## _cr09292 ## Source details **Canonical URL:** [_cr09292](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09292.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09292.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09292.pdf.json) --- ### Executive Summary — Context and recent developments - Tonga is a small, remittance dependant, open economy vulnerable to domestic and external shocks. - Domestic political disturbances in 2006 caused widespread damage in Nuku’alofa and GDP contracted by around 1¾ percent in 2006/07. - The economy rebounded by 2½ percent in 2007/08; growth is estimated to be around ½ percent in 2008/09. - Key structural exposures: - Imports: 41 percent of GDP in 07/08. - Remittances: 31 percent of GDP. - 2008/09 outcomes and indicators: - Inflation peaked at 12 percent in mid-2008 and fell to 2 percent in mid 2009. - Remittances fell by around 15 percent. - International reserves rose to US$60 million—above 4 months of import cover. - Broad money growth slowed to around -1½ percent in March 2009. - Credit growth at March 2009 was below 5 percent, down from 18 percent at the beginning of the year. - The exchange rate appreciated around 6 percent in real effective terms in 2008. ### Outlook and risks - Staff projections: - Growth likely to be less than ½ percent in 2009/10. - International reserves likely to fall to around 3.3 months of import coverage. - Stronger growth expected in 2010/11 as reconstruction peaks and remittances recover; medium-term return to trend thereafter. - Downside risks: - Sharper-than-projected fall in remittances if unemployment in the United States and New Zealand increases. - Sustained increases in oil prices could renew balance of payments pressures. - Rapid, locally intensive reconstruction could boost growth but increase inflation and complicate medium-term management. - Authorities’ outlook: - Budget forecasts growth of 1¾ percent for 2009/10. ### Fiscal policy, budgets, and public debt - 2008/09 budget: - Targeted revenue increases of around 10 percent; actual revenue declined by around 10 percent. - Tight expenditure control and high grants produced an overall budget surplus around 1¼ percent of GDP in 2008/09, including initial expenditure from the reconstruction loan. - 15 million pa’anga will be placed in a newly established emergency and natural disaster fund. - 2009/10 budget stance: - Budget aims to run a small surplus (including grants but excluding reconstruction). Including loan-financed reconstruction staff project an overall deficit of around 4 percent of GDP. - Expenditure increases targeted to infrastructure, social services, and community development. - A 10 percent wage increase for the public sector is incorporated. - Financing projected from increased revenue, external grants, including US$10 million budget support from the Asian Development Bank. - Government decided not to increase tax rates. - Fiscal aggregates (percent of GDP) — staff projections: - Revenue: 22.2 (2008/09 Est.), 24.2 (2009/10 Budget), 22.4 (2009/10 Staff) - Grants: 6.3, 6.7, 5.9 - Current expenditure: 23.4, 26.9, 24.7 - Wages and Salaries: 10.9, 10.9, 11.6 - Other current expenditure: 12.5, 16.1, 13.2 - Capital expenditure: 3.0, 1.7, 4.6 - of which EXIM: 0.7 (...), 2.9 - Net lending: 0.9, -0.1, 2.9 - Overall balance (including grants): 1.3, 2.4, -3.9 - Overall balance (including grants; excluding reconstruction): 2.0, 2.4, 1.8 - Reconstruction loan (Box 2 / debt risk): - US$63 million loan from the EXIM Bank China; terms: 2 percent interest, 20 years, 5 year grace period. - Loan to be drawn down over three years up to 2012; used for public works and on-lent to private sector. - Loan drawdowns of US$15 million were made in 2008/09. Construction began in April 2009; total 2008/09 reconstruction-related expenditure expected to be around US$2.5 million. - When drawdowns are completed, NPV of external debt will be around 40 percent of GDP and 290 percent of exports, above indicative risk thresholds of 30 percent of GDP and 100 percent of exports. - Staff fiscal guidance and recommendations: - Maintain prudent fiscal stance; prioritize expenditure to achieve the budgeted small surplus excluding reconstruction. - Strictly limit additional external borrowing beyond the planned EXIM loan. - Any additional external borrowing should be strictly limited. ### Monetary and financial sector policies - Staff assessment: - Current cautious monetary policy stance is appropriate. - If conditions deteriorate, consider easing provided international reserves and inflation outlooks are benign. - Intensive supervision required to monitor build up of bad loans and ensure strong risk management. - Financial sector developments: - Two dominant banks scaled back lending due to rising non-performing loans. - Broad money and credit growth slowed markedly. - Non-performing loan ratio stood at 20 percent in mid 2009. - NRBT ensured provisions and foreign parents injected capital to comply with prudential regulations. - Policy recommendations: - Consider reducing or eliminating sale of NRBT notes to allow moderate credit growth if reserves and inflation outlook permit. - Step up bank supervision, including more frequent on-site inspections. - Implement newly approved prudential regulations on banks’ governance. - Address NRBT supervisory human resource constraints and seek technical assistance including from MCM. ### External viability and exchange rate policy - Exchange rate: - The exchange rate is a trade-weighted peg and is consistent with external stability. - Staff recommend use of the existing adjustment band to gradually correct modest overvaluation. - Valuation estimates: - Macroeconomic balance approach: REER overvaluation of around 9½ percent. - Equilibrium real exchange rate approach: overvaluation of about 12 percent. - External sustainability approach: overvaluation of about 2½ percent. - Policy implications: - Gradual correction could increase local value of remittances, moderate current account