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### Executive Summary — Background and Key Policy Recommendations
- Tonga’s economy increasingly vulnerable; fiscal discipline has weakened, undermining macroeconomic stability and external viability.
- Civil servants granted in September 2005 average wage increases of about 70 percent payable over the next two years; this decision risks significant negative consequences for macroeconomic and external stability.
- Key policy recommendations:
  - Achieve a sustainable fiscal adjustment to restore macroeconomic stability through downsizing the civil service, stepping up revenue collection efforts, improving public expenditure management, and advancing public enterprise reform.
  - Stand ready to tighten credit; consider making full use of flexibility under the basket peg arrangement to depreciate the pa’anga.
  - Accelerate implementation of structural reforms to enhance the role of the private sector.

### Recent Economic Developments
- Growth and inflation:
  - Real GDP growth: 2004/05: 2.3 percent; 2005/06 (Prel.): 1.9 percent; 2006/07 (Proj.): 0.6 percent.
  - Inflation: declined to 9½ percent in 2004/05 from about 11½ percent previously; eased to 5¼ percent during the year to February 2006. Consumer prices (period average): 2004/05: 9.5; 2005/06 (Prel.): 7.2; 2006/07 (Proj.): 10.3.
- Fiscal developments:
  - Overall fiscal surplus of about 2½ percent of GDP achieved in 2004/05.
  - Original 2005/06 budget targeted a deficit of 1.8 percent of GDP.
  - Available first eight months of 2005/06: revenue weaker than expected; unanticipated cost of first phase of wage increase estimated at about 3 percent of GDP.
  - Authorities working on downsizing civil service by end of fiscal year; related severance payments could amount to about 5 percent of GDP. Proposed severance: minimum of three months salary plus two weeks per year of service up to a maximum of twelve months.
- Credit and liquidity:
  - Net domestic credit expanded 21 percent in 2004/05, driven by housing and personal loans.
  - NRBT reintroduced credit ceilings in January 2006; reserve requirements reduced in March 2006 from 15 percent to 12.5 percent (liquidity impact estimated at about 5.3 million pa’anga, 2.5 percent of total deposits).
  - Central bank started to auction notes for open market-type operations.
- External sector and reserves:
  - Current account shifted into a deficit of 4¾ percent of GDP in 2004/05 from a surplus of about 4¼ percent of GDP in the previous year.
  - Net remittances increased 15 percent y/y; private transfers (net) 2004/05: 91.9 (millions).
  - Gross international reserves: 2004/05: $42.5 million (3¾ months of imports); as of end-March 2006 reserve coverage declined to 3¼ months of imports.

### Policy Discussions — Outlook and Risks
- Short-term outlook:
  - Prospects highly uncertain and depend critically on achieving proposed substantial downsizing of the civil service.
  - Swing from surplus to deficit expected to widen current account deficit in 2005/06. Current account balance (percent of GDP): 2004/05: -4.8; 2005/06 (Prel.): -6.2; 2006/07 (Proj.): -5.2.
  - Only completion of an expected government asset sale to foreign investors would provide sufficient financing to maintain reserves and keep the exchange rate broadly stable.
- Medium-term scenarios:
  - Successful reform path: real GDP growth could reach about 3 percent over the medium term if fiscal balance is restored and private sector activity promoted.
  - If reforms stall: unchecked wage bill could lead to fiscal deficits around 4½ percent of GDP, GDP growth slowing to about 1 percent over the medium term, and high risk of debt distress with NPV public external debt-to-exports breaching the indicative threshold.

### Fiscal Policy — Measures, Projections, and Risks
- Authorities’ stance:
  - Committed to fiscal adjustment; initial corrective measures in 2005/06 focused on capital expenditure cuts and hiring freeze.
  - Aim to reduce civil service by one quarter by end-2005/06 through targeted and voluntary redundancies; severances to be financed by government asset sales and donor assistance.
- Fiscal projection highlights (percent of GDP, staff projections/adjustments):
  - Total revenue and grants: 29.4 (original 1/Staff projections for 2005/06, excluding the wage settlement) — 29.4 (Adjusted).
  - Total expenditure and net lending: 32.3 (original) — 36.1 (Adjusted).
  - Overall balance: -2.9 (original) ... -6.7 (Adjusted) ... -1.5 (projected 2006/07).
  - Privatization receipts: 0.0 ... 4.4 (2005/06 Prel.) ... 0.0 (2006/07 Proj.).
- If downsizing target met by end of fiscal year:
  - Severance payments would widen overall deficit for 2005/06 by about 5 percent of GDP to 6¾ percent, expected mostly financed externally.
  - For 2006/07, with a smaller civil service and continued expenditure restraint, fiscal deficit could be limited to 1.5 percent of GDP.
- Fiscal risks:
  - Voluntary redundancies could fall well short of expectations or require a significantly larger package.
  - Insufficient financing if asset sale does not materialize; discussions with foreign investors and donors ongoing.
  - WTO accession risk: tariff revenue will significantly decline; without timely corrective tax policy and administration measures, the overall fiscal deficit for 2006/07 could amount to 4½ percent of GDP.
  - Cutting capital and related current spending further is infeasible without disrupting social services and infrastructure.

