## EXECUTIVE SUMMARY (1tonea2023001) ## Source details **Canonical URL:** [EXECUTIVE SUMMARY (1tonea2023001)](https://www.imf.org/-/media/files/publications/cr/2023/english/1tonea2023001.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2023/english/1tonea2023001.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2023/english/1tonea2023001.pdf.json) --- ### Context and recent developments - Economy performing strongly, underpinned by resilient remittance inflows and major reconstruction activities following the Hunga Tonga–Hunga Haʻapai (HTHH) volcanic eruption in January 2022. - Supply-side constraints from severe labor shortages and damaged tourism facilities are impeding recovery and intensifying inflation pressures. - FY2022: real GDP estimated to have declined by 2 percent (July 2021–June 2022). - FY2023: real GDP rebounded by 2.6 percent. - Reconstruction hampered by labor shortages (including higher foreign demand from seasonal worker programs in Australia and New Zealand) and higher-than-anticipated construction material costs. - IMF Rapid Credit Facility (RCF) emergency financing in July 2022: 50 percent of quota, equivalent to about US$9 million; Tonga’s outstanding RCF balance stands at 100 percent of quota (first RCF disbursement approved in January 2021, 50 percent of quota). ### Capacity development and technical assistance - Tonga is one of the largest recipients of IMF CD resources in the region; authorities have shown strong ownership. - Ongoing IMF TA areas: central bank legislation, AML/CFT, macroeconomic frameworks, and statistics. - TA priorities: amend the central bank act (following the December 2021 safeguards assessment); address data shortcomings in external, fiscal, and national accounts statistics; enhance banking sector stress testing frameworks for climate-related risks. ### Policy recommendations (short, medium, long term) - Short term: - Fiscal: support reconstruction and recovery with a larger budget envelope for FY2024 as envisaged by the authorities. - Monetary: further tighten to durably stabilize inflation below 5 percent, including increases in the policy rate from the current zero percent level. - Financial sector: banks should closely monitor credit risks and actively provision for loan losses. - Medium to long term: - Strengthen public finances through domestic fiscal measures―including rationalization of tax exemptions and tax administration reform―and seek continued donor support to meet development spending needs while reducing the risk of debt distress. - Structural reform priorities: - (i) leveraging digital technologies; - (ii) increasing public investment in training and education; - (iii) cutting red tape to foster investment; - (iv) reducing gender inequality in the labor market; - (v) improving the quality and timeliness of statistics; - (vi) strengthening the AML/CFT and anti-corruption frameworks. ### Inflation, external sector, and reserves - Headline inflation: peaked at 14.1 percent in September 2022; trended down to 2.9 percent in August 2023. - Core inflation: 8.8 percent in August 2023. - Contributions to core inflation in FY2023 from transport services and hotels and restaurants. - Current account deficit (CAD): estimated to have widened from 6.3 percent of GDP in FY2022 to 7.9 percent in FY2023. - FX reserves and import cover: reserves increased in FY2023; import cover strengthened to 10.9 months, supported by official capital transfers and the IMF’s RCF disbursement. ### Outlook and risks - FY2024 growth projected at 2.5 percent, underpinned by public investment. - Tourism receipts as share of GDP expected to remain below pre-pandemic levels until FY2026 due to slow reconstruction. - Remittances projected to decline from an estimated 43.7 percent of GDP in FY2023 to 39.2 percent in FY2024. - Average inflation projected at 5.8 percent in FY2024—above the NRBT’s reference rate of 5 percent. - Medium-term long-run growth projected at 1.2 percent. - FX reserve coverage projected to stabilize at about 10½–11 months of imports, above NRBT’s target of 7½ months. - Risks tilted to the downside, including continued strong foreign demand for workers, a sharp rise in global commodity prices, a major natural disaster, loss of correspondent banking relationships, and upside risk from faster-than-expected tourism recovery. *Source: EXECUTIVE SUMMARY, 1tonea2023001* --- ### FISCAL OUTCOMES, OUTLOOK, AND ADJUSTMENT OPTIONS ### FY2022–FY2024 outcomes and near-term outlook - Primary deficit declined from 0.6 percent of GDP in FY2021 to 0.2 percent in FY2022. - Primary fiscal balance expected to have shifted to a surplus of 1.0 percent in FY2023 (pickup in external grants, including large one-off budget support from Australia). - Based on authorities’ FY2024 budget and IMF staff forecasts, primary balance expected to revert to a deficit of 6.3 percent of GDP in FY2024 as HTHH-related external grants unwind and reconstruction projects gather momentum. - Authorities phased out most pandemic- and HTHH-related tax exemptions and plan gradual normalization of current spending; planned top-up of the GDL fund to help vulnerable access credit under tighter monetary policy. ### Medium- and long-term fiscal risks and recommended adjustments - Baseline projects primary fiscal deficit to widen further long term, reflecting decline in committed grants and sizable spending needs for SDGs and climate resilience. - Recommended fiscal adjustments: - Gradual increases in tax revenues. - Further reductions in the public wage bill and other current expenditures. - Government plan to refrain from new non-concessional borrowing to help reduce risk of debt distress. ### Illustrative alternative scenario (FY2025–FY2033) — key numeric inputs and impacts - Domestic fiscal measures (deviation from baseline, percentage points of GDP): - FY2025: 0.8 - FY2026: 1.6 - FY2027: 2.4 - FY2028: 3.2 - FY2029–FY2033: 3.7 each year (FY2029–FY2033) - Components of domestic measures (percent of GDP): - Better VAT compliance: 0.5 each year FY2025–FY2033 - Less tax exemptions: FY2025 0.5; FY2026 1.0; FY2027 1.5; FY2028 2.0; FY2029–FY2033 2.0 each year - Lower G&S: -0.3 in FY2025; -0.6 thereafter (FY2026–FY2031 shown) - Lower public sector wage bill: -0.3 in FY2025; -0.6 FY2026–FY2033 - Additional Grants (deviation from baseline, percent of GDP): 2.0 in FY2025; 3.0 each year FY2026–FY2033 - Change in primary balance (deviation from baseline, percent of GDP): - FY2025: 0.8 - FY2026: 3.6 - FY2027: 5.4 - FY2028: 6.2 - FY2029–FY2033: 6.7 each year - Impact on GDP growth (percentage point impacts, deviations): - Without additional reform: FY2025 -0.3; FY2026 -0.3; FY2027 -0.1; FY2028 -0.1; FY2029–FY2033 0.0 - With additional reform: FY2025 -0.3; FY2026 -0.2; FY2027 0.0; FY2028 0.1; FY2029 0.2; FY2030 0.3; FY2031 0.4; FY2032 0.4; FY2033 0.5 - Impact on inflation (percentage point impacts): - Without additional reform: FY2025 -0.2; FY2026 -0.2; FY2027 -0.1; FY2028 -0.1 - With additional reform: FY2025 -0.2; FY2026 -0.2; FY2027 -0.1; FY2028 -0.1 - Memo: Projected primary balance w/ adjustment (percent of GDP): - FY2025 -7.2; FY2026 -5.4; FY2027 -4.6; FY2028 -5.2; FY2029 -5.0; FY2030 -4.1; FY2031 -3.3; FY2032 -1.5; FY2033 0.0 - Debt outcomes under illustrative scenario: - PV of public debt-to-GDP ratio stabilizes below the 70 percent threshold over the long term. - PV of external debt-to-GDP ratio stabilizes below the 55 percent benchmark. ### Reforms to support fiscal adjustments - Revenue administration: rollout of the Electronic Sales Register System expected to improve compliance and reduce administrative burden. - PFM and transparency: planned amendments to the PFM Act to improve fiscal transparency, budget alignment, and medium-term budgeting. - Tax exemptions governance: reduce exemptions, set clear eligibility criteria and timeframes, and vest Minister of Finance with ultimate authority. - Procurement transparency: publish pandemic-related procurement contracts with beneficial ownership information as committed under the IMF’s RCF. ### Authorities’ fiscal priorities and measures - Prioritize reconstruction and social protection in near term while continuing fiscal reforms. - FY2024 budget includes new social protection initiatives (free school breakfasts; affordable housing for low-income households). - Plan to rationalize overtime pay (overtime constituted about 13 percent of total public sector payroll in FY2022). - Committed to revenue mobilization via electronic sales register system, reviewing tax exemptions, and reassessing government fees and charges. - Committed to seeking new grant financing to keep debt sustainable. --- ### MONETARY POLICY, INFLATION ASSESSMENT, AND NRBT SAFEGUARDS ### NRBT measures and effects - NRBT actions in 2023: - Increased statutory reserve deposit (SRD) ratio from 10 to 15 percent in February 2023. - Maintained policy rate (interest rate on excess bank reserves) at zero percent. - Established deposit facility for retirement funds in February 2023 to help absorb banking system liquidity. - Effects to date: helped absorb sizable banking system liquidity and led to more active liquidity management by some banks, but yet to meaningfully affect aggregate demand or bank lending due to still abundant liquidity. ### Further monetary policy recommendations - Increase the policy rate from the current zero percent level, possibly combined with a further hike in the SRD ratio. - Consider resuming issuance of NRBT notes (suspended since 2009) to provide a market-based instrument to absorb excess liquidity. - Clarify operational guidelines for transfer of profits, coverage of losses, and recapitalization to manage sterilization costs and preserve NRBT financial health and operational independence. - Monetary policy should prioritize safeguarding price stability while calibrating to avoid undue output costs during recovery. ### Assessing underlying inflation — key empirical findings - Structural factors: - Imported goods account for 55.1 percent of the household consumption basket. - Core inflation represents 44.2 percent of the CPI basket. - Recent indicator values: - Main core remained elevated at 8.8 percent in August 2023. - The median of indicators has not cooled below the NRBT’s reference rate of 5 percent. - Empirical results: - A one percentage point increase in the NEER (appreciation) decreases underlying inflation by 0.15 percentage point contemporaneously. - After controlling for NEER, global commodity price shocks have either insignificant or deflationary impacts on underlying inflation. - Domestic shocks: - Electricity consumption: a one percentage point shock raises year-on-year underlying inflation by 0.04 percentage points contemporaneously, with the impact three times larger one year later. - Credit to the private sector has inflationary effects. - Vehicle registration and agricultural production appear to have insignificant impacts. - Conclusion: underlying inflation pressures stay high and persistent; further monetary tightening is warranted. ### NRBT safeguards and governance - Progress since 2021 safeguards assessment: NRBT Board fully constituted and committed to strengthening independent oversight; drafting amendments to the NRBT Act underway with IMF TA support. - Authorities recognize need for additional monetary measures and the complementary role of fiscal policy in managing inflation via targeted support and tax rate adjustments. - Reserves remain at adequate levels owing to continued inflows of grants and remittances, important given vulnerability to natural disasters and anticipated increase in external debt repayments to China Exim Bank. *Sources: Tongan authorities; and IMF staff calculations.