## _cr07297 - Executive Summary ## Source details **Canonical URL:** [_cr07297 - Executive Summary](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07297.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07297.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07297.pdf.json) --- ### Background and Country Context - 70 percent civil service wage award in late 2005; full annual cost of about 7 percent of GDP. - About 18–20 percent of civil servants took voluntary redundancy in mid-2006 (about 3 percent of Tonga’s total labor force), at a substantial cost to the budget. - Riots in November 2006 caused estimates of total losses in structures and inventories ranging from 10 to 25 percent of GDP; eight people died and the capital’s business district was ransacked. - Small population (about 100,000); an estimated 100,000 Tongans live abroad; remittances have grown to the equivalent of almost half of GDP. - Chronology highlights: - 2005 July-September—strike and 70 percent wage increase agreement. - 2006 June-July—retrenchment program implemented. - 2006 November—rioting in Nuku'alofa. ### Recent Economic Developments - Output and prices - Real GDP projected to fall by 3½ percent in the fiscal year ending in June 2007, mainly due to the November unrest with a sharp drop in commerce and tourism services. - Consumer price inflation slowed to about 5 percent by early 2007, down from about 10 percent in FY04/05. - Fiscal outcomes and measures - FY05/06 fiscal balance swung into a deficit of 3⅓ percent of GDP from a 2½ percent surplus the year before. - The wage bill rose to 20 percent of GDP from 12 percent of GDP in FY04/05. - Voluntary redundancy program cost about 7½ percent of GDP to the budget, financed by a drawdown of government deposits. - FY06/07 budget targeted narrowing of the deficit to 2⅓ percent of GDP; authorities maintained the overall deficit target for FY06/07 despite revenue losses, necessitating trimming non-wage spending. - Monetary measures and credit - Private credit growth at about 22½ percent (y-o-y) by end of FY05/06; bank-by-bank ceilings introduced and reset through December. - Private sector credit decelerated to an annual rate of 10½ percent by end-December 2006. - NRBT eased liquidity in early 2007 (lowering reserve requirements and reducing outstanding stock of notes) to support reconstruction credit; NRBT issued notes of 28 days or shorter maturity at rates around 4-5 percent. - External sector - External current account deficit projected to widen to 10½ percent of GDP in FY06/07 from 8¼ percent of GDP in FY05/06. - Donor loans (mainly ADB) and recorded private inflows expected broadly at FY05/06 levels. - Official reserves remained broadly stable from mid-2005 to early 2007 despite the riots. - Private remittances data show a decline of about 10 percent cumulatively over FY05/06–FY06/07, though data quality is weak. ### Medium-Term Outlook and Risks - Growth projections - Real GDP projected at 1 percent in FY07/08; medium-term trend about 1 percent a year. - Fiscal baseline (excluding contemplated external borrowing) - Overall deficits in the 1–1½ percent range. - Official reserves stabilizing at 2¼ months of imports of goods and services by 2010 (just under 3 months of imports of goods, the authorities’ benchmark). - Major risks - Political uncertainty related to the democratic transition and potential flare-ups around trials and elections (parliamentary elections in March 2008). - Pressures to increase public sector hiring that could raise the wage bill. - Further drops in remittances and terms-of-trade shocks. - Debt sustainability concerns - Public external debt near 37 percent of GDP. - Stress tests indicate susceptibility to domestic and external shocks and place Tonga at a high risk of debt distress. - Authorities seeking a possible US$50 million (20 percent of GDP) loan from the PRC to finance reconstruction; loan terms sought would entail a grant element of about 30 percent (interest rate 2 percent, 5-year grace period, 25-year maturity). - Permanent increase in external debt service profile from such borrowing would be about 2 percent of GDP per year for 20 years starting in 2013, heightening budget and balance-of-payments pressures and sharply increasing risks of debt distress. ### Fiscal Policy, External Borrowing, and Reconstruction Projects - Authorities intend to target a small budget deficit in FY07/08 of about 1 percent of GDP while continuing to seek a large loan from the People’s Republic of China to finance mainly reconstruction projects. - Authorities’ rationale: with most labor and material inputs procured externally, little pressure would be placed on domestic demand and inflation; authorities confident debt service obligations could be met by savings in future budgets; authorities recognized the currency risk attached to the loans. - Staff concerns and recommendations - Serious concerns about risks of large borrowing for fiscal and external debt sustainability. - Preliminary debt sustainability analysis pointed to heightened risks of medium-term debt distress. - Staff urged scaling back borrowing plans and ensuring all risks (including currency valuation) are carefully accounted for in debt sustainability analysis. - Staff recommended maximizing the role of the private sector in reconstruction efforts to reduce the need for public financing. - Specific risk figures cited - Current plans to borrow externally for reconstruction projects up to US$50 million (20 percent of GDP) entail considerable risks for external debt sustainability in the medium term. - A possible state acquisition of the power company could incur an upfront cost that could exceed 4 percent of GDP and was advised against by staff. ### Revenue Policy and WTO-Related Tax Reform - Authorities intend to complete comprehensive reform envisaged under WTO accession in FY07/08. - Remaining tax bills planned to be tabled at the 2007 session of Parliament, starting in June, include: - a reduction in tariffs compensated by increases in non-discriminatory excises; and - income tax reform. - Authorities confident revenue impact would be neutral, "as it was designed to be." - Staff welcomed plans and encouraged readiness to take corrective revenue measures if needed; recent progress in tax administration should be sustained with donor and PFTAC support. ### Wage Bill, Public Sector Reform, and Fiscal Consolidation - Agreement that continued efforts to reduce the wage bill are crucial to sustaining fiscal consolidation. - Authorities’ intended measures: - Pursue public sector reform program focused on improving professionalism, efficiency, and accountability. - Expect attrition would allow a reduction in staffing numbers. - Favor adopting a more orderly mechanism to adjust public wages to avoid disruptions associated with large one-off settlements. - Develop a medium-term fiscal framework, with support from the AsDB, to strengthen public