pressures and reduce burden on monetary policy. - Authorities intend cautious use of flexibility due to import dependence and commodity price trends. - Tax clearance on current transactions: - Authorities do not see removal of tax clearance certification on current transactions as feasible in short term; will discuss measures to become compliant with the Articles of Agreement. ### Staff views, authorities’ views, and recommendations (summary) - Staff view: - Policy space constrained by high risk debt position, low international reserves, and financial sector fragility. - Recommend: maintain fiscal prudence; limit additional external borrowing; continue cautious monetary policy; use exchange rate adjustment band gradually; strengthen bank supervision and risk management. - Authorities: - Broadly agree with staff analysis and recommendations. - Intend to remain within budget targets and reduce non-priority expenditure if revenues fall short. - Committed to high local content for reconstruction loan use and financing high quality projects. - Emphasize prudent fiscal stance and GDP growth for debt sustainability; prioritize structural reforms to encourage private sector development. ### Medium-term macroeconomic framework (staff estimates) - 2008/09: - GDP Growth: 0.4 - Inflation (annual average): 4.7 - Overall fiscal balance (including grants): 1.3 - External current account balance: -6.5 - International reserves (months of imports): 4.2 - External public debt: 28.3 - 2009/10: - GDP Growth: 0.3 - Inflation (annual average): 1.7 - Overall fiscal balance (including grants): -3.9 - External current account balance: -14.8 - International reserves (months of imports): 3.2 - External public debt: 32.2 - 2010/11: - GDP Growth: 2.3 - Inflation (annual average): 3.3 - Overall fiscal balance (including grants): -3.5 - External current account balance: -12.4 - International reserves (months of imports): 3.4 - External public debt: 36.1 - 2011/12: - GDP Growth: 1.7 - Inflation (annual average): 4.0 - Overall fiscal balance (including grants): -2.3 - External current account balance: -10.7 - International reserves (months of imports): 4.1 - External public debt: 35.4 ### Debt sustainability (LIC DSA) — key findings - Tonga remains at a high risk of debt distress. - Baseline and projections: - With EXIM loan drawdown PV of PPG external debt projected to increase to about 42 percent of GDP by 2012/13, then decline below threshold in 2017 and to 11 percent by end of projection period. - NPV of PPG external debt-to-exports ratio is 243 percent, above the indicative threshold of 100 percent. - Remittances expected to stabilize at around 25 percent of GDP over the medium term and cushion liquidity risks. - Stress tests: - Export shock can raise PV debt-to-exports to 600 percent and keep it above 100 percent for the projection period. - One-time depreciation can raise PV debt to 60 percent of GDP and keep it above the 30 percent threshold until 2022. - Less concessional new borrowing keeps debt above GDP threshold for prolonged periods. - Policy implications from DSA: - Maintain broadly balanced budgets after reconstruction completion. - Limit new public borrowing outside reconstruction; increase use of grants and donor financing on concessional/grant terms. - Anchor public debt management in a medium-term debt management strategy (MTDS). - Prioritize investment projects that generate high growth and employment. ### Stress test scenario outcomes (selected indicators) - PV of debt-to-GDP ratio (selected series, percent): - Baseline (selected): 31, 37, 42, 43, 42, 41, 39, 36, 33, 30, 28, 11 - A2 (less favorable terms): 31, 41, 50, 52, 51, 50, 48, 46, 44, 41, 39, 25 - B6 (one-time 30 percent nominal depreciation in 2009): 31, 52, 60, 61, 60, 58, 55, 51, 47, 43, 39, 16 - PV of debt-to-exports ratio (selected, percent): - Baseline (selected): 243, 277, 304, 308, 302, 293, 278, 259, 238, 218, 199, 81 - A2: 243, 310, 358, 371, 369, 362, 348, 331, 313, 295, 278, 181 - B2 (export shock): 243, 390, 625, 632, 623, 606, 577, 542, 503, 465, 431, 184 - PV of debt-to-revenue ratio (selected, percent): - Baseline (selected): 141, 165, 188, 181, 171, 165, 151, 140, 129, 118, 108, 43 - A2: 141, 184, 221, 219, 209, 204, 188, 179, 169, 160, 151, 97 - B6: 141, 233, 266, 257, 243, 234, 213, 199, 183, 167, 153, 62 ### Structural policies, statistical capacity, and reform priorities - Structural constraints: - Public sector large; state-owned enterprises control around 20 percent of fixed assets yet contribute only 6 percent to GDP. - Private sector constrained by excessive regulation and discretionary licensing. - Reform priorities: - Commercial law reform; reintroduce Companies Registry; divest/rationalize public enterprises; improve governance of public enterprises; strengthen public financial management. - Improve statistical capacity: revised national accounts published; balance of payments improvements underway; further investment in source data and donor support needed. ### IMF Executive Board and authorities’ statements (selected) - Executive Board conclusions (September 4, 2009): - Recovery hampered by global slowdown; remittances declining; banks curtailing credit due to bad loans. - Endorsed reconstruction while aiming for a small non-reconstruction surplus; cautioned on revenue shortfalls and urged prioritization and possible phasing of wage increases. - Recommended vetting reconstruction projects to ensure productivity and reliance on domestic revenues and grants for future infrastructure. - Encouraged maintaining cautious monetary stance and readiness to tighten if credit accelerates and reserve/inflation outlooks worsen. - Urged enhanced banking supervision and structural reform. - Authorities’ actions and statements: - NRBT eased policy in mid-2009 by ceasing issue of NRBT notes and reducing Statutory Required Reserves to 5 percent from 10 percent. - Authorities announced in principle agreement with China on US$45 million infrastructure loan (similar terms