* --- ### FINANCIAL SECTOR SOUNDNESS, NPLs, AML/CFT, AND FINANCIAL INCLUSION ### Banking-sector soundness — key statistics - System-wide capital adequacy ratio: around 35 percent in 2023Q1 (regulatory requirement 15 percent). - Banking profitability: banks remain profitable, average return on assets below pre-pandemic levels as of end-FY2022. - System-wide liquidity: excess reserves standing at a sizable 30.2 percent of GDP as of April 2023. ### Asset quality and provisioning - NPL ratio: increased from 3.6 percent at end-2021 to 7.4 percent in 2023Q1 (other indicators show Non-performing Loans to Total Gross Loans: FY2022 6.3; FY2023 8.0). - NPL coverage ratio: declined from 141.3 percent at end-2021 to 99.3 percent in 2023Q1. - Sectoral NPLs: business NPLs grew more rapidly (distribution and construction); household NPLs share declined; housing loans account for over 75 percent of household NPLs. - NBFIs: lending by non-bank financial institutions accounts for around 20 percent of total credit; retirement funds are major NBFI lenders with loans secured against retirement balances. - Assessment: current NPL levels appear manageable given buffers, but capacity to absorb another severe shock without disrupting credit has likely weakened; lack of detailed NBFI data constrains assessment. ### Policy recommendations to address NPLs and supervision - Supervisory actions: - Intrusive oversight for banks with higher NPLs: more frequent regulatory reporting, intensified on-site supervision, and restrictions on dividend payments if needed. - Continue regular stress tests to ensure sufficient capital buffers. - Enhance risk-based supervision and broaden NRBT’s regulatory remit to cover NBFIs (including pension funds and insurance companies). - Prudential standards and provisioning: - Require banks to adopt a more conservative approach to provisioning, including for secured loans and overdue non-NPL loans. - Request banks to submit concrete NPL reduction plans with operational targets and minimum provisioning thresholds. - Data and capacity building: - Avoid frequent staff turnover; expand scope and frequency of data collection with IMF TA support. - NRBT initiative to set up a local credit registry is welcome and should include NBFIs. ### Financial deepening, inclusion, and payments infrastructure - NRBT actions: - Implement plan to expand the Domestic Electronic Payment System to include the government and NBFIs. - Continue initiative to set up a local credit registry, eventually expanded to NBFIs. - Financial literacy and inclusion: - Strengthen financial education in schools and community engagement. - Leverage government digitalization (national digital ID) to foster inclusion; facilitate customer due diligence and credit histories. ### AML/CFT risks and measures - Tonga faces elevated risks of losing correspondent banking relationships (CBRs) due to AML/CFT gaps and low profitability of overseas correspondent banks. - Ongoing measures: - Adoption of an IT system to strengthen Financial Intelligence Unit analytical capacity. - NRBT seeking to amend AML/CFT law to address gaps identified by the Asia Pacific Group (APG), with IMF TA. ### Authorities’ views on financial stability measures - Authorities concurred with staff’s assessment and recommendations. - Implemented measures to tackle high NPLs: more frequent monitoring, re-evaluation of collaterals, directives to limit problematic exposures, and sensitivity analysis on NPL impacts on capital adequacy. - NRBT reforms underway: revising prudential banking standards related to credit risks, implementing IFRS 9 with PFTAC TA, broadening regulation to cover pension funds and insurance companies with World Bank and ADB support. --- ### STRUCTURAL REFORMS, STATISTICS, AND STAFF APPRAISAL ### Disaster resilience and climate change - Priority: enhance resilience to natural disasters and climate change. - Key measures: - Disaster Risk Management Act of 2023 shifts focus to ex-ante risk mitigation and preparedness. - Expand classification of climate change-related spending and strengthen social protection. - Ongoing PFM reform and initiative to establish a national database of households eligible for social protection. - Stricter enforcement of Building Code and facilitate relocation to safer grounds; allocate fiscal resources accordingly. ### Private sector development, digitalization, and labor market - Digitalization: - National digital ID system planned; synergies with social assistance delivery and credit access. - To reap benefits: reduce paper-based administration and invest in ICT infrastructure to improve internet coverage and quality. - Other reforms: - Increase spending on education and training to reduce skill mismatch amid worker outflows. - Cut red tape, improve land leasehold administration (adopt IT systems), and relax foreign ownership restrictions in certain industries per the Foreign Investment law (October 2020) and regulations (2021). - Labor market and gender: - Temporary worker programs in Australia and New Zealand estimated to have hired about 11 percent of Tonga’s working-age population as of mid-2022, predominantly male. - Measures to increase female labor force participation: strengthen early childhood education and childcare services; flexible work arrangements; enact pending Employment Relations Bill requiring sexual harassment policies. ### Macroeconomic statistics capacity - Severe capacity constraints in producing timely macroeconomic statistics; delays in publishing national accounts and external sector statistics. - Recommendations: - Enforce data sharing and cooperation under current law; allocate fiscal resources to retain, hire, and train staff. - Publish key macroeconomic and financial data regularly through a National Summary Data Page at the IMF website as part of e-GDDS participation. - Authorities agreed strengthening statistics capacity is a top priority. ### Staff appraisal — main macro-financial assessments - Economic performance: economy performing strongly but faces headwinds from labor shortages and damaged tourism facilities contributing to high, persistent inflation. - External position: FY2023 external position broadly in line with fundamentals; CAD widened due to reconstruction-related imports; FX reserves increased supported by grants and the RCF. - Fiscal policy: current expansionary stance appropriate to expedite reconstruction and protect vulnerable; medium-term high risk of debt distress without new grant commitments. - Monetary policy: further tightening warranted; banking system liquidity remains abundant limiting immediate impacts on lending and aggregate demand. - Financial stability: proactive measures needed to tackle asset quality risks; adopt conservative provisioning and NPL plans; broaden NRBT remit to NBFIs. - Structural reforms: comprehensive reforms to enhance climate resilience and nurture private sector; allocate resources for statistics and enforcement of building codes. *Source: IMF staff analysis and recommendations as presented in the provided content.* --- ### OUTLOOK, PROJECTIONS, AND KEY NUMERIC TABLES (SELECTED) ### Real sector projections - Real GDP (Est./Proj.): - FY2021 -2.7 - FY2022 -2.0 - FY2023 2.6 - FY2024 2.5 - FY2025 2.2 - Consumer prices (period average): - FY2021 1.4 - FY2022 8.5 - FY2023 10.2 - FY2024 5.8 - FY2025 4.1 - Consumer prices (end of period): - FY2021 6.9 - FY2022 11.3 - FY2023 7.4 - FY2024 6.2 - FY2025 3.2 - NRBT Reference Rate: 5%. ### External sector projections and indicators - Current account balance (millions): - FY2021 -24.7 - FY2022 -31.5 - FY2023 -43.0 - FY2024 -41.0 - FY2025 -45.0 - Current account balance (percent of GDP): - FY2021 -5.2 - FY2022 -6.3 - FY2023 -7.9 - FY2024 -7.1 - FY2025 -7.4 - Remittances (percent of GDP): - FY2021 46.2 - FY2022 43.4 - FY2023 43.7 - FY2024 39.2 - FY2025 37.0 - Tourism receipts (millions): - FY2021 9.1 - FY2022 9.6 - FY2023 35.6 - FY2024 50.9 - FY2025 58.5 - Gross official foreign reserves (US$ millions): - FY2021 317.9 - FY2022 375.5 - FY2023 388.1 - FY2024 401.4 - FY2025 409.2 - Reserves in months of next year's total imports: - FY2021 11.7 - FY2022 10.3 - FY2023 10.9 - FY2024 10.9 - FY2025 10.8 ### Monetary and financial indicators - Broad money (M2) annual percent change: - FY2021 25.0 - FY2022 13.4 - FY2023 -0.1 - FY2024 4.5 - FY2025 3.4 - Credit to private sector (year-on-year percentage point): - FY2023 Est. 6.4 - FY2024 Proj. 5.9 - FY2025 Proj. 4.3 - Banking soundness indicators: - System-wide capital adequacy ratio: around 35 percent in 2023Q1. - Excess reserves: 30.2 percent of GDP as of April 2023. - Return on Assets (FY2022): 2.2. - Non-performing Loans to Total Gross Loans: FY2016 6.7; FY2017 4.1; FY2018 3.6; FY2019 3.2; FY2020 4.1; FY2021 3.3; FY2022 6.3; FY2023 8.0. - Residential Real Estate Loans to Total Loans: recent level around 40.3 percent. ### Fiscal aggregates (percent of GDP) - Total Revenue: - FY2021 48.3; FY2022 45.2; FY2023 47.7; FY2024 41.6; FY2025 37.6 - Grants (of Total Revenue): - FY2021 22.4; FY2022 19.0; FY2023 24.4; FY2024 17.0; FY2025 12.9 - Total Expenditure: - FY2021 49.3; FY2022 45.9; FY2023 47.4; FY2024 48.3; FY2025 46.1 - Overall balance: - FY2021 -1.0; FY2022 -0.7; FY2023 0.4; FY2024 -6.8; FY2025 -8.5 - Primary balance: - FY2021 -0.6; FY2022 -0.2; FY2023 1.0; FY2024 -6.3; FY2025 -8.0 - Domestic revenue (fiscal anchor = 22%): - FY2021 25.9; FY2022 26.2; FY2023 23.3; FY2024 24.6; FY2025 24.7 - Public debt (total, percent of GDP): - FY2021 47.8; FY2022 45.4; FY2023 41.2; FY2024 45.4; FY2025 51.6 - External debt (percent of GDP): - FY2021 41.2; FY2022 39.4; FY2023 37.2; FY2024 38.0; FY2025 43.9 - Fiscal