financial management. - Box 1 fiscal figures related to civil service wage settlement - Civil service salary increase agreed at 60–80 percent, effective from July 2005, with the salary increase for the first year paid in two phases, in FY05/06 and FY06/07. - Total cost of the wage increase was about 4¼ percent of GDP for FY05/06. - In FY06/07, the additional cost of the settlement is estimated at about 4¼ percent of GDP. - Average wages increased by about 92 percent in FY06/07 from their base level in FY04/05, returning in FY07/08 to a level 70 percent above this base. - Staffing cuts reduced personnel by a significant 18 percent. - Severance packages for voluntary redundancies imposed an additional cost on the budget, estimated at 5½ percent of GDP. - Under pension law, government required to fund pension liabilities of departing civil servants, at a cost of 2 percent of GDP. - Table figures (Wage and Salaries Expenditure, selected entries preserved exactly as in source) - Wage and salaries expenditure (In millions of pa'anga): 49.7 90.8 83.7 75.3 - Of which: 60 % increase ...19.0...... - 40 % carryover......9.6... - Additional 40 % increase......9.6... - Severance package 1/...24.5...... - (In percent of GDP) Wage and salaries expenditure 11.9 20.1 18.1 15.2 - Of which: 60 % increase ...4.2...... - 40 % carryover......2.1... - Additional 40 % increase......2.1... - Severance package 1/...5.4...... - Memorandum item: Wage bill excluding one-off payments (in percent of GDP) 11.9 14.7 16.0 15.2 - Proj./Prel./Years indicated in table: 2004/05 2005/06 2006/07 2007/08 Prel./Proj. ### Monetary Policy, Banking Soundness, and Exchange Rate Regime - Monetary stance and NRBT actions - Recent easing of monetary stance considered understandable given disruptions from the November events. - NRBT’s prudent conduct had been instrumental in reducing inflation and limiting pressures on foreign reserves after the wage settlement. - Concern that lifting of credit ceilings and sharp increases in liquidity could lead to rapid private credit expansion that may be difficult to control; NRBT monitors monetary developments closely and would take prompt action if needed. - Strengthening of monetary policy instruments - Greater use of indirect instruments: issuance of NRBT notes in mid-2006 for the first time in several years. - Staff encouraged strengthening the legal framework for indirect instruments, including planned amendments to the NRBT Act (doubling of the central bank’s capital and clarification of profit transfer rules); authorities confirmed plans to table these amendments at the 2007 parliamentary session. - Staff called for introducing statutory limits on central bank credit to the government to give a legal basis to de facto policy and solidify monetary policy independence. - Exchange rate and reserves - NRBT pegging of the pa’anga to its reference basket has reduced inflation but also introduced risks. - By pegging narrowly to the basket, and with Tonga’s inflation remaining well above that of trading partner countries, the currency had appreciated in real effective terms over 2003-06, albeit to a level that "does not clearly suggest overvaluation." - Staff recommended greater use of exchange rate flexibility to allow the pa’anga to depreciate relative to the currency basket to address external competitiveness concerns. - Exchange control measures and IMF classification - Authorities tightened foreign exchange regulations in 2006 via four exchange control directives tightening documentary requirements for applications to authorized dealers. - Staff determined the tax clearance certification requirement constitutes an exchange restriction under Article VIII, Section 2(a); staff recommended approval of retention of the exchange restriction through July 9, 2008 or the conclusion of the next Article IV consultation with Tonga, whichever is earlier. - Banking sector soundness - Banking soundness indicators suggest banks’ balance sheets and incomes remain solid. - Small increase in the share of impaired assets in total loans in the year to December 2006; bank profitability remained healthy; provisioning levels were adequate. - NRBT did not see systemic risk but recommended vigilant supervision as debt servicing capacity of some borrowers had deteriorated. - Prudential framework improved with adoption of additional supervision guidelines in 2006 after the Financial Institutions Act of 2004 became effective in October 2005. ### Structural Reforms, Public Enterprises, and Statistics - WTO accession - Accession to the WTO is an important achievement; authorities intend to seek parliamentary ratification of WTO accession. - Staff noted WTO accession’s impact could be leveraged by stepping up other reforms to improve investment climate and encourage private foreign investment. - Business environment and governance - Private sector activity constrained by restrictions on business licensing and visas, and red tape. - Tonga’s performance on the World Bank’s governance indicators has deteriorated in recent years and remains well below levels of regional comparators. - A public-private task force set up in early 2006 produced recommendations; authorities indicated they would revive efforts to implement the task force’s recommendations. - Public enterprise reform - Comprehensive agenda developed, including enactment of a Public Enterprise Reform Act, but implementation hampered by capacity constraints and political sensitivity. - Staff supported authorities’ focus on improving enterprise management and accountability to reduce fiscal risks from poor performance. - Statistics and capacity building - Key weaknesses in national, external, and public accounts hamper effective surveillance. - Authorities will seek technical assistance to improve reliability, coverage, and timeliness of statistics; staff encourages continued efforts and Fund assistance. ### Staff Appraisal: Growth, Risks, and Key Recommendations - Economic performance and outlook - Economy showed resilience to large shocks; real GDP projected to decline by 3½ percent in FY06/07. - Inflation stabilized in the mid-single digits; financial stability maintained; exchange reserves losses contained. - Medium-term growth prospects expected to remain muted; economy remains vulnerable to shocks. - Key staff recommendations and warnings - Cautious conduct of fiscal policy remains crucial to ensure stability. - Consolidate revenue gains and resist wage and hiring pressures; reducing the wage bill is the linchpin of medium-term fiscal consolidation efforts. - Consider scaling back external borrowing plans; US$50 million (20 percent of GDP) borrowing plans entail considerable risks of debt distress. - Advise against a possible state acquisition of the power company given fiscal risks. - NRBT should continue to monitor monetary and credit developments closely after recent easing; tightening may be needed if fiscal pressures re-emerge. - Make