to reconstruction loan). - Authorities committed to prudent 2009/10 budget implementation, intensifying revenue collection and protecting social spending through contingency mechanisms. ### Reserves, imports, exchange rate, and banking sector (selected) - Gross foreign reserves: - 5.4 months of imports at the end of July 2009, owing mainly to private capital inflow from sales of government assets and capital injection into banking system. - Earlier series: in millions of U.S. dollars: 44.842.540.447.148.259.545.6 - In months of goods and services imports: 4.83.73.13.93.24.23.2 - Exchange rates and REER: - Pa'anga per U.S. dollar (period average, selected): 2.051.942.012.00... - REER estimates indicate modest overvaluation (see valuation estimates above). - Banking sector: - Liquidity tightened early 2008 with rapid lending (around 20 percent), then liquidity increased, credit growth halted, NRBT withdrew excess liquidity, broad money declined. - Non-performing loan ratio: 20 percent in mid 2009. - Two of three commercial banks running losses though capital remains sufficient; Tonga Development Bank profitable. - NRBT issued six new prudential statements; enhanced offsite monitoring and more frequent onsite visits planned. - Supervisory capacity constrained; bank supervision staff mostly new with less than 1 year experience; further technical assistance required. ### Recommendation and administrative - It is recommended that the next Article IV consultation with Tonga should take place on a standard 12-month cycle. ### Key economic indicators (selected, preserved exactly as reported) - Nominal GDP (2007/08): US$ 340.8 million - Population (2006): 101,991 - GDP per capita (2007/08): US$ 3,341 - Quota: SDR 6.9 million - Selected medium-term projections and historical series are reported in the source tables (real GDP growth, inflation, fiscal balances, external indicators, reserves, external debt, and banking sector ratios) and preserved in the staff projections and DSA excerpts above. *IMF staff report content unit _cr09292.* ### Executive Summary ...................................................................................................... ### Executive Summary ### I. Context and Recent Economic Developments - Tonga is a small, remittance dependant, open economy vulnerable to domestic and external shocks. - Domestic political disturbances in 2006 caused widespread damage in Nuku’alofa and GDP contracted by around 1¾ percent in 2006/07. - The economy rebounded by 2½ percent in 2007/08. - Key structural exposures: - Imports: 41 percent of GDP in 07/08. - Remittances: 31 percent of GDP. - 2008/09 outcomes and developments: - Growth is estimated to be around ½ percent in 2008/09. - Inflation peaked at 12 percent in mid-2008 and fell to 2 percent in mid 2009. - Remittances fell by around 15 percent, reflecting recessions in the United States and New Zealand. - International reserves rose to US$60 million—above 4 months of import cover—supported by strong investment and capital flows in late 2008. - Broad money growth slowed to around -1½ percent in March 2009. - Credit growth at March 2009 was below 5 percent, slowing significantly from 18 percent at the beginning of the year. - The exchange rate appreciated around 6 percent in real effective terms in 2008. ### II. Outlook and Risks - Staff projections: - Growth likely to be less than ½ percent in 2009/10 as remittances remain constrained and the domestic banking sector consolidates. - International reserves likely to fall to around 3.3 months of import coverage due to weak remittances and higher construction imports. - The peak in reconstruction and a recovery in remittances should support stronger growth in 2010/11 before a return to trend in the medium term. - Downside risks: - Remittances are vulnerable to a sharper-than-projected fall if unemployment in the United States and New Zealand continues to increase. - Recent increases in oil prices, if sustained, could renew pressures on the balance of payments. - A more rapid scale up of reconstruction with significant local inputs could boost growth but put pressure on inflation and complicate medium-term management. - Authorities’ outlook: - Authorities are more sanguine and budget forecasts growth of 1¾ percent for 2009/10. ### III. Fiscal Policy and Public Debt - Fiscal context: - The 2008/09 budget targeted revenue increases of around 10 percent but actual revenue declined by around 10 percent due to shortfalls on sales and trade taxes. - Tight expenditure control and high grants produced an overall budget surplus around 1¼ percent of GDP in 2008/09, including initial expenditure from the reconstruction loan. - 15 million pa’anga will be placed in a newly established emergency and natural disaster fund. - 2009/10 budget stance: - The budget aims to run a small surplus (including grants but excluding reconstruction). Including loan-financed reconstruction staff project an overall deficit of around 4 percent of GDP. - Expenditure increases targeted to infrastructure (particularly road maintenance), social services, and new community development programs. - A 10 percent wage increase for the public sector is incorporated; it is the first since a 70 percent increase in 2006/07. - Financing is projected from increased revenue (improved enforcement and activity) and external grants, including US$10 million budget support from the Asian Development Bank. - Government decided not to increase tax rates in view of economic circumstances. - Fiscal aggregates (percent of GDP) — staff projections: - Revenue: 22.2 (2008/09 Est.), 24.2 (2009/10 Budget), 22.4 (2009/10 Staff) - Grants: 6.3, 6.7, 5.9 - Current expenditure: 23.4, 26.9, 24.7 - Wages and Salaries: 10.9, 10.9, 11.6 - Other current expenditure: 12.5, 16.1, 13.2 - Capital expenditure: 3.0, 1.7, 4.6 - of which EXIM: 0.7 (...), 2.9 - Net lending: 0.9, -0.1, 2.9 - Overall balance (including grants): 1.3, 2.4, -3.9 - Overall balance (including grants; excluding reconstruction): 2.0, 