### Tax Administration, WTO Accession, and Reform Measures
- WTO accession:
  - Terms approved by the WTO in December 2005 after ten years of negotiation; ratification conditional by end-July for membership.
  - Commitment to reduce tariffs to a maximum of 20 percent (15 percent for some goods) by the beginning of 2007 and eliminate exemptions under the Industrial Development Incentive Act.
- Tax reforms implemented and planned:
  - Comprehensive tax reform approved in 2002; 15 percent consumption tax introduced in April 2005.
  - Authorities plan to offset foregone revenue through higher excise collection and introduction of a road tax.
  - Next reform step: introduction of a simplified income tax in 2007/08.
- Tax administration progress and needs:
  - Large taxpayer unit established; initiation of computerization; customs capacity improved with external experts.
  - Critical needs: strengthen legal framework and tax enforcement (particularly for excise taxes); build a taxpayer culture.
  - Public expenditure management: only 7 ministries out of 30 effectively connected to accounting system; timely and reliable financial reporting remains a priority.
  - Recommendation: introduce a medium-term budget framework.

### Monetary Policy, Exchange Rate Policy, and NRBT Strengthening
- Monetary and liquidity developments:
  - Total liquidity (M2 basis) annual change: 2004/05: 13.3; 2005/06 (Prel.): 14.1; 2006/07 (Proj.): 10.7.
  - Private sector credit: 2004/05: 29.4 percent annual change; 2005/06 (Prel.): 17.0; 2006/07 (Proj.): 13.3.
  - NRBT reintroduced credit ceilings in January 2006; reserve requirements reduced in March 2006 from 15 percent to 12.5 percent.
- Policy stance and recommendations:
  - Staff and Executive Directors supported further tightening of monetary policy in response to the wage settlement and recommended use of full exchange rate flexibility if needed.
  - Central bank has introduced open-market type instruments (untested); NRBT should stand ready to tighten stance as higher public sector wages and severance payments likely to increase banking system liquidity.
  - Recommendation: make the central bank more independent; early enactment of Amendments to the NRBT Act critical, including doubling NRBT’s capital base, clarifying profit transfer rule, strict limit on direct central bank credit to the government, and clarification of NRBT objectives.

### Structural Reforms, Public Enterprise Reform, and Private Sector Development
- Constraints to private-sector expansion: remoteness, limited pool of entrepreneurs, unreliable infrastructure, unfavorable business climate.
- Doing Business indicators (selected):
  - Rigidity of employment (index 0–100): Tonga 13.0; Other Pacific Islands 14.9; East Asia 37.4.
  - Corporate disclosure (index 0–7): Tonga 3.0; Other Pacific Islands 3.7; East Asia 6.9.
  - Contract enforcement (days): Tonga 510.0; Other Pacific Islands 445.0; East Asia 380.2.
  - Starting a business (days): Tonga 32.0; Other Pacific Islands 39.6; East Asia 69.5.
  - Closing business (years): Tonga 2.7; Other Pacific Islands 3.7; East Asia 3.4.
  - Dealing with licenses (days): Tonga 81.0; Other Pacific Islands 93.9; East Asia 194.2.
- Agreed/planned policy steps:
  - Establish a public-private sector task force with World Bank assistance.
  - Repeal the Industrial Development Incentive Act.
  - Reduce restrictions on business licensing and foreign direct investment in run-up to WTO accession.
- Staff encouraged additional reforms:
  - Amend land regime to extend lease duration and eliminate rent revision uncertainty.
  - Strengthen regulatory agencies.
  - Further corporatize and privatize public enterprises to clarify the state’s role.
- Public enterprise reform:
  - Progress limited; pressure to repurchase the power company noted.
  - Authorities assert no intention to renationalize the power sector and are seeking private foreign investors.
  - Staff supports drawing on external expertise to resolve impediments to privatization or liquidation.

### Financial Sector Supervision, AML/CFT, and Statistics
- Financial sector:
  - Banking soundness indicators improved in 2004/05: risk-weighted capital ratio around 19.7 (2005); non-performing loans to total loans 2005: 4.2; return on assets 2005: 6.6; return on equity 2005: 26.8.
  - Amended Financial Institution Act became effective in April 2006, aligning licensing and supervision with Basle Core Principles; related prudential regulations still being finalized.
  - Close monitoring required of rapid credit growth to avoid asset quality deterioration.
- AML/CFT:
  - Introduction of a database on reporting of suspicious transactions; ongoing work to amend AML-related legislation per Fund recommendations.
- Statistics and data shortcomings:
  - Need to improve reliability, coverage, and timeliness of national accounts, balance of payments, and fiscal data.
  - National accounts: capacity constraints; revisions made per PFTAC recommendations.
  - Balance of payments: investigation of large errors and omissions; need reconciliation of official capital flows with external debt data.
  - Fiscal data: difficulties reconciling above- and below-the-line items in GFS format; planned financial management system improvements expected to strengthen reporting.

### Debt Sustainability and Vulnerabilities
- Key 2004/05 indicators:
  - Nominal GDP (2003/2004): US$ 182.1 million.
  - Population (2003): 101,405.
  - GDP per capita (2003/04): US$1,796.
  - Stock of external public debt (end-2004/05): $76.4 million; NPV of external public debt: $50.1 million.
  - NPV of PPG external debt-to-exports (2004/05): 128.1 percent (threshold for poor performers: 100 percent).
  - NPV of debt-to-GDP (2004/05): 23.3 percent (threshold 30 percent).
  - NPV of debt-to-revenues (2004/05): 79.8 percent (threshold 200 percent).
  - Debt service ratio (2004/05): 8.4 percent of exports (threshold 15 percent).
- Staff assessment:
  - Tonga moved into the LIC category with a high risk of debt distress; NPV of debt-to-exports breaches the indicative threshold under the baseline “reforms stall” scenario.
  - Under “Reforms Stall” scenario, NPV of PPG external debt-to-exports remains above 100 percent for much of the medium term, falling to 102.7 percent by 2015/16 and to 66.1 percent by 2025/26.
  - Domestic debt at end-2004/05: 15.4 percent of GDP; total public debt: 50.8 percent of GDP.
  - Under “reforms stall,” domestic financing of deficits projects total public debt to rise to 62.6 percent of GDP in 2010/11 and continue thereafter.
- Stress test vulnerabilities:
  - A sharp fall in net transfers or a one-time 30 percent real depreciation or a 10 percent of GDP increase in other debt-creating flows would sharply raise debt stock and debt service indicators.
  - Returning real GDP growth and primary balance to historical averages would markedly improve ratios.

