, 50.9, 35.0, 30.5, 27.0, 23.6, 13.8, 14.5
- PV of PPG external debt (in Million of US dollars) (selected):
  - 130.7, 133.3, 131.9, 122.0, 145.9, 170.8, 203.1, 460.6, 894.8

### Public Sector Debt Framework — selected indicators (Baseline Scenario)
- Public sector debt (In percent of GDP) (selected):
  - 2019: 41.3
  - 2020: 43.6
  - 2021: 47.5
  - 2022: 47.6
  - 2023: 45.5
  - 2024: 47.9
  - 2025: 54.5
  - 2026: 62.2
  - 2027: 71.4
  - 2032: 117.9
  - 2042: 143.9
  - Average / other series entries: 47.5, 75.5
- Change in public sector debt (selected):
  - -4.6, 2.3, 3.9, 0.1, -2.1, 2.4, 6.6, 7.7, 9.2, 8.6, 2.8
- Identified debt-creating flows (selected):
  - -6.4, -3.5, 2.3, 1.9, 2.5, 3.0, 6.9, 7.8, 9.1, 9.8, 2.0, -2.0, 7.4
- Primary deficit (selected):
  - -3.9, -6.1, 0.6, 1.6, 4.2, 4.4, 8.1, 8.8, 10.2, 11.9, 4.9, -2.4, 8.8
- Revenue and grants (selected):
  - 41.7, 44.2, 48.3, 51.5, 45.8, 39.9, 37.7, 36.1, 34.3, 31.1, 31.0, 39.2, 36.7
  - of which: grants (selected): 18.3, 19.1, 22.4, 30.2, 20.5, 14.6, 12.7, 11.1, 9.3, 4.1, 4.0, 16.5, 11.5
- Primary (noninterest) expenditure (selected):
  - 37.9, 38.1, 48.9, 53.1, 50.0, 44.3, 45.8, 44.9, 44.6, 43.0, 35.9, 36.8, 45.5
- Automatic debt dynamics (selected):
  - -2.5, 2.6, 1.7, 0.4, -1.7, -1.4, -1.2, -1.0, -1.1, -2.2, -2.9
  - Contribution from interest rate/growth differential (selected): -0.3, 0.1, 1.1, 0.4, -1.7, -1.4, -1.2, -1.0, -1.1, -2.2, -2.9
- Sustainability indicators (selected):
  - PV of public debt-to-GDP ratio (selected): 33.8, 35.2, 34.4, 37.4, 40.4, 43.6, 48.0, 75.5, 90.5
  - PV of public debt-to-revenue and grants ratio (selected): 70.0, 68.5, 75.0, 93.7, 107.2, 120.8, 139.8, 242.9, 291.6
  - Debt service-to-revenue and grants ratio (selected): 8.7, 8.1, 5.4, 5.8, 8.9, 13.6, 24.5, 23.6, 31.0, 25.7, 34.1
  - Gross financing need (selected): -0.2, -2.6, 3.2, 4.6, 8.2, 9.9, 17.3, 17.3, 20.9, 19.9, 15.5

### Sensitivity analysis and stress tests (selected outcomes)
- Table 3 and Table 4 present sensitivity tests for key indicators of public and PPG external debt and public debt under alternative scenarios, bound tests (Real GDP growth, Primary balance, Exports, Other flows, Depreciation, Combination), and tailored tests (Combined contingent liabilities, Natural disaster).
- Selected baseline and stress values (examples taken directly from tables):
  - Baseline (PV of debt-to-GDP ratio, various years): 27, 25, 21, 24, 27, 32, 37, 48, 53, 59 (table entries under Baseline for FY2022–2032)
  - Bound test B1 (Real GDP growth) and B2 (Primary balance) show materially higher ratios under adverse shocks (tables indicate multiple series breaching thresholds).
  - Thresholds displayed: 55 (for PV of debt-to-GDP), 24 (for PV of debt-to-exports), 21 (for debt service-to-exports) and 23 (for debt service-to-revenue) as indicated in the sensitivity tables.
- Grant element assumed on residual financing (i.e., financing required above baseline) (row shown):
  - 49, 49, 49, 49, 49, 49, 49, 49, 49, 49, 49, 49 (series "4949..." shown)

### Drivers of debt dynamics and realism tools
- Figures and charts (described in the source) decompose debt dynamics into contributions from:
  - Primary deficit
  - Real interest rate
  - Real GDP growth
  - Price and exchange rate changes
  - Net current account + FDI
  - Residual / unexpected changes
- The public DSA allows for domestic financing to cover additional financing needs generated by shocks under stress tests; default terms of marginal debt are based on baseline 10-year projections.