greater use of flexibility in the foreign exchange regime to counter real exchange rate appreciation. - Approve retention of the exchange restriction (tax certification requirement) through July 9, 2008 or the next Article IV consultation, whichever is earlier, given authorities intend to resolve related tax arrears within 12 months. - WTO accession welcomed but other reforms remain imperative to achieve faster growth and encourage private foreign investment. - Continue efforts to improve statistical capacity; next Article IV consultation proposed on a 12-month cycle. ### Box 2. Remittances in Tonga — Scale, Trends, and Role - Scale and recent trends - Tonga’s private transfer receipts grew by close to 15 percent a year (in pa’anga) over 2000-05. - Aggregate remittance flows reached 45 percent of GDP in 2005. - Private transfer receipts in U.S. dollar terms peaked in the third quarter of 2004 and have since declined. - Total gross receipts in 2006, in U.S. dollar terms, were 12 percent below the level in 2005. - Latest data showed a pick-up of remittances in the months of January and February, albeit still at levels below than those of the same period in the previous year. - Sources, channels, and data limitations - Bulk remitted from Tongan migrants in Australia, New Zealand, and the U.S. toward the household sector. - 1994 Sydney survey: remittances sent evenly through bank transfers, hand-carried cash, and in-kind deliveries. - Data are difficult to obtain; apparent declines in OET-based measures may reflect increased use of channels not captured in OET data (for example, in-kind remittances). - Drivers and role - Remittance growth supported by sustained income growth in host economies; valuation effects limited. - Remittances have served as a shock absorber: filling reconstruction financing gaps and smoothing consumption. - Some positive response of remittances to the recent unrest expected in the short term. - Recipient composition - Survey for G-20 workshop estimated close to 90 percent of total remittances went to households. ### Box 3. Tonga: Comprehensive Tax Reform — Key Features - Background - Comprehensive tax reform package approved in 2002; broad-based consumption tax introduced in April 2005. - Remaining parts scheduled for implementation in FY07/08 alongside WTO accession; final domestic tax bills planned for Parliament in June 2007. - Key features - Corporate income tax: a corporate income tax rate of 25 percent will be introduced for both domestic and foreign companies, replacing differential rates for foreign companies of 37-40 percent and domestic companies of 15–30 percent. - Individual income tax: the individual income tax threshold will be raised. - Excises: coverage extended to both domestic and imported excisable goods (beer, cigarettes, motor vehicles, liquor). - Customs tariffs: duty rates reduced to a maximum of 15–20 percent. - Revenue design - Reform package planned to be revenue neutral; tariff reductions to be offset mainly through excise tax collection. ### Selected Economic Indicators (highlights from table) - Real GDP (percent change): 2002/03: 3.2; 2003/04: 1.4; 2004/05: 2.3; 2005/06: 1.3; 2006/07: -3.5; 2007/08: 0.8 - Consumer prices (period average): 2002/03: 11.1; 2003/04: 11.7; 2004/05: 9.7; 2005/06: 7.0; 2006/07: 5.9; 2007/08: 5.3 - Central government finance (percent of GDP) - Total revenue and grants: 2005/06: 34.1; 2006/07: 33.8; 2007/08: 34.2 - Total expenditure and net lending: 2005/06: 37.4; 2006/07: 36.1; 2007/08: 45.4 - Overall balance (excl. reconstruction loan): 2006/07: -2.3; 2007/08: -1.0 - Overall balance (incl. reconstruction loan): 2007/08: -11.2 - External financing (net): 2006/07: 1.4; 2007/08: 11.1 - Balance of payments (millions of U.S. dollars) - Exports, f.o.b.: 2006/07: 15.6; 2007/08: 15.9 - Imports, f.o.b.: 2006/07: -118.9; 2007/08: -132.5 - Transfers (net): 2006/07: 87.6; 2007/08: 91.4 - Current account balance (excl. reconstruction loan) (in millions): 2006/07: -23.7; 2007/08: -45.8 - Current account balance (In percent of GDP): 2006/07: -10.5; 2007/08: -19.0 - Gross international reserves - In millions of US dollars: 2006/07: 37.1; 2007/08: 33.5 - In months of total imports: 2006/07: 2.9; 2007/08: 2.2 - External debt (percent of GDP): 2006/07: 36.9; 2007/08: 45.7 - Debt service ratio (percent of exports of goods and services): 2006/07: 10.5; 2007/08: 9.8 *Executive Summary (IMF country report content unit _cr07297).* ### Executive Summary ...................................................................................................... ### _cr07297 - Executive Summary ### Background and Country Context - 70 percent civil service wage award in late 2005; full annual cost of about 7 percent of GDP. - About 18–20 percent of civil servants took voluntary redundancy in mid-2006 (about 3 percent of Tonga’s total labor force), at a substantial cost to the budget. - Riots in November 2006 caused estimates of total losses in structures and inventories ranging from 10 to 25 percent of GDP; eight people died and the capital’s business district was ransacked. - Population context: small population (about 100,000); an estimated 100,000 Tongans live abroad; remittances have grown to the equivalent of almost half of GDP. - Chronology highlights: - 2005 July-September—strike and 70 percent wage increase agreement. - 2006 June-July—retrenchment program implemented. - 2006 November—rioting in Nuku'alofa. ### Recent Economic Developments - Real GDP projected to fall by 3½ percent in the fiscal year ending in June 2007, mainly due to the November unrest with a sharp drop in commerce and tourism services. - Consumer price inflation slowed to about 5 percent by early 2007, down from about 10 percent in FY04/05. - Fiscal outcomes and measures: - FY05/06 fiscal balance swung into a deficit of 3⅓ percent of GDP from a 2½ percent surplus the year before. - The wage bill rose to 20 percent of GDP from 12 percent of GDP in FY04/05. - Voluntary redundancy program cost about 7½ percent of GDP to the budget, financed by a drawdown of government deposits. - FY06/07 budget targeted narrowing of the deficit to 2⅓ percent of GDP. - Authorities maintained the overall deficit target for FY06/07 despite revenue losses, necessitating trimming non-wage spending. - Monetary measures and credit: - Private credit growth at about 22½ percent (y-o-y) by end of FY05/06; bank-by-bank ceilings introduced and reset through December. - Private sector credit decelerated to an annual rate of 10½ percent by end-December 2006. - NRBT eased liquidity in early 2007 (lowering reserve requirements and reducing outstanding stock of notes) to support reconstruction credit; NRBT issued notes of 28 days or shorter maturity at rates around 4-5 percent. - External sector: - External current account deficit projected to widen to 10½ percent of GDP in FY06/07 from 8¼ percent of GDP in FY05/06. - Donor loans (mainly ADB) and recorded private