### IMF Staff Appraisal — Priority Recommendations
- Contain costs of the wage settlement and pursue planned civil service downsizing or credible alternative measures if downsizing does not proceed.
- Strengthen tax administration and enforcement; bolster legal framework for tax collection (including for any new road tax).
- Fully operationalize government accounting across ministries and introduce a medium-term budget framework.
- Accelerate public enterprise reform and resist political pressure to re-enter key sectors (e.g., power).
- Tighten monetary policy as needed; utilize full exchange rate flexibility; enact Amendments to the NRBT Act to strengthen independence and enforcement capacity.
- Improve business and investment climate: repeal the Industrial Development Incentive Act, reduce licensing and FDI restrictions, strengthen property rights and regulatory agencies.
- Improve timeliness, coverage, and reliability of national accounts, government finance, and balance of payments statistics.
- Institutional recommendation: next Article IV consultation proposed on the standard 12-month cycle.

### Key Summary Indicators (select, preserved exactly)
- Nominal GDP (2003/2004): US$ 182.1 million.
- Population (2003): 101,405.
- GDP per capita (2003/04): US$1,796.
- External public debt (stock, end-2004/05): $76.4 million; NPV $50.1 million.
- NPV of PPG external debt-to-exports (2004/05): 128.1 percent.
- Gross international reserves (end-2004/05): $42.5 million (3.7 months of imports).
- Total revenue and grants (2005/06 Prel.): 29.4 percent of GDP.
- Total expenditure and net lending (2005/06 Prel.): 36.1 percent of GDP.
- Overall balance (2005/06 Prel.): -6.7 percent of GDP.
- Total liquidity (M2 survey basis, 2005/06 Prel.): 14.1 percent change.
- Private sector credit (2004/05): 29.4 percent annual change.

*IMF staff report excerpts for Tonga, Article IV Consultation and joint IMF/World Bank Debt Sustainability Analysis (2006).*

### Executive Summary ......................................................................................................

### Executive Summary

### Background
- Tonga’s economy has become increasingly vulnerable. Fiscal discipline has weakened, undermining macroeconomic stability and external viability.
- Some progress has been made recently in trying to restore fiscal balance, but efforts to strengthen governance and promote private sector activity have had negligible success.
- Medium-term prospects have deteriorated since last year’s consultation. Following a lengthy strike, civil servants were granted in September 2005 average wage increases of about 70 percent payable over the next two years. This decision has the potential to have significant negative consequences for macroeconomic and external stability.

### Key Policy Recommendations
- Achieve a sustainable fiscal adjustment to restore macroeconomic stability. Substantial fiscal reforms are needed to offset the cost of the wage settlement, including downsizing the civil service, stepping up revenue collection efforts, improving public expenditure management, and advancing public enterprise reform.
- Stand ready to tighten credit. As higher public sector wages and the severance package could ease the currently tight liquidity conditions in the banking system, a further monetary tightening may be called for. Making full use of the flexibility allowed under the current basket peg arrangement to depreciate the pa’anga may also be needed to protect reserves.
- Accelerate the pace of implementation of structural reforms to enhance the role of the private sector and make the economy more dynamic.

### Introduction — country context and governance
- Tonga is a small agriculture-based economy in the South Pacific with a population of about 100,000 and per capita income of US$1,800.
- Common characteristics with other Pacific island countries: remoteness, openness, limited production diversification, and vulnerability to natural disasters.
- Population has remained broadly constant because of large-scale emigration mainly to Australia, New Zealand, and the United States; Tonga is one of the highest recipients of net remittances among developing countries, which amounted to more than 40 percent of GDP in 2004/05 (year ending June).
- Poor macroeconomic policies and deteriorating governance have increased the country’s vulnerability. Limited progress in broadening production and export base, reducing dependence on external transfers, and strengthening a tax system heavily reliant on trade taxation.
- Fiscal position improved in 2003/04 and 2004/05, but efforts to strengthen governance and promote private sector activity had negligible success.
- Political developments: civil servants were granted in September 2005 average wage increases of about 70 percent (to be implemented over two years). The Prime Minister resigned in February 2006; the Minister of Labor was appointed Acting Prime Minister and confirmed at the end of March.