2.4, 1.8 - Debt risk and reconstruction (Box 2): - Reconstruction financed mainly by a US$63 million loan from the EXIM Bank China. - Loan terms: 2 percent interest, 20 years, with a 5 year grace period. - Loan to be drawn down over three years up to 2012; used for public works and on-lent to the private sector for rebuilding offices and shops. - Reconstruction implemented on a turn-key basis by a Chinese construction company required to use Tongan labor unless skills are unavailable locally. - Loan drawdowns of US$15 million were made in 2008/09. - Construction began in earnest in April 2009; total 2008/09 reconstruction-related expenditure expected to be around US$2.5 million (predominately public works). - When loan drawdowns are completed, the net present value of Tonga’s external debt will be around 40 percent of GDP and 290 percent of exports, above indicative risk thresholds of 30 percent of GDP and 100 percent of exports. - Debt sustainability will rely on sustained GDP growth; loan-financed projects need to add to productive capacity. - Staff fiscal guidance: - The 2008/09 budget targets a small surplus excluding loan-financed reconstruction; achieving this requires strong expenditure prioritization given optimistic growth and revenue projections. - Including reconstruction the fiscal deficit will widen significantly to around 4 percent of GDP. - Any additional external borrowing should be strictly limited. ### IV. Monetary and Financial Sector Policies - Staff assessment: - The current cautious monetary policy stance is appropriate. - If economic conditions deteriorate, some easing should be considered provided the outlook for international reserves and inflation is benign. - Intensive supervision is required to monitor further build up of bad loans and ensure strong risk management. - Financial sector developments: - The two dominant banks scaled back lending in response to a rapid increase in non-performing loans. - Broad money growth and credit growth slowed markedly (see figures above). ### V. External Viability and Exchange Rate Policy - Exchange rate: - The exchange rate is a trade-weighted peg. - It is consistent with external stability. - The existing adjustment band could be used to gradually correct its modest overvaluation. ### VI. Staff Views, Authorities’ Views, and Policy Recommendations - Staff’s views on policy space: - Government’s ability to respond to slowing growth without prejudicing medium term stability is constrained by: - High risk debt position. - Low level of international reserves. - Financial sector fragility. - Staff recommendations (summarized): - Maintain prudent fiscal stance; prioritize expenditure to achieve the budgeted small surplus excluding reconstruction. - Strictly limit additional external borrowing beyond the planned EXIM loan. - Continue cautious monetary policy; consider targeted easing only if reserves and inflation conditions permit. - Use the exchange rate adjustment band to gradually address modest overvaluation. - Strengthen bank supervision and risk management to monitor non-performing loans. - Authorities’ position: - Authorities share the risk analysis and broadly agree with staff’s policy recommendations. - They intend to remain within the budget’s macroeconomic targets and will reduce non-priority expenditure if revenues fall short of targets. - Committed to ensuring high local content in the use of the reconstruction loan and to financing high quality projects. - Emphasize that maintaining a prudent fiscal stance and sustaining GDP growth are key to debt sustainability. - Structural reforms to encourage private sector development are central to their development strategy. ### VII. Medium-Term Macroeconomic Framework (staff estimates) - (Annual percentage change / percent of GDP / months of imports / percent of GDP) - 2008/09: - GDP Growth: 0.4 - Inflation (annual average): 4.7 - Overall fiscal balance (including grants): 1.3 - External current account balance: -6.5 - International reserves (months of imports): 4.2 - External public debt: 28.3 - 2009/10: - GDP Growth: 0.3 - Inflation (annual average): 1.7 - Overall fiscal balance (including grants): -3.9 - External current account balance: -14.8 - International reserves (months of imports): 3.2 - External public debt: 32.2 - 2010/11: - GDP Growth: 2.3 - Inflation (annual average): 3.3 - Overall fiscal balance (including grants): -3.5 - External current account balance: -12.4 - International reserves (months of imports): 3.4 - External public debt: 36.1 - 2011/12: - GDP Growth: 1.7 - Inflation (annual average): 4.0 - Overall fiscal balance (including grants): -2.3 - External current account balance: -10.7 - International reserves (months of imports): 4.1 - External public debt: 35.4 *Executive Summary, Country Report (IMF staff).* ### 10. Staff stressed that projected debt levels leave limited room for maneuver on ### 10. Staff stressed that projected debt levels leave limited room for maneuver on ### Fiscal policy and debt sustainability - Projected debt levels leave limited room for maneuver on medium-term fiscal policy. - Fiscal planning should be based on deficits including reconstruction. - Loan-financed reconstruction is understood as an irreversible government commitment, but: - Loan drawdowns should be limited to productive projects rather than targeting full loan utilization. - Maintaining broadly balanced budgets following completion of reconstruction is important for debt sustainability given the sharp increase in debt stemming from the EXIM Bank loan. - Scenario: Non-reconstruction deficits of just 1 percent of GDP, combined with slow GDP growth, would see public debt above 40 percent of GDP in 2020, compared to staff’s baseline projection of 21 percent. - Additional future borrowing (example: the US$45 million infrastructure loan currently being discussed with China) would intensify debt sustainability concerns and would be better financed through improved government revenue, expenditure reprioritization