anchor on external debt = 50 percent of GDP. --- ### DEBT DYNAMICS, SUSTAINABILITY, AND RISK ASSESSMENT ### Debt composition and near-term repayment pressures - Total public and publicly guaranteed (PPG) external debt: USD185 million (about 38 percent of GDP) as of end-June 2022 (86 percent of total public debt). - Outstanding debt to all multilateral creditors: USD79 million (about 16 percent of GDP), about 43 percent of total external debt. - China Exim Bank accounts for 57 percent of total external debt stock; loans denominated in Chinese renminbi. - Public domestic debt: USD30 million (about 6.1 percent of GDP) at end-June 2022 (14 percent of total public debt). - Annual payments to China Exim Bank beginning in FY2024 average about 2.2 percent of GDP in FY2024–29. - Under the DSSI, debt deferral amounts: 1.4 percent of GDP in FY2021 and 0.7 percent of GDP in FY2022. ### Baseline macro assumptions relevant for DSA - Real GDP growth projected at 1.6 percent on average during FY2023–33; long-term potential growth converging to 1.2 percent. - Baseline assumes FY2023–FY2025 disaster-free; from FY2026 onwards incorporates long-term effects of natural disasters reducing annual GDP growth by 0.16 percentage points. - Inflation projected to average 4.3 percent during FY2023–33; convergence to 3½ percent steady state. - Non-interest current account deficit: estimated 7.5 percent of GDP in FY2023; projected average 7.7 percent of GDP over FY2023–FY2033. - Net FDI inflows: 0.2 percent of GDP over FY2023–33. - New external borrowing expected to commence in FY2025 to refinance repayments and primary deficits. ### Debt sustainability outcomes and risks - External debt-to-GDP ratio expected to decline from 39.4 percent in FY2022 to 38 percent in FY2024 due to large repayments and the second RCF. - From FY2025 onwards new external debt projected; external debt-to-GDP will breach authorities’ fiscal anchor of 50 percent in FY2026 under baseline. - PV of external debt-to-GDP ratio expected to breach 55 percent threshold starting FY2033 and continue rising until FY2043 under baseline. - Under illustrative fiscal adjustment scenario, PV of public and external debt-to-GDP ratios stabilize below 70 percent and 55 percent benchmarks respectively. - Tailored one-time natural disaster shock (14 percentage points to debt-to-GDP in FY2023) would accelerate breaches of debt thresholds (e.g., external debt PV breach as early as FY2024 in that shock). - Staff assessment: Tonga assessed at high risk of debt distress; mechanical LIC DSF rating "moderate" but staff judgement raises overall rating to "high". ### Country classification and stress tests - Tonga's Composite Indicator (CI) index: 3.06, indicating a "strong" debt-carrying capacity under revised LIC-DSA framework. - EM-DAT largest damage from natural disasters during 1980–2016: 28.2 percent of GDP; DSA uses one-off shock of 14 percentage points to debt-to-GDP in FY2023 (only part financed by external debt). - Standard sensitivity analyses show earlier breaches under extreme shocks (growth shock, exports shock, combined contingent liability shock). --- ### RISK ASSESSMENT MATRIX (SELECTED RISKS & POLICY RESPONSES) ### Global risks - Commodity price volatility - Likelihood: High - Expected Impact: Medium-High - Policy recommendations: - Targeted fiscal support to vulnerable households. - Tighten monetary policy if second-round effects materialize. - Prioritize public investment in necessary projects. - Increase public investment to expand productive capacity in the long term. - Abrupt global slowdown or recession - Likelihood: Medium - Expected Impact: Medium-High - Policy recommendations: - Targeted fiscal support to vulnerable households. - Improve private sector climate and diversify the economy. - Accelerate reforms to broaden tax base and improve spending efficiency. ### Domestic risks - Extreme climate events - Likelihood: High - Expected Impact: High - Policy recommendations: - Prioritize ex-ante adaptation investment and ex-post support to affected households. - Strengthen monitoring of potential banking sector asset quality problems. - Strengthen fiscal buffers by accelerating revenue mobilization reforms. - Acceleration of outward migration - Likelihood: High - Expected Impact: Medium-High - Policy recommendations: - Create economic opportunities via private sector development and FDI promotion. - Enhance education and skill development. - Higher or more persistent inflation - Likelihood: Medium - Expected Impact: High - Policy recommendations: - Tighten monetary policy using NRBT instruments. - Provide targeted fiscal support to low-income households. - Partial withdrawal of CBRs (AML/CFT gaps) - Likelihood: Medium - Expected Impact: High - Policy recommendation: - Strengthen AML/CFT framework and risk-based supervision in line with APG assessment. - Further increase in NPLs - Likelihood: Medium - Expected Impact: Medium - Policy recommendation: - Require banks to prepare comprehensive NPL plans with minimum provisioning targets. ### Cross-cutting emphasis - Recurrent policy themes: targeted fiscal support when shocks materialize; use NRBT instruments to tighten policy when needed; prioritize public investment for productive capacity and climate resilience; structural reforms to broaden tax base, improve spending efficiency, diversify economy, and strengthen institutions (AML/CFT, banking supervision, fiscal reporting). *Source: Annex IV. Risk Assessment Matrix (Tonga — Staff Report for the 2023 Article IV Consultation).* --- *Source: IMF staff report content (1tonea2023001).* ### EXECUTIVE SUMMARY ### EXECUTIVE SUMMARY ### Context - The Tongan economy is performing strongly, underpinned by resilient remittance inflows and major reconstruction activities following the Hunga Tonga–Hunga Haʻapai (HTHH) volcanic eruption in January 2022. - Supply-side constraints from severe labor shortages and damaged tourism facilities are impeding the recovery and have intensified inflation pressures. - Authorities face a tradeoff between supporting reconstruction and managing inflation in the short term. - Tonga’s high vulnerability to natural disasters complicates efforts to create fiscal space to finance development spending. ### Capacity Development (CD)‒Surveillance Integration - Tonga is one of the largest recipients of IMF CD resources in the region; authorities have shown strong ownership. - Ongoing IMF technical assistance includes central bank legislation, AML/CFT, macroeconomic frameworks, and statistics. - TA priorities include amending the central bank act (following the December 2021 safeguards assessment) and addressing data shortcomings, especially external, fiscal, and national accounts statistics. - Authorities seek TA to enhance banking sector stress testing frameworks to better manage climate-related risks. ### Policy Recommendations (Short, Medium, and Long Term) - Short term: - Fiscal policy: support reconstruction and recovery with a larger budget envelope for FY2024, as envisaged by the authorities. - Monetary policy: further tighten to durably stabilize inflation below 5 percent, including increases in the policy rate from the current zero percent level. - Financial sector: banks should closely monitor credit risks and actively provision for loan losses. - Medium to long term: - Strengthen public finances through domestic fiscal measures―including rationalization of tax exemptions and tax administration reform―and seek continued donor support to meet development spending needs while reducing the risk of debt distress. - Structural reform priorities: - (i) leveraging digital technologies; - (ii) increasing public investment in training and education; - (iii) cutting red tape to foster investment; - (iv) reducing gender inequality in the labor market; - (v) improving the quality and timeliness of statistics; - (vi) strengthening the AML/CFT and anti-corruption frameworks. ### Recent Developments - FY2022: real GDP estimated to have declined by 2 percent (July 2021–June 2022) due to the HTHH disaster. - FY2023: real GDP rebounded by 2.6 percent. - Reconstruction progress uneven; many tourism-related facilities remain damaged. - Reconstruction hampered by labor shortages (including higher foreign demand from seasonal worker programs in Australia and New Zealand) and higher-than-anticipated construction material costs. - IMF Rapid Credit Facility (RCF) emergency financing in July 2022: 50 percent of quota, equivalent to about US$9 million; Tonga’s outstanding RCF balance stands at 100 percent of quota (first RCF disbursement approved in January 2021, 50 percent of quota). ### Inflation, External Sector, and Reserves - Headline inflation: peaked at 14.1 percent in September 2022; trended down to 2.9 percent in August 2023. - Core inflation: 8.8 percent in August 2023. - Contributions to core inflation in FY2023 from transport services and hotels and restaurants. - Current account deficit (CAD): estimated to have widened from 6.3 percent of GDP in FY2022 to 7.9 percent in FY2023. - FX reserves and import cover: reserves increased in FY2023; import cover strengthened to 10.9 months, supported by official capital transfers and the IMF’s RCF disbursement. ### Credit and Banking Sector - Bank credit growth turned positive since September 2022, reaching 7.5 percent (y/y) in May 2023. - Bank lending to businesses: 15.3 percent growth (sectoral strength in professional and other services, distribution, construction). - Household lending: 1.6 percent growth, with around 80 percent directed towards housing. - Government Development Loan (GDL) scheme: subsidized interest rate loans supporting lending to small businesses and low-income households. ### Outlook and Risks - FY2024 growth projected at 2.5 percent, underpinned by public investment. - Tourism receipts as share of GDP expected to remain below pre-pandemic levels until FY2026 due to slow reconstruction. - Remittances projected to decline from an estimated 43.7 percent of GDP in FY2023 to 39.2 percent in FY2024. - Average inflation projected at 5.8 percent in FY2024—above the National Reserve Bank of Tonga’s (NRBT’s) reference rate of 5 percent. - Medium-term long-run growth projected at 1.2 percent, reflecting exposure to frequent natural disasters, emigration-driven labor losses, and limited economies of scale. - FX reserve coverage projected to stabilize at about 10½–11 months of imports, above NRBT’s target of 7½ months, supported by external financing. - Risks tilted to the downside: - Continued strong foreign demand for Tongan workers could increase inflation risks and slow reconstruction. - A sharp rise in global commodity prices