inflows expected broadly at FY05/06 levels. - Official reserves remained broadly stable from mid-2005 to early 2007 despite the riots. - Private remittances data show a decline of about 10 percent cumulatively over FY05/06–FY06/07, though data quality is weak. ### Medium-Term Outlook and Risks - Real GDP projected at 1 percent in FY07/08; medium-term trend about 1 percent a year. - Medium-term fiscal baseline (excluding contemplated external borrowing) implies overall deficits in the 1–1½ percent range and official reserves stabilizing at 2¼ months of imports of goods and services by 2010 (just under 3 months of imports of goods, the authorities’ benchmark). - Major risks: - Political uncertainty related to the democratic transition and potential flare-ups around trials and elections (parliamentary elections in March 2008). - Pressures to increase public sector hiring that could raise the wage bill. - Further drops in remittances and terms-of-trade shocks. - Debt sustainability concerns: - Public external debt near 37 percent of GDP. - Stress tests indicate susceptibility to domestic and external shocks and place Tonga at a high risk of debt distress. - Authorities seeking a possible US$50 million (20 percent of GDP) loan from the PRC to finance reconstruction; loan terms sought would entail a grant element of about 30 percent (interest rate 2 percent, 5-year grace period, 25-year maturity). - Permanent increase in external debt service profile from such borrowing would be about 2 percent of GDP per year for 20 years starting in 2013, heightening budget and balance-of-payments pressures and sharply increasing risks of debt distress. ### Key Policy Recommendations and Staff Advice - Fiscal policy: - Sustain recent revenue gains and resist pressures on the wage bill. - Ensure non-wage spending is carefully prioritized and trimmed where necessary to meet the FY06/07 deficit target of about 2⅓ percent of GDP. - For FY07/08, aim to place fiscal policy on a sustainable track: revenue administration and compliance improvements, resist hiring pressures to bring the wage bill down to about 15 percent of GDP (a saving of 3 percent of GDP), and prioritize a measured increase in non-wage current and capital spending. With donor financing around about 1 percent of GDP, a reduction in the overall deficit to about 1 percent of GDP for FY07/08 appeared achievable. - Consider scaling back external borrowing plans that would heighten medium-term risks of debt distress. - Monetary and exchange rate policy: - Closely monitor credit developments; monetary tightening may become necessary if new fiscal pressures emerge. - Make greater use of the flexibility in the foreign exchange regime to counter real exchange rate appreciation. - Structural reforms: - Accelerate implementation of structural reforms to improve the business environment, make the economy more dynamic, and support higher medium-term growth. - Reconstruction financing: - Staff warned that the contemplated large loan from the PRC would have limited medium-term growth benefits, a low grant element, and would significantly raise debt-service obligations and debt distress risks. *Executive Summary (IMF country report content unit _cr07297).* ### 14. While the authorities intend to submit a draft budget to Parliament broadly in ### _cr07297 - 14. While the authorities intend to submit a draft budget to Parliament broadly in ### Fiscal policy, external borrowing, and reconstruction projects - Authorities intend to target a small budget deficit in FY07/08 of about 1 percent of GDP while continuing to seek a large loan from the People’s Republic of China to finance mainly reconstruction projects. - Authorities consider these reconstruction projects consistent with short-term macroeconomic objectives on the grounds that, with most labor and material inputs procured externally, little pressure would be placed on domestic demand and inflation; and consistent with long-term goals as they were confident that debt service obligations could be met by savings in future budgets. Authorities recognized the currency risk attached to the loans. - Staff concerns and recommendations: - Staff expressed serious concerns about risks of large borrowing for fiscal and external debt sustainability. - Staff preliminary debt sustainability analysis pointed to heightened risks of medium-term debt distress. - Staff urged authorities to consider scaling back borrowing plans and to ensure all risks were carefully accounted for in debt sustainability analysis, including risks related to changes in currency valuation. - Staff recommended maximizing the role of the private sector in reconstruction efforts to reduce the need for public financing. - Specific risk figures cited by staff: - Current plans to borrow externally for reconstruction projects up to US$50 million (20 percent of GDP) entail considerable risks for external debt sustainability in the medium term. - A possible state acquisition of the power company could incur an upfront cost that could exceed 4 percent of GDP and was advised against by staff. ### Revenue policy and WTO-related tax reform - Authorities intend to complete comprehensive reform envisaged under WTO accession in FY07/08. - Remaining tax bills planned to be tabled at the 2007 session of Parliament, starting in June, include: - a reduction in tariffs compensated by increases in non-discriminatory excises; and - income tax reform. - Authorities are confident that the revenue impact of these tax changes would be neutral, "as it was designed to be." - Staff welcomed plans and encouraged readiness to take corrective revenue measures if needed, noting that recent progress in improving tax administration would need to be sustained. - Authorities agreed on the need to pursue recent tax administration initiatives, with donor and PFTAC support. ### Wage bill, public sector reform, and fiscal consolidation - Authorities and staff agreed that continued efforts to reduce the wage bill are crucial to sustaining fiscal consolidation. - Context and observations: - Despite retrenchment, the wage bill remained large by international or regional standards, reflecting high unit wages relative to per capita income or a high level of civil service employment. - A lower wage bill would allow more flexibility to allocate public resources toward development priorities. - Authorities’ intended measures: - Pursue public sector reform program focused on improving professionalism, efficiency, and accountability. - Expect attrition would allow a reduction in staffing numbers. - Favor adopting a more orderly mechanism to adjust public wages to avoid disruptions associated with large one-off settlements. - Develop a medium-term fiscal framework, with support from the AsDB, to strengthen public financial management. - Boxed statistical and fiscal figures related to the civil service wage settlement (Box 1): - Civil service salary increase agreed