or grants. ### Budget stance, revenues, and expenditure prioritization - Staff supported the 2008/09 budget’s target of a modest non-reconstruction surplus but argued additional policy actions are needed. - A surplus of 1¾ percent of GDP (including grants but excluding reconstruction) is broadly appropriate. - Staff projects revenue will be around 20 million pa'anga (2 percent of GDP) less than budgeted given a significantly lower GDP growth forecast than the authorities’. - As a result, planned expansions in non-wage expenditure will be impossible to achieve while remaining within the budget’s macroeconomic framework. - If grants fall short of projections, significant cuts from 2009/10 levels will be required. - Policy recommendations: - Carefully prioritize expenditure allocations, including possibly phasing the public sector wage rise. - Step up effort in revenue enforcement, particularly customs. - Avoid short-term tax increases given pressures on the domestic economy. ### Authorities’ position and contingency measures - Authorities stressed commitment to prudent fiscal policy, citing recent budget surpluses. - Authorities anticipate full loan utilization for reconstruction spending and expect it to be productive. - A new customs management system is expected to provide scope for significant gains in enforcement. - Contingency: the expenditure review committee chaired by the Prime Minister would ensure priority areas, particularly the social sectors, are protected in the event of revenue shortfalls. ### Monetary and financial sector policies - 2008/09 banking sector developments: - At the beginning of the year banking sector liquidity was tight and lending growth was rapid (around 20 percent). - As the year progressed, liquidity increased, credit growth halted, NRBT withdrew excess liquidity, and broad money declined as deposits were withdrawn. - Interest rates declined from late-2008 highs, but remain high. - Bad debts began to build from mid-2008; the non-performing loan ratio stood at 20 percent in mid 2009. - NRBT ensured the two main commercial banks took provisions and foreign parents injected capital to remain compliant with prudential regulations. - Policy discussions and recommendations: - Staff supported the current cautious monetary policy stance but encouraged easing should economic conditions worsen, suggesting NRBT consider reducing or eliminating the sale of NRBT notes to allow a moderate pace of credit growth, provided reserves and inflation outlooks are benign. - Banking sector may not respond to easing due to highly cautious lending policies. - Staff emphasized the importance of stepped up bank supervision, including more frequent on-site inspections. - Newly approved prudential regulations on banks’ governance, when implemented, will help prevent recurrence. - Authorities highlighted limited human resources in NRBT’s banking supervision department and commissioned an independent study of supervisory actions; they are seeking further technical assistance, including from MCM. ### External viability and exchange rate policies - Exchange rate and remittances: - The pa’anga traded in line with its peg; it depreciated against the US dollar and appreciated against Australia and New Zealand dollars. - NRBT did not make use of the monthly adjustment band within the exchange rate peg. - Valuation and external position: - Staff estimates, limited by data deficiencies, suggest the pa’anga is modestly overvalued. - Specific estimates: the macroeconomic balance approach suggests a REER overvaluation of around 9½ percent, the equilibrium real exchange rate approach suggests overvaluation of about 12 percent, and the external sustainability approach suggests the REER is overvalued by about 2½ percent. - Projected external current account deficits over the medium term are in line with historical levels and can be financed by official and private capital inflows. - Policy recommendations: - The exchange rate peg provides a valuable policy anchor; staff encouraged use of the monthly adjustment band to gradually correct the modest overvaluation of the pa’anga. - Gradual correction could increase the local value of remittances, moderate current account pressures and lessen the burden on monetary policy. - Authorities intend to proceed cautiously on exchange rate flexibility due to import dependence and likely upward trend in commodity prices. - Tax clearance on current transactions: - Given the difficult external environment and budgetary situation the authorities do not see removal of tax clearance certification on current transactions as feasible in the short term. - Authorities will continue discussions with staff to identify measures that provide similar comfort while becoming compliant with the Articles of Agreement. ### Structural policies and statistical capacity - Structural constraints: - Public sector is large; state-owned enterprises control around 20 percent of fixed assets yet contribute only 6 percent to GDP. - Government rationalizing holdings in public enterprises; has divested duty-free retail operation and shares in a commercial bank, but taken into public ownership the power generation and distribution company. - Private sector constrained by excessive regulation and discretionary licensing requirements. - Reform priorities: - Accelerate structural reforms to promote private sector development: commercial law reform, reintroducing the Companies Registry, divesting/rationalizing public enterprises, improving governance of public enterprises, and strengthening public financial management. - Improving governance environment to enhance stability and investor confidence. - Statistical improvements: - Authorities have published a revised set of national accounts with broader coverage and improved estimation technique; improved balance of payments statistics are being developed. - Further improvements require investment in source data and donor support; adopt common forecasting tools across economic agencies. ### Staff