### Recent Economic Developments
- Growth and inflation:
  - Economy expected to expand at a slower pace in 2005/06 than the 2½ percent gain in 2004/05, reflecting a poor squash season and slower growth in construction.
  - Inflation declined to 9½ percent in 2004/05 compared to about 11½ percent in the previous year, and has since eased further to 5¼ percent during the year to February 2006.
- Fiscal developments:
  - An overall fiscal surplus of about 2½ percent of GDP was achieved in 2004/05, in marked contrast to the deficit of 2¼ percent of GDP envisaged in the budget, owing to lower-than-budgeted wages and capital spending, and stronger tax collection.
  - In 2005/06, the original budget targeted a deficit of 1.8 percent of GDP, mostly covered by external concessional financing.
  - Available information for the first eight months of 2005/06 indicates revenue performance was weaker than expected, mainly because of lower nontax and excise collection.
  - The unanticipated cost of the first phase of the wage increase is estimated to be about 3 percent of GDP.
  - Savings carried out (mostly capital expenditure cuts and a hiring freeze) are expected to offset this cost as well as the likely revenue shortfall.
  - Authorities working on downsizing the civil service by the end of the fiscal year; related severance payments could amount to about 5 percent of GDP.
  - Severance package under consideration: minimum of three months of salary with an additional two weeks for every year of service, up to a maximum of twelve months.
- Credit and liquidity:
  - Liquidity in the banking system increased following the improvement in the government’s net credit position and the repayment of loans by a major private utility company in 2003/04.
  - These funds were used to finance a 21 percent expansion in net domestic credit in 2004/05, mainly driven by a rapid rise in housing and personal loans.
  - The National Reserve Bank of Tonga (NRBT) reintroduced credit ceilings in January 2006. The practice of announcing quarterly credit ceilings for individual banks had been discontinued in the second half of 2004.
  - With liquidity conditions tightening, pressure mounted to ease monetary stance; reserve requirements were reduced in March (from 15 percent to 12.5 percent). The liquidity impact of this reduction is estimated to be about 5.3 million pa’anga (2.5 percent of total deposits).
  - The central bank started to auction notes for open market-type operations.
- External sector and reserves:
  - Trade balance deteriorated in 2004/05 as imports expanded on the back of strong domestic demand, more than offsetting a rebound in exports.
  - Net remittances increased (15 percent y/y) but the current account shifted into a deficit of 4¾ percent of GDP in 2004/05 from a surplus of about 4¼ percent of GDP in the previous year.
  - The capital account surplus declined to US$16.4 million, from a record high of US$37 million in 2003/04, as private capital inflows returned to a more normal level following the exceptional refinancing operation.
  - Gross international reserves fell to 3¾ months of current year’s imports of goods and services. Recent data suggest the current account remained in deficit in the first half of 2005/06 and reserve coverage declined to 3¼ months of imports as of end-March 2006.
- Exchange rate and competitiveness:
  - The pa’anga is determined on a weighted basket of currencies including the U.S., Australian, and New Zealand dollars and the Japanese yen. NRBT may adjust its value relative to the basket by up to 5 percent per month and aims to maintain reserves above three months of imports.
  - With foreign reserves remaining above this level, NRBT has kept the Tongan currency broadly stable in nominal effective terms since 2004.
  - Given high inflation in Tonga relative to main trading partners, this translated into a real appreciation of the Tongan currency of about 11 percent from January 2004 to February 2006.
  - Regional competitiveness indicators, including export market share and tourist arrivals, do not clearly signal at this stage an overvaluation of the pa’anga nor do they suggest that Tonga has lost competitiveness relative to other countries in the region.
  - Private sector consultations indicated the major obstacle for exports was lack of reliable infrastructure and unfavorable business climate rather than the current level of the exchange rate, given the relatively high import content of exports and the niche market for Tongan squash in Japan.

### Policy Discussions — Outlook and Risks
- Short-term outlook:
  - Short-term economic prospects are highly uncertain and depend critically on the authorities achieving a proposed substantial downsizing of the civil service.
  - The swing in the fiscal position from surplus to deficit is expected to contribute to a widening of the current account deficit in 2005/06.
  - Only if an expected government asset sale to foreign investors is completed will there be sufficient financing to maintain the reserve position, keep the exchange rate broadly stable, and prevent major inflationary pressures from emerging.
  - In 2006/07, economic activity would be adversely affected by the proposed civil service downsizing. Payment of the severance package would cushion this effect somewhat, although it could also put pressure on reserves and the exchange rate.
- Medium-term prospects and scenarios:
  - Under a successful reform path: Following the wage settlement, the authorities should follow through on their stated commitment to push ahead with key reforms to safeguard macroeconomic stability, improve governance, and enhance the role of the private sector. While restoring fiscal balance will take a short-term toll on growth, achieving a more stable macroeconomic environment and promoting private sector activity would create a climate conducive to higher investment. Under these conditions, real GDP growth could reach about 3 percent over the medium term (Table 5).
  - If reforms stall: Should fiscal adjustment fail and reforms stall, the outlook would be much worse. If the wage bill were to remain unchecked, fiscal deficits of the order of 4½ percent of GDP could materialize. With the civil service union trying to preserve real income through additional wage increases, a wage-price spiral would be triggered, as the budget would have to rely on domestic financing (Table 6). Authorities would lack fiscal resources to increase public capital expenditure, and unstable macroeconomic conditions would not provide a business climate conducive to private investment. The economy would be expected to stagnate, with GDP growth slowing over the medium term to about 1 percent. Under this scenario, Tonga would be at a high risk of debt distress, its NPV of public external debt-to-exports ratio breaching the indicative threshold (Annex I). The debt profile would be particularly vulnerable to a sharp fall in net remittances or in the value of the currency.