at 60–80 percent, effective from July 2005, with the salary increase for the first year paid in two phases, in FY05/06 and FY06/07. - Total cost of the wage increase was about 4¼ percent of GDP for FY05/06. - In FY06/07, the additional cost of the settlement is estimated at about 4¼ percent of GDP. - Average wages increased by about 92 percent in FY06/07 from their base level in FY04/05, returning in FY07/08 to a level 70 percent above this base. - Staffing cuts reduced personnel by a significant 18 percent. - Severance packages for voluntary redundancies imposed an additional cost on the budget, estimated at 5½ percent of GDP. - Under pension law, government required to fund pension liabilities of departing civil servants, at a cost of 2 percent of GDP. - Table figures (Wage and Salaries Expenditure, selected entries preserved exactly as in source): - Wage and salaries expenditure (In millions of pa'anga): 49.7 90.8 83.7 75.3 - Of which: 60 % increase ...19.0...... - 40 % carryover......9.6... - Additional 40 % increase......9.6... - Severance package 1/...24.5...... - (In percent of GDP) Wage and salaries expenditure 11.9 20.1 18.1 15.2 - Of which: 60 % increase ...4.2...... - 40 % carryover......2.1... - Additional 40 % increase......2.1... - Severance package 1/...5.4...... - Memorandum item: Wage bill excluding one-off payments (in percent of GDP) 11.9 14.7 16.0 15.2 - Proj./Prel./Years indicated in table: 2004/05 2005/06 2006/07 2007/08 Prel./Proj. (labels preserved as in source). ### Monetary policy, banking soundness, and exchange rate regime - Monetary stance and NRBT actions: - Recent easing of monetary stance was considered understandable given disruptions from the November events. - NRBT’s prudent conduct of monetary policy had been instrumental in reducing inflation and limiting pressures on foreign reserves in the wake of the wage settlement. - Concern that lifting of credit ceilings and sharp increases in liquidity could lead to rapid private credit expansion that may be difficult to control. - NRBT monitors monetary developments closely and would take prompt action if needed. - Strengthening of monetary policy instruments: - Greater use of indirect instruments: issuance of NRBT notes in mid-2006 for the first time in several years. - Staff encouraged strengthening the legal framework for indirect instruments, including planned amendments to the NRBT Act that provide for a doubling of the central bank’s capital and a clarification of profit transfer rules. - Authorities confirmed plans to table these amendments at the 2007 parliamentary session. - Staff called for introducing statutory limits on central bank credit to the government to give a legal basis to de facto policy and solidify monetary policy independence. - Exchange rate and reserves: - NRBT pegging of the pa’anga to its reference basket has reduced inflation but also introduced risks. - By pegging narrowly to the basket, and with Tonga’s inflation remaining well above that of trading partner countries, the currency had appreciated in real effective terms over the period 2003-06, albeit to a level that "does not clearly suggest overvaluation." - Vulnerabilities noted: fiscal situation, weak export performance, and slow structural reform progress raised concerns about external competitiveness, warranting use of exchange rate flexibility to allow the pa’anga to depreciate relative to the currency basket. - Authorities acknowledged risks from sustained real appreciation but argued a broadly stable nominal exchange rate was crucial for inflation decline and financial stability. - Authorities noted foreign reserves had held steady thus far and signaled readiness to tighten monetary policy if significant pressures emerged. - Exchange control measures and IMF classification: - Authorities tightened foreign exchange regulations in 2006 via four exchange control directives tightening documentary requirements for applications to authorized dealers. - Staff determined that the tax clearance certification requirement imposed by authorities on the making of payments and transfers for certain current international transactions constitutes an exchange restriction under Article VIII, Section 2(a) because its scope extends to payments of all other taxes due by the applicant for foreign exchange. - Staff recommendation: approval of the retention of the exchange restriction through July 9, 2008 or the conclusion of the next Article IV consultation with Tonga, whichever is earlier, given authorities’ intention that the problem of tax arrears giving rise to this requirement will be resolved within 12 months. - Banking sector soundness: - Banking soundness indicators suggest banks’ balance sheets and incomes remain solid. - Financial stability preserved despite liquidity stress in some banks after the November events. - Small increase in the share of impaired assets in total loans in the year to December 2006; bank profitability remained healthy; provisioning levels were adequate. - NRBT did not see systemic risk but recommended vigilant supervision as debt servicing capacity of some borrowers had deteriorated. - Prudential framework improved with adoption of additional supervision guidelines in 2006 after the Financial Institutions Act of 2004 became effective in October 2005. ### Structural reforms, public enterprises, and statistics - WTO accession: - Accession to the WTO is an important achievement; authorities intend to seek parliamentary ratification of WTO accession. - Staff noted WTO accession’s impact could be leveraged by stepping up other reforms to improve investment climate and encourage private foreign investment. - Business environment and governance: - Private sector activity constrained by restrictions on business licensing and visas, and red tape. - Tonga’s performance on the World Bank’s governance indicators has deteriorated in recent years and remains well below levels of regional comparators. - A public-private task force set up in early 2006 produced recommendations; authorities indicated they would revive efforts to implement the task force’s recommendations. - Public enterprise reform: - A comprehensive agenda developed, including enactment of a Public Enterprise Reform Act, but implementation hampered by capacity constraints and political sensitivity. - Staff supported authorities’ focus on improving enterprise management and accountability to reduce fiscal risks from poor performance. - Statistics and capacity building: - Key weaknesses in national, external, and public accounts hamper effective surveillance. - Authorities aware and will seek technical assistance to improve reliability, coverage, and timeliness of statistics. - Staff encourages continued efforts to improve statistical capacity; Fund will continue to assist with technical assistance. ### Staff appraisal: growth, risks, and key recommendations - Economic performance and outlook: - Economy has shown resilience