appraisal — key findings and risks - Growth and macro outlook: - Tonga’s recovery from the 2006 disturbances has been hampered by global and domestic conditions. - Growth will likely slow to less than ½ percent in 2008/09 and 2009/10 as remittances decline and banks curtail credit. - Decline in international food prices should allow inflation to remain moderate and reserves adequate. - Risks are tilted to the downside, particularly if remittances fall more sharply due to prolonged high unemployment in the United States and New Zealand; a return to high world oil prices would renew external pressures. - Reconstruction activities may support growth but could add to inflation. - Policy space and constraints: - Authorities’ ability to respond to weak growth is limited: high public debt limits fiscal stimulus and monetary policy is constrained by weak transmission and relatively low international reserves. - Budget assessment: - The 2009/10 budget takes a broadly appropriate macroeconomic stance but is based on ambitious revenue projections; shortfalls are likely. - Greater attention to improving revenue enforcement, especially customs, is crucial. - Debt risks: - Risk of debt distress will increase with drawdown of large reconstruction loan; planned disbursement profile is consistent with manageable—if high risk—debt dynamics, conditional on continued GDP growth, broadly balanced budgets over the medium term and productive loan-financed expenditure. - Additional borrowing, such as the large infrastructure loan under consideration, could lead to unsustainable debt dynamics. - Monetary and financial sector stance: - With reserves likely to remain in the lower part of the Reserve Bank’s comfort zone, the cautious monetary policy stance is appropriate; some easing should be considered if conditions worsen and reserves and inflation outlooks are benign. - Continued stepped up supervision is necessary to prevent further deterioration in banks’ balance sheets; regulation must remain vigilant against surges in high risk lending. - Exchange rate: - Exchange rate remains consistent with external stability; projected external current account deficits are sustainable. - Gradual correction of the pa’anga’s modest overvaluation using the adjustment band could help safeguard reserve coverage and promote domestic commerce. - Structural and statistical priorities: - Improving GDP growth and living standards requires sustained structural reform: rationalizing public enterprises, enhancing infrastructure and improving business regulation. - Improving statistical capacity remains a priority; continued technical assistance and improvements in underlying data are needed. *IMF staff report extract.* ### 36. It is recommended that the next Article IV consultation with Tonga should take place ### _cr09292 - 36. It is recommended that the next Article IV consultation with Tonga should take place ### Recommendation - It is recommended that the next Article IV consultation with Tonga should take place on a standard 12-month cycle. ### Key economic developments and indicators (selected) - Nominal GDP (2007/08): US$ 340.8 million - Population (2006): 101,991 - GDP per capita (2007/08): US$ 3,341 - Quota: SDR 6.9 million - Real GDP (selected annual percent change series, 2003/04–2009/10): 2/1.3-1.00.3-1.72.60.40.3 - Consumer prices (period average, 2003/04–2009/10): 11.79.77.05.19.84.71.7 - Consumer prices (end of period, 2003/04–2009/10): 10.18.76.45.612.21.42.5 - Central government finance (Total revenue and grants, percent of GDP, 2003/04–2009/10): 23.624.326.828.626.528.628.3 - Total revenue (percent of GDP): 22.523.225.124.825.222.222.4 - Grants (percent of GDP): 1.11.11.73.81.36.35.9 - Total expenditure and net lending (percent of GDP): 23.322.229.627.524.927.332.2 - Current expenditure (percent of GDP): 21.621.428.926.524.523.424.7 - Capital expenditure (percent of GDP): 0.80.80.80.90.43.04.6 - Overall balance (percent of GDP): 0.32.1-2.81.11.71.3-3.9 - Overall balance (excl. reconstruction loan, percent of GDP): 0.32.1-2.81.16.52.92.1 - Money and credit (annual percent change and levels) - Total liquidity 3/ (percent change series): 16.713.313.313.35.0-0.52.4 - Broad money (M2) (percent change series): 18.912.816.611.96.4-1.02.5 - Domestic credit (percent change series): -10.920.925.811.612.8-4.31.5 - Private sector credit (percent change series): -4.329.422.69.518.00.42.0 - Interest rates (end of period) - Average deposit rate 4/: 4.65.15.25.65.75.1... - Base lending rate 4/: 9.09.59.09.410.010.0... - Balance of payments (percent of GDP, selected) - Exports, f.o.b. (percent of GDP series): 13.816.015.413.312.48.08.4 - Imports, f.o.b. (percent of GDP series): -82.6-105.4-122.2-108.6-138.1-126.4-127.8 - Services (net, percent of GDP): -2.8-10.0-7.8-17.9-3.3-9.5-4.8 - Investment income (net, percent of GDP): -0.41.62.83.53.429.24.2 - Current transfers (net, percent of GDP): 79.791.988.984.294.877.469.9 - Private transfer receipts (percent of GDP): 90.1107.4102.093.3106.786.278.8 - Current account balance (percent of GDP): 7.7-5.8-22.8-25.5-30.8-21.3-50.1 - Current account balance (excl. reconstruction loan, percent of GDP): 7.7-5.8-22.8-25.5-30.8-19.4-34.3 - (In percent of GDP series): 3.4-2.2-8.0-8.5-9.0-6.5-14.8 - Gross official foreign reserves - In millions of U.S. dollars: 44.842.540.447.148.259.545.6 - In months of goods and services imports: 4.83.73.13.93.24.23.2 - External debt (in percent of GDP) - External debt: 34.630.535.732.628.930.833.6 - Debt service ratio (in percent of exports): 1.41.21.11.11.41.32.3 - Exchange rates (selected) - Pa'anga per U.S. dollar (period average): 2.051.942.012.001.942.07... - Pa'anga per U.S. dollar (end of period): 2.001.932.061.951.912.24... - Memorandum item: Nominal GDP (millions of T$) 470.88503.37577.29597.98649.15688.71711.16 ### Government operations (selected levels in millions of U.S. dollars and percent of GDP, 2003/04–2009/10) - Total revenue and grants (millions of U.S. dollars): 