could intensify inflation, erode real purchasing power, and widen the CAD. - A major natural disaster could derail recovery, strain public resources, and raise banking sector asset quality risks. - Loss of correspondent banking relationships (CBRs) related to AML/CFT weaknesses could disrupt transfers and remittances. - Upside: tourism could recover faster if pent-up demand is stronger-than-expected. ### Debt and Debt-Related Risks - Tonga assessed at high risk of debt distress (DSA Annex). - Without additional grant commitments to staff’s baseline projection, the PV of external and public debt-to-GDP ratios projected to rise and reach above the 55 percent threshold and the 70 percent benchmark, respectively, in FY2033. - Debt obligations largely external; over half of external debt to China Exim Bank. - Debt repayments expected to surge in FY2024, mainly to Exim Bank, and stay elevated at over 3 percent of GDP until FY2027. ### Authorities’ Views - Authorities broadly agreed with staff’s outlook and risks. - Near-term recovery expected to be driven by major government construction projects, sustained remittances, and agricultural rebound. - Authorities noted several one-off developments (expiration of school fee waiver, resumption of large social events after border reopening) have contributed to high domestic inflation. - Supply-side bottlenecks from worker outflows and damaged accommodation facilities expected to persist and constrain long-term growth potential. ### Policy Guidance Summary - Macroeconomic policy should aim to simultaneously support reconstruction and tackle inflation: - Monetary policy: prioritize safeguarding price stability. - Fiscal policy: provide ample financial support to the vulnerable and postpone non-urgent spending while supporting reconstruction. - All-government effort required to balance the dual objectives; delays in reconstruction and persistently high inflation would incur substantial welfare costs, especially for low-income households and small businesses. *Source: EXECUTIVE SUMMARY, 1tonea2023001* ### 13. The fiscal balance continued to improve in FY2023. Despite the HTHH disaster, the ### 13. The fiscal balance continued to improve in FY2023. Despite the HTHH disaster, the ### Fiscal outcomes and near-term outlook - Primary deficit declined from 0.6 percent of GDP in FY2021 to 0.2 percent in FY2022, reflecting lower-than-targeted reconstruction expenditures due to capacity constraints and COVID-19-related mobility restrictions. - Primary fiscal balance is expected to have shifted to a surplus of 1.0 percent in FY2023, as a pickup in external grants—including a large one-off budget support from Australia in FY2023—more than offset increased reconstruction-related expenditures. - Based on the authorities’ FY2024 budget and IMF staff’s forecasts, the primary balance is expected to revert to a deficit of 6.3 percent of GDP in FY2024 as HTHH-related external grants unwind and implementation of public reconstruction projects gathers momentum. - Authorities have phased out most pandemic- and HTHH-related tax exemptions and plan to gradually normalize current spending, including by limiting the public sector wage bill. - Planned top-up of the GDL fund under the current budget intended to help the vulnerable maintain access to credit at affordable costs under tighter monetary policy. ### Medium- and long-term fiscal risks and required adjustments - Baseline projects the primary fiscal deficit to widen further in the long term, primarily reflecting a decline in committed grants and sizable spending needs to achieve Tonga’s SDGs and climate resilience objectives. - Implementation of development spending is predicated on sustained TA and skill transfers from development partners. - Fiscal adjustments recommended to address deterioration in debt dynamics: - Gradual increases in tax revenues. - Further reductions in the public wage bill and other current expenditures. - Government’s plan to refrain from new non-concessional borrowing would help reduce Tonga’s risk of debt distress. ### Illustrative alternative scenario (FY2025–FY2033) — key numeric inputs and impacts (Text Table 1) - Domestic fiscal measures (deviation from baseline, in percentage points of GDP): - FY2025: 0.8 - FY2026: 1.6 - FY2027: 2.4 - FY2028: 3.2 - FY2029–FY2033: 3.7 each year (FY2029–FY2033) - Components of domestic measures (in percent of GDP): - Better VAT compliance: 0.5 each year FY2025–FY2033 - Less tax exemptions: FY2025 0.5; FY2026 1.0; FY2027 1.5; FY2028 2.0; FY2029–FY2033 2.0 each year - Lower G&S: -0.3 in FY2025; -0.6 thereafter (FY2026–FY2031 shown) - Lower public sector wage bill: -0.3 in FY2025; -0.6 FY2026–FY2033 - Additional Grants (deviation from baseline, percent of GDP): 2.0 in FY2025; 3.0 each year FY2026–FY2033 - Change in primary balance (deviation from baseline, percent of GDP): - FY2025: 0.8 - FY2026: 3.6 - FY2027: 5.4 - FY2028: 6.2 - FY2029–FY2033: 6.7 each year - Impact on GDP growth (percentage point impact, deviations): - Without additional reform: FY2025 -0.3; FY2026 -0.3; FY2027 -0.1; FY2028 -0.1; FY2029–FY2033 0.0 - With additional reform: FY2025 -0.3; FY2026 -0.2; FY2027 0.0; FY2028 0.1; FY2029 0.2; FY2030 0.3; FY2031 0.4; FY2032 0.4; FY2033 0.5 - Impact on inflation (percentage point impact): - Without additional reform: FY2025 -0.2; FY2026 -0.2; FY2027 -0.1; FY2028 -0.1 - With additional reform: FY2025 -0.2; FY2026 -0.2; FY2027 -0.1; FY2028 -0.1 - Memo: Projected primary balance w/ adjustment (in percent of GDP) — entries shown include: - FY2025 -7.2; FY2026 -5.4; FY2027 -4.6; FY2028 -5.2; FY2029 -5.0; FY2030 -4.1; FY2031 -3.3; FY2032 -1.5; FY2033 0.0 - Debt outcomes under the illustrative scenario: - PV of public debt-to-GDP ratio stabilizes below the 70 percent threshold over the long term, even with a multi-year growth shock. - PV of external debt-to-GDP ratio stabilizes below the 55 percent benchmark under this scenario. - Growth effects can be partly offset by reforms that enhance public investment efficiency. ### Reforms to support fiscal adjustments - Revenue administration and compliance: - Ongoing rollout of the Electronic Sales Register System expected to improve revenue compliance and reduce administrative burden. - Public financial management and transparency: - Planned amendments to the PFM Act to improve fiscal transparency, budget allocation alignment with national economic objectives, and medium-term budget processes. - Tax exemptions governance: - Reduce tax exemptions and strengthen governance for granting new exemptions by setting clear eligibility criteria, limited timeframes, and allowing the Minister of Finance to have ultimate authority to grant exemptions in government. - Procurement transparency: - Fully deliver on commitment under the IMF’s RCF to publish pandemic-related procurement contracts with information on beneficial ownership. ### Authorities’ views on fiscal priorities - Prioritize reconstruction and social protection in the near term while continuing fiscal reforms for long-term public finance strengthening. - Expect post-disaster reconstruction and renewable energy projects to pick up speed in FY2024. - FY2024 budget includes new social protection initiatives (free school breakfasts; affordable housing for low-income households). - Plan to rationalize overtime pay (overtime constituted about 13 percent of total public sector payroll in FY2022) and expand stricter overtime policy to all ministries. - Committed to revenue mobilization through the electronic sales register system, reviewing tax exemptions, and reassessing government fees and charges. - Remain committed to seeking new grant financing from development partners to keep debt on a sustainable path. ### Monetary policy actions and recommendations - NRBT measures taken in 2023: - Increased statutory reserve deposit (SRD) ratio from 10 to 15 percent in February 2023. - Maintained policy rate (interest rate on excess bank reserves) at zero percent. - Established deposit facility for retirement funds in February 2023 to help absorb banking system liquidity. - Effects to date: - Measures have helped absorb sizable banking system liquidity and led to more active liquidity management by some banks, but have yet to meaningfully affect aggregate demand or bank lending due to still abundant liquidity. - Further actions recommended to contain underlying inflation pressures: - Increase the policy rate from the current zero percent level, possibly combined with a further hike in the SRD ratio. - Consider resuming issuance of NRBT notes (suspended since 2009) to provide a market-based instrument to absorb excess liquidity. - Clarify operational guidelines for transfer of profits, coverage of losses, and recapitalization to manage sterilization costs and preserve NRBT financial health and operational independence. ### Assessing underlying inflation (Box 1) — key facts and empirical findings - Structural factors: - Imported goods account for 55.1 percent of the household consumption basket. - Core inflation represents 44.2 percent of the CPI basket. - Recent indicator values: - Main core remained elevated at 8.8 percent in August 2023. - The median of indicators has not cooled below the NRBT’s reference rate of 5 percent (peaked in August 2022). - Empirical results (local projection method by Jorda (2005); Stock and Watson (2016) indicators): - A one percentage point increase in the NEER (appreciation) decreases underlying inflation by 0.15 percentage point at the time of the shock. - After controlling for NEER, global commodity price shocks have either insignificant or deflationary impacts on underlying inflation. - Domestic shocks: - Electricity consumption: a one percentage point electricity consumption shock raises year-on-year underlying inflation by 0.04 percentage points contemporaneously, with the impact three times larger one year later. - Credit to the private sector has inflationary effects. - Vehicle registration and agricultural production appear to have insignificant impacts. - Conclusion: Underlying inflation pressures stay high and persistent; further monetary tightening is warranted to prevent high inflation expectations from becoming entrenched. ### NRBT safeguards and views - Progress since 2021 safeguards assessment: - NRBT Board has been fully constituted and committed to strengthening independent oversight of internal controls. - Drafting amendments to the NRBT Act to strengthen central bank autonomy is underway with IMF TA support. - Authorities’ perspective: - Recognize need for additional monetary measures to tackle inflation risks, while ensuring careful calibration to avoid undue output costs during recovery. - Emphasize complementary role of fiscal policy in managing inflation via targeted support measures and tax rate adjustments. - Note that reserves remain at adequate levels owing to continued inflows of grants and remittances, important given vulnerability to natural disasters and anticipated increase in external debt repayments to China Exim Bank. *Sources: Tongan authorities; and IMF staff calculations.