### Authorities' statement
- Statement by Ms. Lim, Mr. Mochtar, and Mr. Nghiem on Tonga Executive Board Meeting (Senior Advisor to Executive Director, July 15, 2022):
  - On behalf of the Tongan authorities, they thanked the IMF mission team led by Mr. Minsuk Kim for candid and constructive policy dialogues during the 2022 Article IV consultation.
  - Authorities broadly concur with staff’s assessment and policy recommendations and appreciate staff’s continuous engagement and policy advice.

*Sources: Country authorities; and staff estimates and projections (as presented in the provided content).*

### 1. Tonga has been hard hit by a double blow from the Hunga Tonga Hunga Haʻapai (HTHH)

### 1. Tonga has been hard hit by a double blow from the Hunga Tonga Hunga Haʻapai (HTHH)

### Impact and macroeconomic overview
- The Hunga Tonga Hunga Haʻapai (HTHH) volcanic eruption and the first local outbreak of COVID-19 in early 2022 disrupted a nascent economic recovery in the second half of FY2021 (July 2020‒June 2021).
- The economy is projected to contract by 2.5 percent in FY2022.
- Inflation is elevated over the year to 9.4 percent as of April 2022, above the 5 percent target by the National Reserve Bank of Tonga (NRBT).
- Risks are tilted to the downside due to geopolitical tensions, rising international commodity and energy prices, and supply-side disruptions from the volcanic eruption affecting domestic prices.
- A swift vaccination campaign: "Nea rly 100 percent of population a ged 18 and above received one vaccine shot, 91 percent two doses, a nd56 percent with boosters a s of end April 2022."

### Emergency financing, external support, and balance of payments
- The authorities requested emergency financing of SDR 6.9 million (50 percent of quota) under the exogenous shock window of the IMF’s Rapid Credit Facility (RCF) to meet BOP needs and help with rebuilding efforts.
- Tonga’s current account deficit is estimated to increase to about 6 percent of GDP in FY2022 and 22.5 percent in FY2023.
- The authorities estimate the urgent BOP issue at about US$121 million.
- Development partners pledged additional budget support in grants worth about 7 percent of GDP for FY2022 and 4 percent for FY2023 to cover emergency spending (health care, social protection, reconstruction).
- Official foreign reserves increased substantially by US$86.7 million yoy to US$375 million as at end June, 2022, equivalent to 12.6 months of import cover.

### Outlook and policy priorities
- Near-term policy priorities: assisting the vulnerable and poor, supporting reconstruction, ensuring macroeconomic stability, and containing inflationary pressures.
- The authorities issued the HTHH Recovery Plan targeting long-term recovery and resilience, and restoration/stabilization of Government services including telecommunications.
- The authorities forecast the economy to grow moderately at 3.2 percent in FY2023, mainly owing to the recovery in the construction and tourism sectors.
- Inflation is expected to remain elevated in the near term before easing to below the 5 percent reference rate in FY2023, supported by rebound in domestic crop production and easing of global supply disruptions.
- Authorities remain vigilant to: geopolitical tensions, higher global food and energy prices, and the possibility of subsequent natural disasters. Upside risk: FX reserves remaining at record high levels due to recent large inflows of grants, relief funds and remittances.

### Fiscal policy
- Fiscal policy remains accommodative to entrench near-term economic recovery.
- Support measures include relief assistance for businesses and employees, tax exemptions, and electricity price subsidy.
- Specific exemptions in FY2021/2022: duty on goods imported by citizens in affected areas until June 2022, and payment of school fees (Term 1) for all students in Tongatapu, Ha’apai and ‘Eua.
- Budget deficit is expected to narrow in FY2022 due to:
  - Estimated revenue drop by US$17.1 million (7 percent).
  - Fall in total expenditure by US$13.5 million (6.2 percent).
  - Delays in ongoing project implementation caused by the COVID-19 pandemic.
- Measures to strengthen revenue collection and fiscal sustainability:
  - Introduction of electronic sales register system.
  - E-tax services to modernize tax administration.
  - Review of affordability and relevance of selected government fees and charges (education, electricity, water, waste, communications).
- Over the medium term: strengthen public finances to reduce risk of debt distress, prioritize financing plans drawing on additional donor support, improve expenditure prioritization (education, health, infrastructures), reduce tax exemptions in certain areas, adjust public spending (public sector wage bill), enhance transparency and competitive contract awards.