to large shocks. - Following the 70 percent wage award to civil servants in 2005 and voluntary redundancies, and civil unrest in November 2006, real GDP is projected to decline by 3½ percent in FY06/07. - Despite shocks, inflation stabilized in the mid-single digits; financial stability maintained; exchange reserves losses contained. - Medium-term growth prospects expected to remain muted; economy remains vulnerable to shocks. - Key staff recommendations and warnings: - Cautious conduct of fiscal policy remains crucial to ensure stability. - Consolidating revenue gains and resisting wage and hiring pressures are necessary; reducing the wage bill is the linchpin of medium-term fiscal consolidation efforts. - Staff advises authorities to consider scaling back external borrowing plans; US$50 million (20 percent of GDP) borrowing plans entail considerable risks of debt distress. - Staff advises against a possible state acquisition of the power company given fiscal risks. - NRBT should continue to monitor monetary and credit developments closely after recent easing; tightening may be needed if fiscal pressures re-emerge. - Authorities should make greater use of flexibility in the foreign exchange regime to counter real exchange rate appreciation. - Staff recommend approval of retention of the exchange restriction (tax certification requirement) through July 9, 2008 or the next Article IV consultation, whichever is earlier, given authorities intend to resolve related tax arrears within 12 months. - WTO accession welcomed but other reforms remain imperative to achieve faster growth and encourage private foreign investment. - Staff encourages continued efforts to improve statistical capacity; next Article IV consultation proposed on a 12-month cycle. *IMF staff report content as provided in the source PDF unit* ### Box 2. Remittances in Tonga ### Box 2. Remittances in Tonga ### Scale and recent trends - Tonga’s private transfer receipts grew by close to 15 percent a year (in pa’anga) over 2000-05. - Aggregate remittance flows reached 45 percent of GDP in 2005. - Private transfer receipts in U.S. dollar terms peaked in the third quarter of 2004 and have since declined. - Total gross receipts in 2006, in U.S. dollar terms, were 12 percent below the level in 2005. - Latest data showed a pick-up of remittances in the months of January and February, albeit still at levels below than those of the same period in the previous year. ### Sources, channels, and data limitations - The bulk of remittances is remitted from Tongan migrants in Australia, New Zealand, and the U.S. towards the household sector. - A 1994 survey of Tongans living in Sydney showed that remittances were sent evenly through bank transfers, hand-carried cash, and in-kind deliveries. - Data are notoriously difficult to obtain, especially as remittances come in through different channels. - Apparent declines in OET-based remittance measures may reflect increased use of channels not captured in OET data (for example, in-kind remittances). ### Drivers and role of remittances - Remittance growth was supported by sustained income growth in the host economies—and valuation effects played a limited role over the reference period. - Growth in private transfer receipts in Tonga consistently outpaced income growth in the main host countries over the past decade, faster even than the continued increase in the number of migrants might imply. - Remittances have long served as a shock absorber in Tonga: filling in the financial gap needed for reconstruction of damaged assets; and smoothing consumption for those affected. - Some positive response of remittances to the recent unrest are expected in the short term. ### Recipient composition - A recent survey prepared for G-20 workshop estimated that close to 90 percent of total remittances went to households. *Box 2. Remittances in Tonga.* ### Box 3. Tonga: Comprehensive Tax Reform ### Box 3. Tonga: Comprehensive Tax Reform ### Background and Context - A comprehensive tax reform package was approved in 2002 as part of the trade liberalization process, shifting revenue sources away from trade taxes to greater reliance on domestic taxation. - For the first phase of the reform, a broad-based consumption tax was introduced in April 2005. - Administrative efforts undertaken include registration of large businesses, introduction of a new computer system, and reorganization of a one-stop shop for customs tariff payments. - The remaining parts of the tax reform are scheduled to be implemented in FY07/08, with planned accession to the WTO and associated reduction in tariffs; the authorities plan to submit the final set of domestic tax bills to the Parliament in June 2007. ### Key Features of the Final Reform Package - Corporate income tax: - A corporate income tax rate of 25 percent will be introduced for both domestic and foreign companies. - This will replace the current differential rates for foreign companies of 37-40 percent and domestic companies of 15–30 percent. - Individual income tax: - The individual income tax threshold will be raised. - Excises: - Excise tax coverage will be extended from domestically manufactured goods to both domestic and imported excisable goods, such as beer, cigarettes, motor vehicles, and liquor. - Customs tariffs: - Customs tariff duty rates will be reduced to a maximum of 15–20 percent. ### Revenue and Fiscal Design - The reform package is planned to be revenue neutral. - Care has been taken to set tax rates to prevent a potential revenue shortfall. - The authorities plan to offset the revenue foregone resulting from tariff reduction mainly through excise tax collection. *Source: Box 3. Tonga: Comprehensive Tax Reform.* ### ANNEX IV. TONGA: RELATIONS WITH THE ASIAN DEVELOPMENT BANK ### ANNEX IV. TONGA: RELATIONS WITH THE ASIAN DEVELOPMENT BANK ### ADB strategy and program (As of April 2007) - ADB strategy supports the Government’s development goals aimed at improving the quality and standard of living for all Tongans. - Government strategic objective: steady average GDP growth of around 2.5% in real terms through a dynamic and highly competitive economy driven mainly by the private sector and an efficient public sector. - Political developments, particularly the riot that destroyed the business district of Nuku’alofa in November 2006, have made achieving the GDP target difficult. - A Country Partnership Strategy (CPS) for Tonga is under preparation, with approval tentatively scheduled in July 2007. - ADB strategy for Tonga for 2007–2001 (sic in source) is to support implementation of Strategic Development Plan (SDP)-8 with emphasis on three SDP-8 goals. - ADB lending under the CPS will focus on delivery of basic social services and urban reconstruction under an Integrated Urban Development Project to be approved 2007. - TA 4865-TON is providing support for SDP-8 implementation, including its midterm review. - Planned/complementary