* ### 25. Systemic risks appear modest overall, with the banking sector remaining well ### Systemic risks appear modest overall, with the banking sector remaining well capitalized and liquid ### Banking-sector soundness: key findings - System-wide capital adequacy ratio: around 35 percent in 2023Q1, well above the regulatory requirement (15 percent). - Banking profitability: banks remain profitable, although the average return on assets is below pre-pandemic levels and others in the region as of end-FY2022. - System-wide liquidity: excess reserves standing at a sizable 30.2 percent of GDP as of April 2023 despite the NRBT’s recent mop-up measures. ### Asset quality risks and non-performing loans (NPLs) - NPL ratio: increased from 3.6 percent at end-2021 to 7.4 percent in 2023Q1. - Sectoral dynamics: - Business and household NPLs both climbed; business NPLs grew more rapidly, led by distribution and construction. - The share of household NPLs in total NPLs declined; housing loans account for over 75 percent of household NPLs. - NPL coverage ratio: declined from 141.3 percent at end-2021 to 99.3 percent in 2023Q1. - NBFIs: lending by non-bank financial institutions (NBFIs) accounts for around 20 percent of total credit; retirement funds are major NBFI lenders, and their loans are secured against borrowers’ retirement balances. - Assessment: current level of NPLs appears manageable given existing financial buffers, but capacity to sustain another severe shock without disrupting bank credit has likely weakened. - Data limitations: lack of detailed published data on NBFIs constrains a definitive assessment. ### Policy recommendations to address NPLs and strengthen supervision - Supervisory actions: - Conduct more intrusive oversight for banks with relatively higher NPLs, possibly through more frequent and detailed regulatory reporting, intensified on-site supervision, and restrictions on dividend payments if needed. - NRBT should continue to conduct regular stress tests to ensure banks maintain sufficient capital to absorb potential losses. - Enhance risk-based supervision and broaden NRBT’s regulatory and supervisory remit to cover NBFIs (including pension funds and insurance companies). - Prudential standards and provisioning: - Require banks to adopt a more conservative approach to provisioning, including for secured loans and overdue non-NPL loans. - Request banks to prepare and submit concrete plans to address NPLs, including operational targets (e.g., reducing NPLs to a target level over a specific time window and maintaining provisioning above a minimum threshold). - Strengthen prudential standards and regulations (e.g., for credit unions and those related to provisioning). - Data and capacity building: - Avoid frequent staff turnover and expand the scope and increase the frequency of relevant data collection, with support from ongoing IMF technical assistance (TA) in these areas. - NRBT initiative to set up a local credit registry is welcome and should be expanded to include NBFIs to capture all loans extended to individual borrowers. ### Financial deepening, inclusion, and payments infrastructure - NRBT actions: - Implement plan to expand the Domestic Electronic Payment System to include the government and NBFIs. - Continue the initiative to set up a local credit registry, eventually expanded to NBFIs. - Financial literacy and inclusion: - Strengthen efforts to tackle low financial literacy, including financial education in schools and engagement with local communities. - Leverage the government’s ongoing digitalization initiative (¶32) to foster financial inclusion. - Complementary reforms: - Customer due diligence facilitation and support for creating credit histories can foster inclusion. ### AML/CFT framework - Risk environment: - Tonga faces elevated risks of losing correspondent banking relationships (CBRs), including due to gaps in the AML/CFT framework and low profitability of overseas correspondent banks. - Ongoing measures: - Adoption of an IT system to strengthen the analytical capacity of the Financial Intelligence Unit. - NRBT is seeking to amend the AML/CFT law to address gaps identified by the Asia Pacific Group on Money Laundering (APG) in the Mutual Evaluation Report, with ongoing IMF TA. ### Authorities’ views on financial stability measures - Authorities concurred with staff’s assessment and recommendations aimed at safeguarding financial stability. - Measures already implemented to tackle high NPLs include: - More frequent and intensive monitoring. - Re-evaluation of collaterals by banks. - Directives to limit problematic exposures and diversify risks. - Sensitivity analysis to assess NPL impacts on capital adequacy. - NRBT reforms underway: - Revising prudential banking standards related to credit risks and implementing IFRS 9, supported by PFTAC TA. - Broadening NRBT’s regulation to cover pension funds and insurance companies, with TA from the World Bank and ADB on relevant legislation. --- ### Structural reform: disaster resilience and climate change - Priority: Enhancing resilience to natural disasters and climate change is a top reform priority. - Key measures: - Disaster Risk Management Act of 2023 shifts focus from ex-post responses to proactive ex-ante risk mitigation and preparedness, improving coordination across ministries and management of scarce resources. - Expand classification of climate change-related spending and strengthen the social protection system. - Ongoing PFM reform and initiative to establish a national database of households eligible for social protection benefits. - Stricter enforcement of the Building Code, especially for residential properties, and facilitating relocation to safer grounds; allocate adequate fiscal resources to support these measures. ### Private sector development, digitalization, and labor market - Digitalization: - Ongoing efforts to launch a national digital ID system are significant and can create synergies with social assistance delivery and credit access (¶32). - To reap full benefits: reinforce with a government-wide drive to reduce paper-based administration and invest in ICT infrastructure to improve internet coverage and quality. - Other priority reforms: - Increase government spending on education and training to reduce skill mismatch given continuing worker outflows. - Cut red tape hindering private sector investment, especially by improving land leasehold administration efficiency (e.g., adoption of IT systems). - Relax foreign ownership restrictions in certain industries; Foreign Investment law (October 2020) and regulations (2021) removed inward investment restrictions for non-residents in 10 industries/activities such as retail, education, and health. - Gender and labor market: - Temporary worker programs in Australia and New Zealand estimated to have hired about 11 percent of Tonga’s working-age population as of mid-2022, predominantly male workers. - Measures to increase female labor force participation: strengthen government support for early childhood education and childcare services; allow more flexible work arrangements (e.g., work from home); enact the pending Employment Relations Bill requiring employers to implement sexual harassment policies. ### Macroeconomic statistics capacity - Challenge: Severe capacity constraints in producing timely macroeconomic statistics; delays in publishing core data like national accounts and external sector statistics. - Recommendations: - Enforce data sharing and cooperation requirements under current law; allocate additional fiscal resources to retain, hire, and train staff in critical areas. - Publish key macroeconomic and financial data regularly through a National Summary Data Page at the IMF website as part of participation in the Enhanced General Data Dissemination System (e-GDDS). - Authorities’ view: Agreed that strengthening capacity for accurate and timely macroeconomic statistics is a top priority and called for closer inter-agency cooperation and data sharing. --- ### Staff appraisal: summary of main macro-financial assessments and policy directions - Economic performance and headwinds: - Tonga’s economy is performing strongly but faces growing headwinds: rebound after border reopening in August 2022 led by reconstruction projects, sustained remittances, and pickup in tourist arrivals. - Severe labor shortages due to worker migration and damaged tourism facilities are increasingly binding and contributing to high and persistent inflation pressures. - External position and reserves: - External position in FY2023 was broadly in line with fundamentals and desirable policy settings. - Current account deficit (CAD) estimated to have widened in FY2023 due to higher import needs for reconstruction-related capital goods. - FX reserves continued to increase, supported by official capital transfers and the RCF disbursement in July 2022. - Fiscal policy: - Current expansionary fiscal stance is appropriate to expedite reconstruction and protect the vulnerable. - Under the authorities’ FY2024 budget, the primary balance for FY2024 is expected to revert to a deficit, reflecting lower external grants and continued reconstruction projects. - Policy guidance: focus budget execution on priority areas such as reconstruction and social protection; postpone non-urgent spending given limited administrative capacity and inflation pressures. - Medium-term: Tonga assessed as being at high risk of debt distress without new grant commitments; sizeable external debt repayments in coming years would further strain public finances. - Recommendation: gradual fiscal adjustments over the medium term involving additional tax revenue mobilization and reductions in current expenditures, plus securing grants in line with historical levels; enhance spending efficiency and fiscal transparency. - Monetary policy: - Further monetary policy tightening warranted to contain inflation pressures. - Despite an increase in the SRD ratio and other early-2023 measures, banking system liquidity remains abundant, limiting impacts on lending and aggregate demand. - Policy recommendations: tighten policy further including increasing the policy rate, combined with additional liquidity absorption measures; resume issuance of NRBT notes and strengthen NRBT’s operational independence to foster financial market development and improve the monetary policy framework. - Current currency arrangement: the currency basket-weight system has served Tonga well. - Financial stability: - More proactive measures required to tackle asset quality risks: require banks to adopt more conservative provisioning and submit concrete NPL reduction plans; NRBT to enhance risk-based supervision and broaden remit to cover NBFIs. - Structural reforms: - Comprehensive reforms to enhance climate resilience and nurture private sector are essential to boost low growth potential. - Stricter enforcement of Building Codes and facilitating relocation to safer grounds would enhance disaster resilience. - Reduce gender inequality and augment public investment in training and education to tackle labor shortages. - Accelerate digital adoption in public administration, continue efforts to cut red tape, and strengthen AML/CFT framework. - Allocate ample fiscal resources to ensure timely and reliable macroeconomic statistics. *Source: IMF staff analysis and recommendations as presented in the provided content.