### Fiscal Policy
- Authorities’ stance and measures:
  - Authorities are committed to fiscal adjustment. Staff welcomed prompt corrective measures in 2005/06 to contain the costs of the first phase of the wage settlement.
  - Reliance mainly on capital expenditure cuts and a freeze in hiring provides only a limited and temporary solution.
  - Authorities agreed that more sustainable savings needed to be identified. To achieve such savings and contain the costs of the second phase of the settlement, authorities are working on reducing the civil service by a quarter by the end of 2005/06 through targeted and voluntary redundancies, with severances to be financed by government asset sales and donor assistance. The civil service union does not oppose this plan as long as redundancies remain voluntary.
- Fiscal impact projections (2005/06–2006/07) — summary of staff projections and adjustments (in percent of GDP):
  - Total revenue and grants: 29.4 (original 1/Staff projections for 2005/06, excluding the wage settlement) — 29.4 (Adjusted).
  - Total expenditure and net lending: 32.3 (original) — 36.1 (Adjusted).
  - Total wage and salaries (include retirement fund employer contribution): 13.8 (original) 2.8 (adjustment) -1.6 (additional cost) 4.9 (corrective measures) 19.9 (original 2/Adjusted for 2006/07) 12.2 6.5 -4.0 14.7 (table shows detailed pathway across columns).
  - Other current expenditure: 15.9 (original) ... -1.1 (adjustment) ... 14.8 (original 2/Adjusted) 14.4 ... 14.4.
  - Capital expenditure: 2.8 ... -1.2 ... 1.6 ... 1.6.
  - Overall balance: -2.9 (original) ... -6.7 (Adjusted) 1.0 ... -1.5.
  - Financing: 2.9 ... 4.9 -6.7 -1.0 ... 1.5.
  - External financing: 1.8 ... 0.0 1.8 1.3 ... 1.3.
  - Domestic financing: 1.1 ... 0.5 0.5 -2.3 ... 0.2.
  - Privatization receipts: 0.0 ... 4.4 4.4 0.0 ... 0.0.
  - (Table labeled "Fiscal Projections for the Wage Settlement, 2005/06–2006/07")
- If the downsizing target is met by end of current fiscal year:
  - Severance payments would widen the overall deficit for 2005/06 by about 5 percent of GDP to 6¾ percent, with the expectation that the deficit would be mostly financed externally.
  - For 2006/07, the combination of a smaller civil service and continued expenditure restraint could limit the fiscal deficit to 1.5 percent of GDP.

*IMF staff executive summary (page excerpts).*

### 13.      There are serious downside risks to this fiscal outlook and effective alternative

### 13.      There are serious downside risks to this fiscal outlook and effective alternative measures need to be identified.

### Fiscal risks and civil service downsizing
- The envisaged downsizing of the public service is unprecedented given Tonga’s relatively large civil service (Figure 2 referenced).
- Preliminary reactions of civil servants to the proposed severance package suggest:
  - voluntary redundancies could fall well short of expectations, or
  - the package would need to be significantly increased to achieve the desired objective.
- Authorities intend to provide those leaving with business incentives and training to assist re-employment and strengthen the private sector.
- Staff concern: insufficient financing for redundancy payments if the anticipated government asset sale does not materialize.
  - Authorities: discussions with foreign investors for the asset sale were well advanced and donors had been approached for possible assistance.
- WTO accession risk: tariff revenue will significantly decline and there is a risk of a revenue shortfall if corrective tax policy and administration measures are not taken on time (Box 2 reference).
- If these risks materialize, the overall fiscal deficit for 2006/07 could amount to 4½ percent of GDP.
- Cutting capital and related current spending further is infeasible without disrupting key social services and infrastructure improvements.

### Authorities’ stance on downsizing and alternatives considered
- Authorities recognized the downsizing plan was ambitious but saw no alternative.
- Options considered and set aside:
  - renegotiating the wage settlement (rejected due to prospect of another strike),
  - forced redundancies (rejected due to social unrest concerns).
- Decision: pursue downsizing based on targeted, voluntary redundancies.
- Civil service union unwilling to revisit the wage settlement despite its macroeconomic implications.

### Tax administration, WTO accession, and fiscal measures
- Progress noted:
  - establishment of a large taxpayer unit,
  - initiation of computerization,
  - customs administrative capacity improved with key positions filled by external experts.
- Critical needs to offset tariff revenue decline from WTO accession:
  - strengthening the legal framework and tax enforcement, in particular for excise taxes,
  - building a taxpayer culture.
- Public expenditure management improvements required:
  - accounting system extension delayed by lack of funding and training (only 7 ministries out of 30 are effectively connected to the system),
  - timely and reliable financial reporting remains a priority.
- Introduction of a medium-term budget framework would help signal commitment to sustainable fiscal policy and foster donor support.

### Monetary policy and exchange rate policy
- Staff and authorities agreed further tightening of monetary policy may be needed in response to the wage settlement.
- Central bank actions to date:
  - reintroduction of credit ceilings to rein in unsustainable credit growth in first half of 2005/06,
  - easing in March with reduction in reserve requirements was questioned by staff,
  - introduction of open market-type instruments (new instruments remain untested).
- Liquidity pressures: higher public sector wages and severance payments likely to increase banking system liquidity; NRBT agreed it should stand ready to tighten stance.
- Concerns about NRBT’s ability to pursue tight policy:
  - new instruments untested; may need to continue relying on credit ceilings in short run,
  - central bank response to recent pressure to reduce reserve requirements raises doubts.
- Recommendation: make the central bank more independent to limit political interference.
- Exchange rate policy:
  - Given vulnerability to natural disasters, terms of trade shocks, lack of effective monetary policy, weak fiscal discipline, and low reserves, the current exchange rate arrangement provides appropriate flexibility but at the cost of higher inflation.
  - With wage settlement and severance package likely to increase imports, downward pressure on the exchange rate may materialize; the flexibility of the current arrangement should be fully utilized and the pa’anga allowed to depreciate relative to the currency basket if needed.

### Strengthening the NRBT and legal framework
- Early enactment of the Amendments to the NRBT Act is critical.
  - Proposed amendments include doubling the NRBT’s capital base and clarifying the profit transfer rule; these failed to be approved by the Legislative Assembly.
  - Authorities plan to re-submit amendments with greater communication efforts; staff recommended amendments also include a strict limit on direct central bank credit to the government and a clarification of NRBT objectives.
  - Authorities agreed to examine these issues while revising the amendments.