### Monetary policy
- NRBT maintains an accommodative monetary policy stance to support recovery and macroeconomic stability.
- Core inflation has remained below the NRBT’s 5 percent reference rate while credit growth has turned negative since July 2020.
- Authorities anticipate monetary policy tightening by AE central banks and associated pass-through via imported prices; NRBT will remain vigilant and stands ready to tighten if inflation rises beyond the reference rate for longer.

### Financial sector policies and payments system
- The financial system remains sound, supported by strong capital positions, high liquidity, and adequate profitability.
- Non-performing loans (NPLs) increased to 4.8 percent of total loans reflecting HTHH disaster and COVID-19 lockdown impacts.
- Ongoing measures:
  - Close monitoring of affected sectors and customers, risk assessments and stress testing.
  - Scrutiny of banks’ adherence to provisioning requirements aligned with IFRS9.
  - Establishment of the Financial Stability Unit to develop and implement macroprudential policies and monitor indebtedness.
  - IMF PFTAC assistance to review prudential standards and establish standards for newly regulated non-bank financial institutions.
- Payments system modernization: rollout of the Domestic Electronic Payment System (DEPS) completed to increase automation of clearing and settlement.

### Regulatory and structural reforms
- Strengthening AML/CFT framework to alleviate de-risking and de-banking risks:
  - Review of the Money Laundering and Proceeds of Crime Act (MLPC Act) with IMF Legal Department assistance.
  - Augmented AML/CFT supervision capacity to extend supervision to all financial institutions and cash dealers under the MLPC Act.
  - Strengthening FIU’s information database and analytical tools, establishment of NRBT’s e-KYC database, and deeper collaboration with regional supervisors and FIUs.
- Progress on safeguards assessment recommendations: Board vacancies filled, internal audit function established, review of the National Reserve Bank of Tonga Act in progress.
- Regulatory work in progress for non-bank financial institutions: draft legislations for licensing and supervision of pension funds and insurers; drafting legislation for licensing and supervision of capital markets, credit information system, and payment systems including digital financial services; implementation of newly enacted legislation for licensing and supervision of credit unions.

### Labor mobility, employment, and climate resilience
- Labor Mobility Policy framework developed to maximize workers’ ability to move overseas for employment.
- Thousands of Tongans employed in labor mobility schemes in New Zealand and Australia.
- Australia streamlined Seasonal Workers’ Program (SWP) and Pacific Labor Scheme (PLS) into Pacific Australia Labor Mobility (PALM) scheme to facilitate worker progression from unskilled to semi-skilled categories and transfers between employers.
- Climate resilience actions:
  - Monitoring and Evaluation (M&E) System Guide and Standard Operating Procedure (SOP) launched in October 2019 to track progress on the 2nd Joint National Action Plan on Climate Change and Disaster Risk Management (JNAP2).
  - Implementation of recommendations from the 2020 IMF/WB Climate Change Policy Assessment to mainstream climate resilience into sectoral plans and strengthen inter-ministerial cooperation.

### Conclusion and commitments
- Authorities committed to:
  - Strengthening macroeconomic policy to support recovery while enhancing resilience.
  - Remaining vigilant to rising inflationary risks and responding agilely to contain inflation and ensure macroeconomic stability.
  - Adhering to medium-term fiscal targets and calibrating fiscal policy in sync with macroeconomic developments.
  - Closely monitoring and supervising the financial sector to mitigate macro-financial risks.
  - Accelerating structural reforms to meet higher development needs, strengthen climate mitigation measures, and promote private sector development.
- Authorities committed to using RCF resources to meet urgent BOP needs in an accountable and transparent manner.

*Source: 1tonea2022001 - 1. Tonga has been hard hit by a double blow from the Hunga Tonga Hunga Haʻapai (HTHH)*

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_Source: https://www.imf.org/-/media/files/publications/cr/2022/english/1tonea2022001.pdf_