* ### 43. It is recommended that the next Article IV consultation for Tonga take place on a ### 1tonea2023001 - 43. It is recommended that the next Article IV consultation for Tonga take place on a ### Article IV timing recommendation - It is recommended that the next Article IV consultation for Tonga take place on a standard 12-month cycle. ### Real sector: developments and projections - Recovery led by construction and tourism-related services. - Labor market has strengthened significantly. - Electricity consumption has been strong; agricultural production has yet to show signs of a sustained rebound. - Tourists are returning after the border reopening in August 2022. - Real GDP (Est./Proj.): FY2021 -2.7; FY2022 -2.0; FY2023 2.6; FY2024 2.5; FY2025 2.2. - Consumer prices (period average): FY2021 1.4; FY2022 8.5; FY2023 10.2; FY2024 5.8; FY2025 4.1. - Consumer prices (end of period): FY2021 6.9; FY2022 11.3; FY2023 7.4; FY2024 6.2; FY2025 3.2. - NRBT Reference Rate: 5%. ### External sector: developments and projections - Donors’ aid expected to moderate post-pandemic; external grants decline from exceptional pandemic levels. - Trade deficits remain large due to rebuilding needs. - Increase in travel receipts is expected to be more than offset by moderation of remittances and grants, contributing to widening of the current account deficit in FY2024. - Current account balance (in millions): FY2021 -24.7; FY2022 -31.5; FY2023 -43.0; FY2024 -41.0; FY2025 -45.0. - Current account balance (In percent of GDP): FY2021 -5.2; FY2022 -6.3; FY2023 -7.9; FY2024 -7.1; FY2025 -7.4. - Remittances (in percent of GDP): FY2021 46.2; FY2022 43.4; FY2023 43.7; FY2024 39.2; FY2025 37.0. - Tourism receipts (in millions): FY2021 9.1; FY2022 9.6; FY2023 35.6; FY2024 50.9; FY2025 58.5. - Gross official foreign reserves (millions of U.S. dollars): FY2021 317.9; FY2022 375.5; FY2023 388.1; FY2024 401.4; FY2025 409.2. - Reserves in months of next year's total imports: FY2021 11.7; FY2022 10.3; FY2023 10.9; FY2024 10.9; FY2025 10.8. - Real effective exchange rate has appreciated recently due to both nominal appreciation and high inflation. ### Monetary sector: developments and outlook - Monetary policy was tightened in February 2023. - Stock of broad money is expected to remain largely unchanged. - Net domestic assets and net foreign assets both expected to increase marginally. - Liquidity in the banking system decreased due to recent tightening but remains high. - Credit to the private sector is picking up; loan-to-deposit ratio has been low due to an increase in total deposits. - Broad money (M2) annual percent change: FY2021 25.0; FY2022 13.4; FY2023 -0.1; FY2024 4.5; FY2025 3.4. - Credit to private sector (year-on-year percentage point): FY2023 Est. 6.4; FY2024 Proj. 5.9; FY2025 Proj. 4.3. - Excess Reserve Ratio and Central Government Demand Deposits in Commercial Banks: central government demand deposits and excess reserve ratio trends shown to rise through Jan-23. ### Fiscal sector: developments, projections, and fiscal anchors - Primary fiscal balance expected to deteriorate in FY2024. - Tax revenues expected to gradually recover in the short term. - Current expenditure expected to stay elevated in the short term to support reconstruction. - Existing capital grants expected to cover increased post-HTHH capital expenditure needs. - Public debt has risen since the pandemic, while external debt remains below the fiscal anchor. - Central government finance (In percent of GDP): - Total Revenue: FY2021 48.3; FY2022 45.2; FY2023 47.7; FY2024 41.6; FY2025 37.6. - Grants (of Total Revenue): FY2021 22.4; FY2022 19.0; FY2023 24.4; FY2024 17.0; FY2025 12.9. - Total Expenditure: FY2021 49.3; FY2022 45.9; FY2023 47.4; FY2024 48.3; FY2025 46.1. - Overall balance: FY2021 -1.0; FY2022 -0.7; FY2023 0.4; FY2024 -6.8; FY2025 -8.5. - Primary balance: FY2021 -0.6; FY2022 -0.2; FY2023 1.0; FY2024 -6.3; FY2025 -8.0. - Domestic revenue (in percent of GDP) fiscal anchor = 22%; Actual FY2021 25.9; FY2022 26.2; FY2023 23.3; FY2024 24.6; FY2025 24.7. - Public debt (total, external and domestic) as percent of GDP: FY2021 47.8; FY2022 45.4; FY2023 41.2; FY2024 45.4; FY2025 51.6. - External debt (percent of GDP): FY2021 41.2; FY2022 39.4; FY2023 37.2; FY2024 38.0; FY2025 43.9. - Fiscal anchor on external debt = 50 percent of GDP. ### Financial sector: developments and risks - Capital buffers are comparable to the PIC average. - Bank income continues to rely on net interest income (58% in 2020). - Interest rate spreads remain wide; banks remain profitable despite a slight decline in profitability. - Non-performing loans increased notably in FY2022 and FY2023. - Selected financial soundness indicators: - Return on Assets (FY2022): 2.2 (FY2023 1/ quarter: 2.2). - Non-performing Loans to Total Gross Loans: FY2016 6.7; FY2017 4.1; FY2018 3.6; FY2019 3.2; FY2020 4.1; FY2021 3.3; FY2022 6.3; FY2023 8.0. - Residential Real Estate Loans to Total Loans: recent level around 40.3 percent (2015–2023 series). - Capital Adequacy Ratio: FY2012–FY2023 series shows FY2023 around 12–14 range compared to PIC average. ### Key balance of payments and medium-term indicators - Balance of payments projections (selected): - Trade balance (millions): FY2021 -198.2; FY2022 -199.8; FY2023 -279.4; FY2024 -267.3; FY2025 -275.8. - Exports f.o.b. (millions): FY2021 16.2; FY2022 15.1; FY2023 16.3; FY2024 18.4; FY2025 19.6. - Imports f.o.b. (millions): FY2021 -214.5; FY2022 -214.9; FY2023 -295.7; FY2024 -285.7; FY2025 -295.4. - Medium-term baseline macro projections (FY2025–FY2028) incorporate average long-term effects of natural disasters and climate change from FY2025 onwards. - Nominal GDP (millions of US$): FY2021 470.5; FY2022 497.6; FY2023 547.2; FY2024 581.1; FY2025 607.4. *Source: IMF staff estimates and projections contained in the Tonga country chapter.* ### 8. Decent Work & Economic Growth10. Reduce Inequalities ### 8. Decent Work & Economic Growth10. Reduce Inequalities ### Recommendations from the 2022 Article IV Consultation — Key Actions and Follow-up - Fiscal Policies - Findings/recommendations: - "A combination of domestic fiscal measures and additional donor support is needed to meet large development spending needs while reducing the risk of debt distress." - Continue reform efforts to broaden the tax base and improve spending efficiency. - Manage debt repayment to the China EXIM Bank. - Actions since 2022 Article IV Consultation: - The authorities pursued additional grants from development partners and received additional budget support from Australia. - The Electronic Sales Register System regulations were gazetted in June 2022. By March 2023, 54 business across 163 outlets in Tongatapu and Vava’u have been registered onto the system. The authorities expect more than 200 businesses to be registered by end FY23. - The government has set up a Debt Repayment Sinking Fund to facilitate timely repayments of the China EXIM Bank loans. - Monetary Policy - Recommendation: Tighten monetary policy stance if inflation is expected to stay above the reference rate for longer. - Actions: The NRBT increased the statutory reserve deposit (SRD) ratio from 10 to 15 percent and established a deposit facility in February 2023. - Financial Sector Policies - Recommendations: - Improve financial supervision and develop a macroprudential policy framework. - Support credit and promote financial deepening and inclusion. - Actions: - With assistance from the PFTAC, the NBRT is working on developing/reviewing regulatory and supervisory frameworks for non-banking credit institutions and foreign exchange dealers. - Authorities continue to support lending to micro-, small-, and medium-sized enterprises (MSMEs) and low-income households, including subsidized interest rate loans under the Government Development Loan scheme. - Structural Policies - Recommendations: - Enhance resilience to natural disasters and climate change. - Develop the private sector to boost Tonga’s long-term growth potential. - Continue to reinforce the AML/CFT framework. - Actions: - Reconstruction projects under a comprehensive plan are being implemented and the Disaster Risk Management Act was enacted in 2023 focusing on ex-ante disaster preparedness. - Authorities are promoting digitalization including efforts to launch a national digital ID system. - Tonga advanced on amending AML/CFT legislation with IMF technical assistance; draft amendments and implementing regulations are expected to be submitted to Parliament in late 2023. The NRBT has established a dedicated unit to strengthen AML/CFT supervision and enhance regional collaboration. ### Integration Matrix of Surveillance Issues and Capacity Building (selected items) - Fiscal Sector - Public Financial Management: √√√√√√ - Expenditure framework: √√√√√ - Revenue Framework: √√√√ - Real and Macro-Financial Sectors - Macroeconomic Frameworks: √√ - Financial supervision and regulation: √√√√√ - Financial market development: √√√√√√ - AML/CFT: √√√ - Macro-Structural Issues - Infrastructure: √√√√√ - Private sector development: √√√√ - Governance issues: √√√√√ - Poverty/Gender/Inequality: √√√ - Climate change: √√√√√ - Natural disaster management: √√√√√ - Financial Inclusion: √ - Gender: √√√√ - Labor markets: √√ - Business climate: √√ - Statistics - Data Enhancement: √√√ ### External Sector Assessment — Overall Findings and Policy Responses - Overall Assessment - "Tonga’s external position in FY2023 was broadly in line with the level implied by fundamentals and desirable policy