### Structural reforms, public enterprises, and private sector development
- A more dynamic private sector is needed to absorb redundant workers and facilitate downsizing.
- Constraints on private sector activity: remoteness from main export markets and a limited pool of entrepreneurs.
- Doing Business indicators (selected comparisons as presented):
  - Rigidity of employment (index 0–100): Tonga 13.0; Other Pacific Islands 14.9; East Asia 37.4.
  - Corporate disclosure (index 0–7): Tonga 3.0; Other Pacific Islands 3.7; East Asia 6.9.
  - Contract enforcement (days): Tonga 510.0; Other Pacific Islands 445.0; East Asia 380.2.
  - Starting a business (days): Tonga 32.0; Other Pacific Islands 39.6; East Asia 69.5.
  - Closing business (years): Tonga 2.7; Other Pacific Islands 3.7; East Asia 3.4.
  - Dealing with licenses (days): Tonga 81.0; Other Pacific Islands 93.9; East Asia 194.2.
- Policy steps agreed or planned:
  - establish a public-private sector task force with World Bank assistance to identify impediments,
  - repeal the Industrial Development Incentive Act,
  - reduce restrictions on business licensing and foreign direct investment in the run-up to WTO accession.
- Staff encouraged further actions:
  - amend the land regime to extend duration of leases and eliminate rent revision uncertainty,
  - strengthen regulatory agencies,
  - further corporatize and privatize public enterprises to better delineate the role of the state.

### Public enterprise reform and contingent liabilities
- Progress limited by capacity constraints and political sensitivities; authorities faced pressure to repurchase the power company.
- Staff concern: fiscal implications of slow public enterprise reform.
- Authorities asserted no intention to renationalize the power sector and are seeking potential private foreign investors for the power company.
- Staff supported drawing on external expertise to resolve financial and legal issues delaying privatization or liquidation of public enterprises.

### Financial sector supervision and AML/CFT
- Banking soundness indicators improved in 2004/05, but credit developments require close monitoring to avoid asset quality deterioration given recent rapid lending growth.
- Amended Financial Institution Act became effective in April 2006, aligning licensing and supervision with Basle Core Principles; related prudential regulations and standards are still being finalized.
- AML/CFT progress: introduction of a database on reporting of suspicious transactions and ongoing work to amend AML-related legislation in line with Fund recommendations.

### Statistics and data shortcomings
- Authorities acknowledged urgent need to improve reliability, coverage, and timeliness of statistics and intend to devote more resources.
- Specific data issues:
  - national accounts: capacity constraints in Statistics Department; revisions made in response to PFTAC recommendations,
  - balance of payments: ongoing investigation of large errors and omissions; need to reconcile official capital flows with external debt data,
  - fiscal data: difficulties reconciling above- and below-the-line items in GFS format; planned improvements in financial management system expected to strengthen reporting.

### Staff appraisal: outlook and policy recommendations
- Economic prospects have deteriorated since last consultation due to the substantial civil service wage increase decided in September 2005.
- Urgent need for authorities to follow through on reforms to safeguard macroeconomic stability, improve governance, and enhance private sector role.
- Key staff recommendations and observations:
  - prompt and effective corrective measures required to contain fiscal implications of the wage settlement;
  - authorities’ ambitious downsizing plan may be insufficient; if voluntary redundancies fall short, alternative measures, including more difficult ones, must be considered to maintain macroeconomic stability;
  - build a taxpayer culture and strengthen legal framework and enforcement for taxes, especially excise taxes, to offset revenue decline from WTO accession;
  - fully operationalize and roll out the accounting system to all ministries and introduce a medium-term budget framework to signal commitment to sustainable fiscal policy and foster donor support;
  - resist political pressure to re-enter the power sector and accelerate public enterprise reform;
  - further monetary tightening may be needed and full exchange rate flexibility should be used; NRBT’s capacity to implement needed policies is uncertain and greater central bank independence is required—early enactment of Amendments to the NRBT Act is critical;
  - improve the business and investment climate (including repealing the IDI Act and clarifying public-private boundaries), strengthen independent regulatory agencies, and amend the land regime to extend lease durations and reduce rent uncertainty;
  - improve the reliability, coverage, and timeliness of national, external, and public accounts data to assist policymaking.
- Institutional recommendation: next Article IV consultation proposed on the standard 12-month cycle.

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06241.pdf*

### Box 2. Tonga’s Accession to the World Trade Organization

### Box 2. Tonga’s Accession to the World Trade Organization

### Background and objectives
- Tonga’s impending accession to the WTO represents a significant step in its efforts to liberalize trade.
- After ten years of negotiation, the terms of Tonga’s membership, including the schedule of its commitments, were approved by the WTO in December 2005.
- If Tonga ratifies these terms by end-July, it will become the 150th member and the fourth Pacific islands country to join the institution (after Fiji, Papua New Guinea, and the Solomon Islands).
- In Tonga, accession to the WTO is seen as a way to enhance trade security, improve market access, and foster competitiveness.

### Regional integration context
- Accession to the WTO would complement Tonga’s regional efforts towards greater economic integration.
- Tonga has signed:
  - the Pacific Island Countries Trade Agreement, which is expected to bring a regional free trade zone by 2010–12, and
  - the Pacific Agreement on Closer Economic Relations, which aims to liberalize trade with Australia and New Zealand.
- Tonga is also negotiating with the European Union a new trade arrangement under the Economic Partnership Agreement.