technical assistance during 2007-2009 will address: - (i) improved fiscal governance, - (ii) private sector development, - (iii) further support for process of rationalization of public enterprises. - ADB will also (iv) provide a TA for preparing the Urban Planning and Management System to complement the PPTA currently ongoing. - ADB has approved fifteen loans totaling $57.8 million from the Asian Development Fund (ADF) to Tonga since 1972. - Fifty-four technical assistance projects with a value of $20.1 million were provided to improve capacity and strengthen institutional development. - Past investments focused on finance development and infrastructure in transport, power, agriculture and fisheries. ### Active projects and technical assistance - Active projects include five TAs in the country portfolio. - The latest loan on Economic and Public Sector Reform was completed successfully in 2004. - Five ongoing TAs focus on: - public enterprise reforms, - youth micro-enterprise development, - preparing the integrated urban development projects, - support for the implementation of the Strategic Development Plan 2006/2007—2008/2009, - Rationalization of Public Enterprises, Phase III. - Regional TA on strengthening pro-poor policy in the Pacific for Tonga for $0.2m implemented on a regional basis; counted as country TA. ### I. TONGA: LOAN AND TECHNICAL ASSISTANCE APPROVALS, 2002–06 - Loan approvals: - 2002: Number 1; Amount (in millions of U.S. dollars) 10 - 2003: Number 0; Amount 0 - 2004: Number 0; Amount 0 - 2005: Number 0; Amount 0 - 2006: Number 0; Amount 0 - Technical assistance approvals (Number / Amount (in millions of U.S. dollars)): - 2002: Number 1; Amount 0.7 - 2003: Number 3; Amount 0.9 - 2004: Number 3; Amount 0.7 - 2005: Number 1; Amount 0.7 - 2006: Number 2; Amount 0.9 ### Statistical issues: data strengths and continuing deficiencies - General - Economic statistics are broadly adequate for surveillance, but data deficiencies complicate monitoring and policy formulation. - SD and MOF have received technical assistance in national accounts, government finance, and balance of payments from STA and PFTAC; data provision to the Fund continues with long delays. - Main sources - Quarterly Bulletin of the National Reserve Bank of Tonga (NRBT). - Annual and semi-annual budget reports from the MOF. - GDDS participation - Tonga has been participating in the General Data Dissemination System (GDDS) since May 30, 2006. - Metadata certified in May 2006. - Real sector - National accounts estimates based primarily on the production approach; only rough estimates of expenditure components available. - SD completed revision of national accounts (base period 2000/01) based on a new business establishment survey with technical assistance from the Secretariat for the Pacific Community. - Significant inconsistencies remain in agricultural, fishing and forestry data. - Insufficient source data and indicators to derive value added for commerce, hotel and restaurant sectors. - August 2004 PFTAC mission proposed improvements to source data and methodologies and suggested revisions of recent year GDP estimates. - Consumer Price Index based on basket from the 2000/01 Household Income and Expenditure Survey. - Labor market statistics weak: employment statistics not compiled since 2003; average earnings statistics not available. - Government finance statistics - FY 2002/03 Budget Statement introduced presentation of fiscal data compiled according to GFSM 2001. - Improvements still needed: proper classification of transactions, shorter lags in updating accounting system; published data often subject to significant revisions. - External sector statistics - Official BOP figures compiled annually by SD with long lags. - Monthly trade figures from customs available with a three-month lag. - NRBT compiles monthly BOP statistics from Overseas Exchange Transactions records with a six-week lag; significant differences exist between SD and NRBT estimates. - Large errors and omissions suggest possible under recording of imports. - Work needed to reconcile data on stocks of reserve assets from various sources. - MOF has a system providing detailed information on official sector external disbursements and debt service. - Monetary and financial statistics - Reporting to the Fund for IFS publication has recently become irregular and less timely. - Authorities submitted test monetary data using standardized report forms (SRFs) at STA request; data not yet published in IFS Supplement because of discrepancies for other depository corporations and no current reserve bank data beyond August 2006. - NRBT resource constraints have impeded completion of the project. ### IMF Article IV consultation (Public Information Notice No. 07/102; August 13, 2007) — Background and assessment - Background: Article IV consultation concluded July 11, 2007. - Economic impact of events and recent trends: - Economic activity disrupted by November 2006 unrest. - Real GDP growth: slowed in FY05/06; estimated to turn negative in FY06/07, declining by 3½ percent. - External current account deficit estimated to widen to 10½ percent of GDP in FY06/07 from 8¼ percent of GDP in FY05/06. - Consumer price inflation slowed to about 5 percent by early 2007, from about 10 percent in FY04/05. - Fiscal developments: - FY05/06: fiscal balance swung into a deficit of 3⅓ percent of GDP from a 2½ percent surplus the year before. - Wage bill rose to 20 percent of GDP from 12 percent of GDP in FY04/05 due to payment of first installment of wage settlement and voluntary redundancy program. - Non-wage spending kept under tight control; revenues increased sharply, reflecting consumption tax introduced in 2005 and higher customs revenues. - Despite revenue losses from November unrest, FY06/07 Budget maintained deficit target of 2⅓ percent of GDP, citing buoyant revenue collection and decline in wage bill ratio to GDP. - Monetary policy and liquidity management: - NRBT took steps in 2006 to limit private credit growth and cope with liquidity implications of large severance payments. - Credit ceilings introduced January 2006; reset July 2006 for 6-month period to December. - NRBT stepped up issuance of central bank notes to contain liquidity effects of redundancy payments. - Private sector credit growth decelerated to an annual rate of 10½ percent by end-December 2006. - Early 2007: NRBT eased liquidity after the riots by lowering reserve requirements and reducing outstanding stock of notes to support reconstruction and restocking. - Government seeking a possible large external loan to finance reconstruction projects. - Risks and debt sustainability: - Economy remains subject to uncertainty and shocks. - Growth expected to return to positive, albeit low, levels in the medium term. - Risks include pressures to increase public sector hiring and a government borrowing plan that raises serious concerns for debt sustainability. - Debt service