settings, based on the results of the IMF’s EBA-lite current account model." - Potential Policy Responses - Strengthening public finances and promoting private sector development, together with continued strong financial support from development partners, would help preserve external sector stability amid large development spending needs. ### Foreign Assets, Liabilities and Debt Dynamics - Background and current stock - "Tonga’s debt obligations are largely external, and over half of its external public debt is to China, with a sharp spike in debt repayments due from FY2024 onwards." - "Total public and publicly guaranteed (PPG) external debt stood at about 38 percent of GDP as of end FY 2022, accounting for 86 percent of total public debt." - "Outstanding debt to all multilateral creditors stood at about 16 percent of GDP, or about 43 percent of the total external debt stock." - Assessment - "New external borrowing is expected to commence in FY2025 and to gradually increase over the medium term due to debt repayments and high primary deficits." ### Current Account (CA) — Developments and Model-Based Assessment - Historical and FY2023 developments - From FY2014 to FY2022, Tonga’s current account (CA) deficit averaged about 6 percent of GDP. - "The current account deficit is estimated to widen from 6.3 percent of GDP in FY2022 to 7.9 percent of GDP in FY2023." - The CA deficit is projected to narrow slightly in FY2024, reflecting continued tourism recovery and lower good imports partially offset by declines in official grants and private remittances. - EBA-lite estimates and assessment (FY2023, in percent of GDP) - CA-Actual: -7.9 - Cyclical contributions (from model): (-)0.5 - COVID-19 adjustors: (-) 2/-0.9 - Natural disasters and conflicts: (-)0.7 - Adjusted CA: -8.2 - CA Norm (from model, cyclically adjusted): -8.2 - Adjusted CA Norm: -8.2 - CA Gap: 0.0 - o/w Relative policy gap: 2.6 - Elasticity: -0.3 - REER Gap (in percent): -0.1 - Assessment note - "With a gap close to 0, the external position in FY2023 is assessed to be broadly in line with medium-term fundamentals and desirable policies." ### Real Exchange Rate (REER) — Developments and Assessment - Background and performance - The Tonga pa’anga exchange rate is determined by a weighted basket of the US dollar, Australian dollar, New Zealand dollar, and Fijian dollar; basket weights last reviewed in February 2023. - "The REER appreciated by about 8.9 percent on average in FY2023 (July 2022-June 2023), reflecting the appreciation of the NEER by about 4.9 percent and Tonga’s higher inflation compared with its major trading partners." - Assessment caveats - Large uncertainty due to: (i) official BOP data for FY2023 not yet published; (ii) unusually large expected changes in grants, tourism receipts, and remittances; (iii) recent inflation developments affecting CA and REER. ### Capital and Financial Accounts — Flows and Policy Measures - Background - Recent CA deficits have been largely financed by project support grants and grants in-kind. - The Foreign Investment Act 2020 reduced restrictions and opened sectors such as tourism, fisheries, and agriculture, but FDI inflows remain limited because of structural impediments (land leasehold operations, regulatory barriers). - Recent external borrowings have been limited and exclusively concessional, including the IMF’s RCF disbursed in FY2021 and FY2023. - Assessment and policy advice - Authorities’ efforts to pursue additional grants and avoid new non-concessional external borrowing are appropriate to help strengthen reserves. - Ongoing reform to promote FDI, including reducing market entry barriers, is encouraged. ### FX Intervention and Reserves — Levels, Adequacy, and Risks - Reserve levels and drivers - Gross official reserves were US$388 million (about 10.9 months of the following year’s imports) in FY2023, compared to US$375.5 million (10.3 months of imports) in FY2022. - Reserves remained comfortable due to inflows of grants, remittances, and tourism recovery; medium-term pressures include moderation in remittances, lower grants after commitments are met, and rising debt repayments. - Optimal reserve assessment (staff analysis tailored for small credit-constrained economies) - A cost-benefit analysis suggests an optimal level between 4½ and 7½ months of imports. - If large shock probability equals the sample average of 50 percent, estimated optimal level would be 4½ months of imports. - Incorporating Tonga’s high vulnerability to natural disasters raises the estimated adequate level to about 7½ months of imports. - "Additional reserve buffers may be needed to cover the pickup in debt repayments from FY2024 onwards, mostly due to China Exim Bank." - IMF staff estimates — International Reserve Adequacy Metric (FY2023) - Actual Reserves (months of prospective imports): 10.9 - Optimal level with standard shock probability: 4.6 - Optimal level with higher shock probability: 7.3 - Optimal level taking into account debt repayment: 8.0 - Broad Money coverage: 283% *Sources: Tongan authorities; and IMF staff estimates.* ### Annex IV. Risk Assessment Matrix ### Annex IV. Risk Assessment Matrix ### Overview: RAM purpose and likelihood definitions - The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). - The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, "medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). - The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. - Non-mutually exclusive risks may interact and materialize jointly. ### Global risks — findings and policy recommendations - Commodity price volatility - Likelihood: High - Expected Impact: Medium-High. If prices increase, a larger import bill and current account deficit, leading to lower FX reserves; higher inflation and weaker private consumption due to lower real income; delays in reconstruction or investment projects if wage inflation pressures or construction material prices increase. - Policy Recommendation: - Provide targeted fiscal support to the vulnerable. - Monetary policy should be tightened using the NRBT’s usual monetary policy instruments if strong second-round effects materialize. - Prioritize public investment in the most necessary projects. - In the long-term, increase public investment to expand the productive capacity. - Abrupt global slowdown or recession - Likelihood: Medium - Expected Impact: Medium-High. Weaker remittance and grant inflows; slower recovery in tourism; lower foreign demand for agricultural products; lower fiscal revenue. - Policy Recommendation: - Provide targeted fiscal support to the vulnerable. - Improve the private sector business climate and diversify the economy. - In the long-term, increase public investment to expand the productive capacity. - Accelerate the reforms aimed at broadening the tax base and improving spending efficiency. - Footnotes related to global risks: - 1/ A succession of supply disruptions (e.g., due to conflicts, uncertainty, and export restrictions) and demand fluctuations causes recurrent commodity price volatility, external and fiscal pressures in EMDEs, contagion effects, and social and economic instability. - 2/ Global and idiosyncratic risk factors combine to cause a synchronized sharp growth downturn, with recessions in some countries, adverse spillovers through trade and financial channels, and market fragmentation causing sudden stops in EMDEs. ### Domestic risks — findings and policy recommendations - Extreme climate events - Likelihood: High - Expected Impact: High. Disruptions in economic activity; lower GDP growth; amplifying inflationary pressures; damages to properties and infrastructure, resulting in lower growth potential; larger fiscal burden and public debts. - Policy Recommendation: - Prioritize ex-ante adaptation investment and ex-post expenditure to support the affected households. - Strengthen the monitoring of potential asset quality problems in the banking sector. - Strengthen fiscal buffers by accelerating reforms to mobilize additional revenues. - Footnote: - 3/ Extreme climate events driven by rising temperatures cause loss of human lives, severe damage to infrastructure, supply disruptions, lower growth, and financial instability. - Acceleration of outward migration - Likelihood: High - Expected Impact: Medium-High. Higher inflation pressures owing to tighter domestic labor market; lower long-term growth due to increased difficulties in expanding the narrow domestic production base. - Policy Recommendation: - Create economic opportunities by developing the small private sector, attracting FDI, and diversifying the economy. - Enhance education and skill development. - Higher or more persistent inflation - Likelihood: Medium - Expected Impact: High. Lower private consumption that results in decreased real purchasing power if wages adjust with significant lags; wage-price spiral accompanied with de-anchored inflation expectations. - Policy Recommendation: - Monetary policy should be tightened using the NRBT’s usual monetary policy instruments. - Provide targeted fiscal support to the low-income households. - Partial withdrawal of CBRs, including due to gaps in the AML/CFT framework - Likelihood: Medium - Expected Impact: High. Lower remittance inflows, leading to weaker private consumption and a larger current account deficit. - Policy Recommendation: - Strengthen the AML/CFT framework and enhance the implementation, including by improving risk-based supervision and enforcement in line with the Asia-Pacific Group assessment. - Further increase in non-performing loans (NPLs) - Likelihood: Medium - Expected Impact: Medium. Lower lending activities or tighter lending conditions, resulting in lower GDP growth. - Policy Recommendation: - Consider requesting banks to prepare a comprehensive plan to tackle NPLs, including with a minimum target provisioning level. ### Cross-cutting policy emphasis - Recurrent recommendations across risks include: - Targeted fiscal support to vulnerable households when shocks materialize. - Use of NRBT’s usual monetary policy instruments to tighten policy when inflation or second-round effects materialize. - Prioritization and scaling up of public investment to expand productive capacity and climate resilience. - Structural reforms to broaden the tax base, improve spending efficiency, diversify the economy, and strengthen the business climate. - Strengthening institutional frameworks (e.g., AML/CFT, banking supervision, fiscal reporting) to mitigate risks to external flows, financial stability, and debt dynamics. *Source: Annex IV. Risk Assessment Matrix (Tonga — Staff Report for the 2023 Article IV Consultation).