### WTO commitments and implementation timeline
- As part of the WTO accession, Tonga is committed to reduce tariffs to a maximum of 20 percent (15 percent for some goods) by the beginning of 2007, and eliminate the tax and tariff exemptions allowed under the Industrial Development Incentive Act.
- Key dates and milestones:
  - Ten years of negotiation leading to approval in December 2005.
  - Ratification conditional by end-July for WTO membership status.
  - Tariff reduction target by the beginning of 2007.
  - Regional free trade zone expected by 2010–12.

### Tax reforms and revenue adjustments
- Tonga has been carrying out tax reforms to minimize the revenue implications of its accession.
- A comprehensive tax reform was approved in 2002 to shift Tonga’s tax system away from trade taxes and towards greater reliance on domestic taxation, coupled with efforts to strengthen overall tax compliance.
- A 15 percent consumption tax was introduced in April 2005 to replace the domestic sales tax and the ports and services tax.
- The authorities plan to offset the resulting foregone revenue through higher excise collection and the

### Current tariff profile (as described)
- Most of the remaining tariff rates range now from 0–30 percent.
- Some products attract higher rates:
  - motor vehicles: 45 percent
  - petroleum products: 35 percent

*Box 2. Tonga’s Accession to the World Trade Organization — IMF staff summary as presented in the source PDF*

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### _cr06241 - introduction of a road tax. To

### Macroeconomic outlook and recent developments
- Real GDP growth: 2004/05: 2.3; 2005/06 (Prel.): 1.9; 2006/07 (Proj.): 0.6.
- Consumer prices (period average): 2004/05: 9.5; 2005/06 (Prel.): 7.2; 2006/07 (Proj.): 10.3.
- Short-term prospects are highly uncertain and hinge on successful implementation of civil service downsizing and asset sale proceeds to finance severance and stabilize reserves.
- Civil service wage increase granted in September 2005: average wage increases of about 70 percent; payment schedule 60 percent in 2005/06 and 40 percent in 2006/07. Estimated unanticipated cost of the first phase: about 3 percent of GDP.
- Proposed downsizing: authorities aim to reduce the civil service by a quarter by end-fiscal year, with related severance payments that could amount to about 5 percent of GDP.

### Fiscal developments, composition, and reform measures
- Fiscal balances (percent of GDP):
  - Total revenue and grants: 2004/05: 29.1; 2005/06 (Prel.): 29.4; 2006/07 (Proj.): 29.0.
  - Total expenditure and net lending: 2004/05: 26.7; 2005/06 (Prel.): 36.1; 2006/07 (Proj.): 30.5.
  - Overall balance: 2004/05: 2.4; 2005/06 (Prel.): -6.7; 2006/07 (Proj.): -1.5.
- Fiscal financing and receipts:
  - External financing (net): 2004/05: 0.4; 2005/06 (Prel.): 1.8; 2006/07 (Proj.): 1.3.
  - Domestic financing (net): 2004/05: -2.8; 2005/06 (Prel.): 0.5; 2006/07 (Proj.): 0.2.
  - Privatization receipt: 2005/06 (Prel.): 4.4 (percent of GDP); 2006/07 (Proj.): 0.0.
- Key reform steps and needs:
  - Introduction of a road tax (implementation would require strengthened legal framework and tax enforcement).
  - Next reform step: introduction of a simplified income tax in 2007/08.
  - Strengthen legal framework and capacity for tax enforcement to offset revenue loss from WTO accession.
  - Fully operationalize accounting system and roll out to all ministries; introduce a medium-term budget framework.
  - Accelerate public enterprise reform; avoid renationalization of the power sector.
  - Consider alternatives if the large-scale civil service downsizing does not materialize.

### External sector, reserves, and remittances
- Balance of payments and external flows (millions of U.S. dollars and percent of GDP):
  - Exports, f.o.b.: 2004/05: 16.0; 2005/06 (Prel.): 15.9; 2006/07 (Proj.): 16.9.
  - Imports, f.o.b.: 2004/05: -105.4; 2005/06 (Prel.): -114.0; 2006/07 (Proj.): -122.2.
  - Services and income (net): 2004/05: -12.8; 2005/06 (Prel.): -5.7; 2006/07 (Proj.): -2.5.
  - Transfers (net): 2004/05: 91.9; 2005/06 (Prel.): 89.9; 2006/07 (Proj.): 95.4.
  - Current account balance (in percent of GDP): 2004/05: -4.8; 2005/06 (Prel.): -6.2; 2006/07 (Proj.): -5.2.
- Gross international reserves:
  - In millions of U.S. dollars: 2004/05: 42.5; 2005/06 (Prel.): 45.0; 2006/07 (Proj.): 39.5.
  - In months of goods and services imports: 2004/05: 3.7; 2005/06 (Prel.): 3.7; 2006/07 (Proj.): 3.0.
- Remittances:
  - Private transfer receipts (net, percent of GDP and levels): private transfers are a large external inflow—2004/05: transfers (net) 91.9 (millions); noted that in 2004/05 net remittances were over two times the value of exports.