111.0122.1154.5171.1172.2196.8201.4 - Total revenue (millions of U.S. dollars): 105.9116.6144.6148.5163.5153.1159.4 - Tax revenue (millions of U.S. dollars): 86.198.4122.2126.2139.0128.6130.7 - Grants (in cash, millions of U.S. dollars): 5.25.59.922.68.743.742.0 - Total expenditure and net lending (millions of U.S. dollars): 109.8111.6170.7164.7161.4188.0228.9 - Current expenditure (millions of U.S. dollars): 101.7107.9167.0158.5158.8160.9176.0 - Wages and salaries (millions of U.S. dollars): 45.749.790.880.170.274.882.2 - Capital expenditure (millions of U.S. dollars): 3.94.34.65.62.620.932.5 - Of which: PRC reconstruction loan: ...............5.120.8 - Overall balance (incl. grants, millions of U.S. dollars): 1.310.5-16.16.410.88.8-27.4 - Total financing (millions of U.S. dollars): -1.3-10.516.1-6.4-10.8-8.827.4 - External financing (millions of U.S. dollars): 12.71.42.30.81.47.129.7 - Domestic financing (millions of U.S. dollars) 6/7/: -14.0-11.913.9-7.2-12.2-15.9-2.3 ### Banking sector and monetary accounts (selected, 2004/05–2009/10) - Net foreign assets (millions of pa'anga, selected): 76.371.981.179.3116.2114.3107.1105.583.9 - Foreign assets (millions of pa'anga): 91.895.0103.699.9143.7148.9149.9148.2118.0 - NRBT foreign assets: 82.183.291.689.1128.5123.9130.6129.098.7 - DMBs foreign assets: 9.711.812.010.815.225.019.319.319.3 - Foreign liabilities (millions of pa'anga): -15.5-23.1-22.6-20.6-27.5-34.6-42.7-42.7-34.0 - NRBT foreign liabilities: -3.2-7.1-4.7-3.1-10.1-12.1-12.5-12.5-10.0 - DMBs foreign liabilities: -11.4-15.3-17.2-16.9-16.8-17.2-25.0-25.0-19.9 - TDB foreign liabilities: -0.9-0.6-0.6-0.6-0.6-5.3-5.2-5.2-4.1 - Net domestic assets (millions of pa'anga): 154.2186.1211.4222.2174.1192.4185.7194.6223.4 - Net domestic credit (millions of pa'anga): 210.3264.5295.2332.9317.3330.1328.0318.7323.6 - Government (net): -25.2-18.9-12.9-30.9-38.0-29.0-30.7-46.8-49.1 - Private sector: 226.8278.0304.3359.1350.7354.8354.1360.5367.7 - Total liquidity (millions of pa'anga): 223.7253.4287.1301.5290.3306.7292.9300.1307.4 - Broad money (M2, millions of pa'anga): 203.7237.5265.8282.8271.5287.4272.7280.0287.0 - Narrow money: 68.755.773.872.666.377.379.779.280.2 - Quasi money: 134.9181.8192.0210.2205.2210.1193.0200.7206.8 - Annual percent change (selected) - Net foreign assets (percent change series): -8.9-5.812.7-2.225.211.028.433.0-20.4 - Net domestic assets (percent change series): 27.220.713.65.1-17.2-9.4-13.2-12.414.8 - Total liquidity (percent change series): 13.313.313.35.0-2.5-1.1-1.5-0.52.4 - Broad money (M2) (percent change series): 12.816.611.96.4-2.2-0.8-1.6-1.02.5 ### Balance of payments summary (selected, 2003/04–2009/10) - Trade balance (millions of U.S. dollars): -68.8-89.3-106.7-95.3-125.7-118.4-119.4 - Exports, f.o.b. (millions of U.S. dollars): 13.816.015.413.312.48.08.4 - Exports annual percent change series: -21.216.0-3.8-13.6-7.3-35.04.2 - Imports, f.o.b. (millions of U.S. dollars): -82.6-105.4-122.2-108.6-138.1-126.4-127.8 - Imports annual percent change series: 11.327.515.9-11.127.1-8.41.1 - Of which: PRC reconstruction loan effect on imports: ...............-2.0-15.9 - Services (net, millions of U.S. dollars) - Receipts: 25.823.725.319.436.934.536.7 - Payments: -28.6-33.6-33.2-37.3-40.1-44.0-41.5 - Investment income (net, millions of U.S. dollars): -0.41.62.83.53.429.24.2 - Receipts: 2.73.44.96.46.831.66.8 - Payments: -3.1-1.8-2.1-2.9-3.5-2.4-2.6 - Current transfers (net, millions of U.S. dollars): 79.791.988.984.294.877.469.9 - Official transfers (net): 0.30.00.00.00.31.01.1 - Private transfers (net): 79.491.988.984.294.576.468.8 - Current account balance (millions of U.S. dollars): 7.7-5.8-22.8-25.5-30.8-21.3-50.1 - (In percent of GDP): 3.4-2.2-8.0-8.5-9.0-6.5-14.8 - Capital and financial account balance (millions of U.S. dollars): 37.012.522.526.936.332.636.1 - Official capital flows (net, millions of U.S. dollars): 13.74.88.49.812.02.022.3 - Note: Includes T$25m grants from China under investment receipt and related official capital outflow in 2008/09. - Private capital flows (net, millions of U.S. dollars): 23.27.714.117.124.330.613.8 - Errors and omissions (millions of U.S. dollars): -18.8-10.71.02.7-6.80.00.0 - Overall balance (change in gross official foreign reserves, millions of U.S. dollars): 25.9-4.00.64.2-1.311.3-14.0 - Memorandum items: - Gross official foreign reserves (millions of U.S. dollars): 44.842.540.447.148.259.545.6 - In months of goods and services imports: 4.83.73.13.93.24.23.2 - Pa'anga per U.S. dollar (period average): 2.051.942.012.001.902.092.10 - Pa'anga per U.S. dollar (end of period): 2.001.932.061.951.951.992.09 - Nominal GDP (millions of U.S. dollars): 230.2259.7287.4298.6340.8329.8338.4 ### Medium-term scenario (2005/06–2013/14) — selected projections - Output and prices - Real GDP (annual percent change series, 2005/06–2013/14): 0.3-1.72.60.40.32.31.71.71.7 - Consumer prices (end of period, percent): 6.45.612.21.42.54.04.06.06.0 - Consumer prices (period average, percent): 7.05.19.84.71.73.34.05.06.0 - Central government finance (percent of GDP, projections) - Total revenue and grants: 26.828.626.528.628.328.528.028.128.0 - Total revenue: 25.124.825.222.222.422.623.624.624.7 - Grants: 1.73.81.36.35.96.04.43.53.3 - Total expenditure and net lending: 29.627.524.927.332.232.130.329.128.9 - Current expenditure: 28.926.524.523.424.724.523.522.221.9 - Capital expenditure: 0.80.90.43.04.64.74.84.84.9 - Overall balance (percent of GDP): -2.81.11.71.3-3.9-3.5-2.3-1.0-0.9 - External financing (net, percent of GDP): 0.40.10.21.04.25.54.40.00.9 - Domestic financing (net, percent of GDP): 2.4-1.2-1.9-2.3-0.3-2.0-2.1-0.10.0 - Balance of payments projections (selected) - Exports, f.o.b. (percent of GDP): 15.413.312.48.08.48.68.99.29.6 - Imports, f.o.b. (percent of GDP): -122.2-108.6-138.1-126.4-127.8-131.6-130.8-121.0 -124.2 - Services and investment income (net, percent of GDP): -5.0-14.40.119.7-0.63.73.83.94.1 - Transfers (net, percent of GDP): 88.984.294.877.469.976.079.582.385.1 - Private transfer