* ### 3. Tonga's debt obligations are largely external, and over half of its external public debt is to ### 1tonea2023001 - 3. Tonga's debt obligations are largely external, and over half of its external public debt is to ### Debt composition and creditors - Total public and publicly guaranteed (PPG) external debt stood at USD185 million (about 38 percent of GDP) as of end-June 2022, accounting for 86 percent of total public debt. - Outstanding debt to all multilateral creditors stood at USD79 million (about 16 percent of GDP), or about 43 percent of the total external debt stock. - Export-Import Bank of China (China Exim Bank) accounts for 57 percent of total external debt stock. - Loans from China Exim Bank are denominated in Chinese renminbi. - Public domestic debt stood at USD30 million (about 6.1 percent of GDP) at end-June 2022, accounting for 14 percent of total public debt. - Domestic financial institutions hold about half of total domestic debt; the rest is held mainly by domestic pension funds. - The authorities plan to issue domestic debt in FY2023 and beyond, if necessary. ### Repayment schedule, DSSI, and near-term cash flow implications - Tonga started repayments to China Exim Bank in FY2019 with larger repayments coming due starting in FY2024. - The spike in repayments reflects previously extended grace periods and the DSSI rescheduling. - Tonga’s request for temporary suspension of calendar year 2020 and 2021 debt service to China Exim Bank under the G20 DSSI has been accepted; the rescheduled debt 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. - Annual payments to China Exim Bank beginning in FY2024 average about 2.2 percent of GDP in FY2024–29. ### Baseline macroeconomic assumptions and projections - Real GDP growth is projected at 1.6 percent on average during FY2023–33. - Long-term potential growth is projected to gradually converge to 1.2 percent. - The baseline assumes years FY2023–FY2025 are disaster-free; from FY2026 onwards the baseline incorporates long-term effects of natural disasters and climate change by lowering annual GDP growth by 0.16 percentage points. - Inflation is projected to average 4.3 percent during FY2023–33; inflation is expected to converge to a steady state level of 3½ percent. - The non-interest current account deficit is estimated to have reached 7.5 percent of GDP in FY2023. - The non-interest current account deficit is projected to average 7.7 percent of GDP over FY2023–FY2033. - Net FDI inflows are expected to stand at 0.2 percent of GDP over FY2023–33. - External borrowing: new external borrowing is expected to commence in FY2025 and gradually increase over the medium term to refinance debt repayments and the primary deficit expected to reach double digits over FY2027–2031. - International reserves are estimated at 10.9 months of next year’s imports at end-FY2023 and are expected to remain stable despite large repayments to China EXIM Bank. ### Fiscal outlook and public finances - Primary fiscal balance: 1 percent of GDP surplus in FY2023 shifting to 6.3 percent of GDP deficit in FY2024 and then double-digit deficits during FY2027–FY2031. - The FY2023 surplus driven by a higher level of grants and slower-than-anticipated budget execution of reconstruction projects. - Long-term deterioration driven by lower grant inflows after existing commitments are met and sizable spending needs for infrastructure, climate resilience, and SDGs. - Public sector wage bill expected to drop below the fiscal target of 53 percent of domestic revenue in FY2024. - Fiscal deficit as percent of GDP expected to decline after FY2029 as capital spending needs moderate. ### Debt sustainability: external debt - External debt-to-GDP ratio expected to decline from 39.4 percent in FY2022 to 38 percent in FY2024 due to large repayments to China Exim Bank and the second RCF. - From FY2025 onwards new external debt is projected, and external debt-to-GDP ratio will breach the authorities’ fiscal anchor of 50 percent in FY2026. - The PV of external debt-to-GDP ratio is expected to breach the threshold of 55 percent starting from FY2033 and continue rising until FY2043 under the baseline. - Under a combination of diverse shocks (most extreme scenario), the PV of external debt-to-GDP would breach the threshold earlier in FY2028. - Tailored one-time natural disaster shock: a one-off shock of 14 percentage points (ppts) to the debt-to-GDP ratio in FY2023; real GDP growth and exports lowered by 3 and 7 ppts, respectively, in the year of the shock. Under this tailored shock the PV of external debt-to-GDP would jump in FY2024 and breach the threshold three years earlier in FY2030. ### Debt sustainability: public debt - Under the baseline, the PV of the public debt-to-GDP ratio would breach 70 percent from FY2033 onwards. - The public debt dynamic is driven by a large primary fiscal deficit. - Compared to the previous DSA, nominal public debt-to-GDP is lower from FY2023 onward due to additional grants committed in FY2023 and FY2024. - Standardized sensitivity analysis: the most extreme shock (growth shock—growth one standard deviation below baseline for two years starting 2023) leads to earlier breach; PV of public debt-to-GDP would cross 70 percent in FY2029 under a multi-year GDP growth shock and breach in FY2030 under an exports shock. - Tailored one-time natural disaster shock causes the PV of public debt-to-GDP to cross 70 percent in FY2030, three years earlier than baseline. - Combined contingent liability shock shifts the PV of public debt-to-GDP upward by 4 percentage points from baseline. ### Country classification, stress tests, and risk assessment - Tonga's Composite Indicator (CI) index is 3.06, indicating a "strong" debt-carrying capacity under the revised LIC-DSA framework. - Emergency Events Database (EM-DAT) largest damage from natural disasters during 1980–2016 was 28.2 percent of GDP; DSA assumes one-off shock of 14 percentage points to debt-to-GDP in FY2023 (only part financed by external debt). - Tailored natural disaster stress test conducted given severity and frequency of disasters. - Projected external net financing flows show new commitments by IDA and other IFIs (chart information noted). - Risk of external debt distress is assessed as high. Mechanical LIC DSF rating: "moderate"; staff judgement raises the overall rating to "high" because PV of external debt-to-GDP is expected to breach its indicative threshold from FY2033 until FY2043. - Overall risk of debt distress is assessed as high. Mechanical LIC DSF rating: "moderate"; staff judgement assesses the overall debt distress risk as "high" given PV of public debt-to-GDP projected to breach the indicative benchmark from FY2033 until FY2043 and long-term natural disaster effects. *Source: IMF staff report content (1tonea2023001).* ### 17. In the short term, fiscal policy should prioritize reconstruction and protecting ### 17. In the short term, fiscal policy should prioritize reconstruction and protecting ### Short-term fiscal policy priorities - Prioritize rebuilding and repairs while supporting vulnerable households and businesses amid high inflation. - Contain current spending, especially recurrent portions such as public sector wages, to ease inflation pressures and preserve fiscal buffers. - Policy measures cited to contain public wage pressures include limiting overtime allowances and undertaking a comprehensive organizational review. ### Medium- to long-term public debt sustainability assessment - Staff assess that Tonga’s 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 multi-year growth shock. - The PV of external debt-to-GDP ratio would stabilize below the 55 percent benchmark under this scenario. - Fiscal adjustments are expected to take place post-reconstruction and include: - A gradual increase of tax revenues. - Reduction of current expenditure to levels similar to other PICs. - New grant commitments consistent with historical trends to fund capital investment projects for SDGs and climate resilience. - The government’s strategy aligned with this fiscal path includes: - Further improve revenue administration. - Collect tax arrears. - Contain public wage bill within the fiscal target. - Pursue additional grants from development partners. - Avoid any new non-concessional borrowing from external creditors. ### Grants and baseline assumptions - Cash and in-kind grants averaged 16.7 percent of GDP annually over FY2015–2019. - Under the baseline, staff assume continued budget support in line with historical levels and capital grants falling to zero from FY2030 onwards. - The amount of grants declines over time in the baseline scenario since it only includes committed or highly likely grants, in line with the LIC DSA guidance note. ### Authorities’ views and implementation challenges - Authorities agreed on the need for fiscal adjustment and emphasized the importance of sustained support from development partners. - Authorities shared staff’s concern regarding the high public sector wage bill relative to the narrow domestic revenue base and are taking steps to contain it. - Growing pay differentials with New Zealand and Australia, in a context of strong labor demand there, have made it difficult to retain civil servants and exert upward pressure on public sector wages. - Authorities intend to seek new grant financing from development partners to meet climate resilience and development goals, while ensuring debt remains on a sustainable path. ### Projections, scenarios, and analytical notes (as presented) - “The red line does not include the public investment reforms which would lower the debt path further.” (figure note) - Time horizons and scenario windows referenced: FY2016–FY2024 (balances chart), 2023–2033 (debt and sensitivity analyses), FY2020–2043 (debt sustainability framework tables). - Tables and figures referenced include: - Table 1. Tonga: External Debt Sustainability Framework, Baseline Scenario, FY2020–2043. - Table 2. Tonga: Public Sector Debt Sustainability Framework, Baseline Scenario, FY2020–2043. - Table 3. Tonga: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, FY2023–2033. - Table 4. Tonga: Sensitivity Analysis for Key Indicators of Public Debt, FY2023–2033. - Figure 1. Tonga: Indicators of Public and Publicly Guaranteed External Debt under Alternatives Scenarios, FY2023–2033. - Figure 2. Tonga: Indicators of Public Debt Under Alternative Scenarios, FY2023–2033. - Figure 3. Tonga: Drivers of Debt Dynamics—Baseline Scenario External Debt. - Figure 4. Tonga: Realism Tools. *Source: Content unit 1tonea2023001 (IMF chapter text provided).* --- _Source: https://www.imf.org/-/media/files/publications/cr/2023/english/1tonea2023001.pdf_