### Debt sustainability—external and public debt assessment
- Nominal GDP (2003/2004): US$ 182.1 million; Population (2003): 101,405; GDP per capita (2003/04): US$1,796.
- External public debt and NPV indicators (end-2004/05):
  - Stock of external public debt: $76.4 million; NPV of external public debt: $50.1 million.
  - NPV of debt-to-exports (2004/05): 128.1 percent (policy-based indicative threshold for poor performers: 100 percent).
  - NPV of debt-to-GDP (2004/05): 23.3 percent (threshold 30 percent); NPV of debt-to-revenues (2004/05): 79.8 percent (threshold 200 percent).
  - Debt service ratio: 2004/05: 8.4 percent of exports (threshold 15 percent).
- Staff finding: Tonga has moved into the LIC category with a high risk of debt distress; NPV of debt-to-exports breaches threshold from 2004/05 through 2016/17 under the baseline “reforms stall” scenario.
- Projections under “Reforms Stall” scenario:
  - NPV of PPG external debt-to-exports remains above 100 percent for much of the medium term, falling to 102.7 percent by 2015/16 and to 66.1 percent by 2025/26.
  - External debt (in percent of GDP): projected 2004/05: 35.5; 2005/06: 35.7; 2006/07: 34.7; then gradual decline in long run.
- Vulnerabilities and stress tests:
  - A sharp fall in net transfers (historical average minus one standard deviation) in 2006/07–07/08 could push debt stock indicators well above threshold levels, though debt service ratio may remain below threshold.
  - One-time 30 percent real depreciation or a 10 percent of GDP increase in other debt-creating flows in 2006/07 would sharply raise debt stock and debt service indicators.
  - Conversely, returning key variables (real GDP growth and primary balance) to historical averages would markedly improve all ratios.
- Fiscal debt (domestic) risks:
  - Domestic debt at end-2004/05: 15.4 percent of GDP; total public debt: 50.8 percent of GDP.
  - Under “reforms stall,” domestic financing of deficits projects total public debt to rise to 62.6 percent of GDP in 2010/11, continuing thereafter.
- Staff assessment conclusion: Tonga’s external debt dynamics are subject to a high risk of debt distress; full implementation of planned fiscal and private sector reforms is critical to restore sustainability.

### Monetary, banking, and financial sector developments
- Monetary aggregates (annual percent change):
  - Total liquidity (M2 basis): 2004/05: 13.3; 2005/06 (Prel.): 14.1; 2006/07 (Proj.): 10.7.
  - Broad money (M2): 2004/05: 12.8; 2005/06 (Prel.): 14.6; 2006/07 (Proj.): 10.9.
  - Domestic credit: 2004/05: 20.9; 2005/06 (Prel.): 18.7; 2006/07 (Proj.): 14.5.
  - Private sector credit: 2004/05: 29.4; 2005/06 (Prel.): 17.0; 2006/07 (Proj.): 13.3.
- Central bank and policy actions:
  - Rapid rise in housing and personal loans led NRBT to reintroduce credit ceilings in January 2006.
  - Reserve requirements were reduced in March 2006 amid tightening liquidity and pressure to ease monetary stance.
  - Executive Directors supported further tightening of monetary policy in response to wage settlement and recommended use of full exchange rate flexibility if needed; introduction of open-market type instruments seen as useful but untested.
  - Amendments to the NRBT Act to strengthen enforcement capacity are pending enactment by Parliament.
- Banking soundness indicators (2000–05 highlights):
  - Risk-weighted capital ratio ranged: 18.1 (2000) to 24.7 (2001) to 19.7 (2005).
  - Non-performing loan to total loans: 2000: 9.3; 2005: 4.2.
  - Return on assets: 2005: 6.6; Return on equity: 2005: 26.8.

### Policy recommendations and priorities highlighted by IMF staff/Executive Directors
- Fiscal policy and public sector:
  - Contain costs of the wage settlement; pursue the planned civil service downsizing or alternative measures if downsizing does not proceed.
  - Strengthen tax administration and enforcement; bolster legal framework for tax collection (including for any new road tax).
  - Adopt a medium-term budget framework and fully operationalize government accounting across ministries.
  - Accelerate public enterprise reform; resist renationalization of key sectors (e.g., power).
- Monetary and exchange rate policy:
  - Tighten monetary policy as needed to contain inflationary pressures from wage increases.
  - Utilize the full flexibility of the exchange rate system if circumstances require.
  - Introduce and test open-market type instruments to improve central bank control over monetary conditions.
  - Enact amendments to the NRBT Act to strengthen central bank independence and enforcement capacity.
- Financial sector and AML/CFT:
  - Continue close monitoring of rapid credit growth to avoid asset quality deterioration.
  - Build on progress in AML/CFT to address remaining issues.
- Structural reforms to boost growth:
  - Improve the business and investment climate: repeal distortionary tax incentives, reduce restrictions on business licensing and foreign direct investment, and strengthen legal framework for property rights.
  - Implement private-sector reforms to foster higher growth and improve debt dynamics.
- Statistics and data:
  - Improve timeliness, coverage, and reliability of national accounts, government finance, and balance of payments statistics to support policy analysis and donor coordination.

### Key summary indicators (select)
- Nominal GDP (2003/2004): US$ 182.1 million.
- Population (2003): 101,405.
- GDP per capita (2003/04): US$1,796.
- External public debt (stock, end-2004/05): $76.4 million; NPV $50.1 million.
- NPV of PPG external debt-to-exports (2004/05): 128.1 percent.
- Gross international reserves (end-2004/05): $42.5 million (3.7 months of imports).
- Total revenue and grants (2005/06 Prel.): 29.4 percent of GDP; Total expenditure and net lending (2005/06 Prel.): 36.1 percent of GDP; Overall balance (2005/06 Prel.): -6.7 percent of GDP.
- Total liquidity (M2 survey basis, 2005/06 Prel.): 14.1 percent change; Private sector credit (2004/05): 29.4 percent annual change.

*Source: IMF staff report and annexes for Tonga, Article IV Consultation and joint IMF/World Bank Debt Sustainability Analysis (2006).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06241.pdf_