requirements from proposed borrowing could place serious strain on medium-term fiscal and external positions, placing Tonga at a high risk of debt distress. - Further drop in remittances and terms of trade shocks could pressure official reserves. ### Executive Board Assessment — Principal messages - Directors welcomed resilience: inflation declining, continued financial stability, contained international reserve position — reflecting cautious policies, tight credit policy, and basket exchange rate peg. - Policy recommendations and observations: - Remove impediments to private sector activity to improve medium-term growth prospects; constructive political transition will help limit economic vulnerabilities. - Continue prudent fiscal policies and set fiscal policy on a sustainable track. - Further fiscal consolidation needed through prioritization of nonwage spending and rationalization of public sector wage setting practices over the medium term. - Resist pressure for new hires in short term; build public support for continued reduction in civil service staffing over the medium term. - Continue improvements in revenue administration and compliance, especially given planned cuts in import duties and income tax reforms. - Adopt a cautious public borrowing policy to ensure sustainable public and external debt dynamics. - Noted increased risks to external debt sustainability associated with proposed reconstruction loan; several Directors encouraged scaling back borrowing plans or improving concessionality of the loan. - Other Directors noted urgent need and positive growth effects of reconstruction projects; some encouraged maximizing private sector role in reconstruction. - Note financial risks from possible state acquisition of the power company. - Monetary policy: monetary easing after disturbances was justifiable short term, but credit policy may need tightening if fiscal pressures re-emerge; NRBT should monitor monetary and credit developments closely. - Support reform of legal framework for indirect monetary instruments and enhance independence of monetary policy. - Support initiatives to improve financial sector supervision and call for vigilance in face of rapid household credit growth. - Exchange rate: basket peg provided credible nominal anchor and low inflation; Directors recommended greater use of flexibility to counter real exchange rate appreciation and emphasized structural reforms to preserve external competitiveness. - Sustain reform momentum to achieve faster growth via enhanced business and investment environment and strengthened public enterprise performance; step up pace of public sector reform program and implementation of public-private task force recommendations on business climate. - Directors welcomed Tonga’s accession to the World Trade Organization. - Encourage authorities to strengthen statistical capacity and supported continued Fund assistance to improve reliability, coverage, and timeliness of statistics. ### Selected economic indicators (Tonga: Selected Economic Indicators, 2002/03–2007/08) - Output and prices (in percent change) - Real GDP: 2002/03: 3.2; 2003/04: 1.4; 2004/05: 2.3; 2005/06: 1.3; 2006/07: -3.5; 2007/08: 0.8 - Consumer prices (period average): 2002/03: 11.1; 2003/04: 11.7; 2004/05: 9.7; 2005/06: 7.0; 2006/07: 5.9; 2007/08: 5.3 - Central government finance (in percent of GDP) - Total revenue and grants: 2002/03: 28.4; 2003/04: 29.9; 2004/05: 29.3; 2005/06: 34.1; 2006/07: 33.8; 2007/08: 34.2 - Total expenditure and net lending: 2002/03: 31.4; 2003/04: 29.0; 2004/05: 26.7; 2005/06: 37.4; 2006/07: 36.1; 2007/08: 45.4 - Overall balance (incl. reconstruction loan): 2002/03: -3.0; 2003/04: 0.9; 2004/05: 2.5; 2005/06: -3.3; 2006/07: -2.3; 2007/08: -11.2 - Overall balance (excl. reconstruction loan): 2002/03: -3.0; 2003/04: 0.9; 2004/05: 2.5; 2005/06: -3.3; 2006/07: -2.3; 2007/08: -1.0 - External financing (net): 2002/03: 1.4; 2003/04: 2.9; 2004/05: 0.3; 2005/06: 0.2; 2006/07: 1.4; 2007/08: 11.1 - Domestic financing (net): 2002/03: 1.6; 2003/04: -3.8; 2004/05: -2.8; 2005/06: 3.1; 2006/07: 0.9; 2007/08: 0.1 - Money and credit (in percent change) - Total liquidity 2/: 2002/03: 18.2; 2003/04: 16.7; 2004/05: 13.3; 2005/06: 13.3; 2006/07: 6.8; 2007/08: ... - Broad money (M2): 2002/03: 13.6; 2003/04: 18.9; 2004/05: 12.8; 2005/06: 16.6; 2006/07: 7.3; 2007/08: ... - Domestic credit: 2002/03: 18.8; 2003/04: -10.9; 2004/05: 20.9; 2005/06: 25.8; 2006/07: 11.9; 2007/08: ... - Private sector credit: 2002/03: 12.7; 2003/04: -4.3; 2004/05: 29.4; 2005/06: 22.6; 2006/07: 11.9; 2007/08: ... - Balance of payments (in millions of U.S. dollars) - Exports, f.o.b.: 2002/03: 17.6; 2003/04: 13.8; 2004/05: 16.0; 2005/06: 15.1; 2006/07: 15.6; 2007/08: 15.9 - Imports, f.o.b.: 2002/03: -74.2; 2003/04: -82.6; 2004/05: -105.4; 2005/06: -117.7; 2006/07: -118.9; 2007/08: -132.5 - Services (net): 2002/03: -5.4; 2003/04: -2.9; 2004/05: -9.9; 2005/06: -7.8; 2006/07: -10.1; 2007/08: -22.9 - Income (net): 2002/03: -1.5; 2003/04: -0.3; 2004/05: 1.6; 2005/06: 2.8; 2006/07: 2.1; 2007/08: 2.3 - Services and income (net): 2002/03: -6.9; 2003/04: -3.2; 2004/05: -8.3; 2005/06: -4.9; 2006/07: -8.0; 2007/08: -20.6 - Transfers (net): 2002/03: 58.7; 2003/04: 79.7; 2004/05: 91.9; 2005/06: 89.0; 2006/07: 87.6; 2007/08: 91.4 - Current account balance (excl. reconstruction loan) (in millions): 2002/03: -4.9; 2003/04: 7.7; 2004/05: -5.7; 2005/06: -18.5; 2006/07: -23.7; 2007/08: -45.8 - Current account balance (incl. reconstruction loan) (in millions): 2002/03: -4.9; 2003/04: 7.7; 2004/05: -5.7; 2005/06: -18.5; 2006/07: -23.7; 2007/08: -20.8 - Current account balance (In percent of GDP): 2002/03: -3.1; 2003/04: 4.2; 2004/05: -2.6; 2005/06: -8.2; 2006/07: -10.5; 2007/08: -19.0 - Gross international reserves - In millions of US dollars: 2002/03: 17.2; 2003/04: 44.8; 2004/05: 42.5; 2005/06: 40.4; 2006/07: 37.1; 2007/08: 33.5 - In months of total imports: 2002/03: 2.0; 2003/04: 4.8; 2004/05: 3.7; 2005/06: 3.2; 2006/07: 2.9; 2007/08: 2.2 - External debt (in percent of GDP) - External debt (in percent of GDP): 2002/03: 42.9; 2003/04: 41.1; 2004/05: 35.4; 2005/06: 36.7; 2006/07: 36.9; 2007/08: 45.7 - Debt service ratio 3/ (in percent of exports of goods and services): 2002/03: 6.3; 2003/04: 8.7; 2004/05: 8.3; 2005/06: 9.3; 2006/07: 10.5; 2007/08: 9.8 - Exchange rate (period average) - Pa'anga per U.S. dollar: 2002/03: 1.9; 2003/04: 3.9; 2004/05: 1.7; 2005/06: 1.4; 2006/07: 2.0; 2007/08: ... - Real effective exchange rate (1990=100) through end-December 2006: 2002/03: 89.9; 2003/04: 93.7; 2004/05: 100.2; 2005/06: 103.5; 2006/07: 105.0; 2007/08: ... - Nominal effective exchange rate (1990=100) through end-December 2006: 2002/03: 75.2; 2003/04: 71.4; 2004/05: 71.1; 2005/06: 70.5; 2006/07: 69.5; 2007/08: ... *Prepared by Asian Development Bank staff; sources: The Tongan authorities; IMF staff estimates and projections.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07297.pdf_