receipts (millions of U.S. dollars): 88.984.294.576.468.874.878.881.584.5 - Private transfers (as percent of imports, goods and services): 57.257.753.144.840.643.445.649.649.9 - Current account balance (millions of U.S. dollars): -22.8-25.5-30.8-21.3-50.1-43.3-38.6-25.5-25.4 - (In percent of GDP): -8.0-8.5-9.0-6.5-14.8-12.4-10.7-6.8-6.6 - Gross international reserves (end of period) - In millions of U.S. dollars (projection series): 40.447.148.259.545.648.858.667.174.7 - In months of imports (goods and services): 3.13.93.24.23.23.44.14.95.3 - External debt (percent of GDP) — projections - Public sector external debt: 29.127.425.428.332.336.135.433.230.6 - Of which: PRC reconstruction loan contribution to public sector external debt: .........4.510.315.716.616.115.3 - Debt service ratio (percent of exports): 1.11.11.41.32.31.91.81.72.3 - Of which: PRC reconstruction loan debt-service contribution: .........0.090.200.290.300.280.42 - Commodity price indexes (2005 = 100) — projections - Food: 105.2118.9142.2144.7132.7133.0133.4134.3135.4 - Fuel: 109.6125.5158.1150.8128.6143.3148.1150.8152.9 - Nominal GDP (millions of T$ projected): 577.3598.0649.2688.7711.2751.3795.0849.4916.1 ### Banking sector indicators (2003–08, percent, end of period) - Capital adequacy - Risk-weighted capital ratio: 21.923.919.721.322.127.3 - Total capital to total assets: 18.516.316.317.318.019.8 - Asset quality - Nonperforming loan to total loans: 9.65.94.23.75.315.0 - Nonperforming loans to capital: 39.124.420.216.122.957.7 - Nonperforming loans net of provisions to total capital: 14.20.13.00.63.536.3 - Profitability - Return on assets: 5.86.06.65.44.5-1.7 - Return on equity: 23.022.124.921.517.6-9.7 - Net interest margin: 8.710.08.68.18.17.4 - Net interest income to gross income: 61.261.160.560.354.053.0 - Liquidity - Liquid asset to total asset: 8.812.86.47.910.610.2 - Liquid asset ratio (LAR): .........9.111.311.4 ### Joint IMF/World Bank Debt Sustainability Analysis (LIC DSA) — summary findings - The Low Income Country Debt Sustainability Analysis (LIC DSA) indicates that Tonga remains at a high risk of debt distress. - Under the baseline scenario: - The NPV-of-debt to GDP as well as the NPV-of-debt to export ratios remain above the country-specific indicative thresholds for a prolonged period. - Remittance inflows: - Tonga benefits from very high remittance inflows (over 30 percent of GDP), which are by far the largest source of foreign exchange earnings and help mitigate liquidity risks. - Debt profile and trend: - Tonga’s overall public sector debt indicators, while elevated over the short term, show a decreasing trend over the longer run. - Taking into account the cushion provided to the economy by the large workers’ remittances, the projected debt profile is consistent with manageable—if high risk—debt dynamics. - Policy implications drawn from the DSA: - The results underscore the importance of maintaining broadly balanced budgets following the completion of reconstruction borrowing. - Sustaining growth near historical averages is key to maintaining stable debt levels in the medium term and declining debt levels in the long term. *Source: IMF staff estimates and projections; data provided by the Tongan authorities; Joint IMF/World Bank Debt Sustainability Analysis 2009.* ### 1. The external and public debt sustainability analyses are based on the standard ### The external and public debt sustainability analyses are based on the standard LIC DSA framework ### Executive summary and recent debt developments - The DSA was prepared jointly with the World Bank in accordance with the Debt Sustainability Framework for low-income countries. - Tonga’s total public sector debt stock (including publicly guaranteed debt) declined to 34 percent of GDP in FY07/08 from 40 percent of GDP in 2005/06. - Donor grants of about US$15 million were channeled through designated banks as off-budget, low interest rate loans in the second half of 2007/08 to businesses affected by the November 2006 civil unrest. - A long-term reconstruction loan from the EXIM Bank of China was signed in November 2007; the first drawdown was made in April 2009. The loan bears a 2 percent interest rate and will be repaid over 20 years with a 5 year grace period. - Disbursements of the EXIM loan were postponed initially; the loan proceeds will finance public works in the capital and private sector office and retail construction. ### Key macroeconomic assumptions (Box 1 and related projections) - Real GDP growth is projected to average 1.2 percent over the period 2009/10–2014/15, reflecting a slowdown from the global financial crisis in the first two years and an average of 1¾ percent thereafter. - Inflation as measured by the GDP deflator is projected to average 5 percent over the projection period 2009/10–2014/15. - The non-reconstruction public sector budget is projected to remain broadly balanced. - Fiscal revenue is projected to grow steadily before it stabilizes at around 26 percent of GDP. - Grants are projected to decline but remain significant at around 2 percent of GDP over the medium term. - The EXIM Bank reconstruction loan is assumed to be fully drawn down by 2012/13 and no major further infrastructure lending is assumed. - Total expenditure is projected to remain below revenues and grants, yielding primary surpluses of around 1 percent of GDP. - The external current account balance is projected to decline this year to 7.9 percent of GDP from 10 percent of GDP in 2007/08; over the medium term the deficit should stabilize around 6 percent of GDP. - FDI is projected to stabilize below recent levels at around 6–7 percent of GDP. - The export base is projected to remain narrow and relatively undiversified; remittances are expected to recover and play an important external cushion. - Key projection table (as presented in source): - 10 year 2008/09 2014/15 Historical 2013-14 2028/29 Average - Real GDP growth (percent)1.41.71.8 - Growth of exports of goods and services (U.S. dollar terms)1.84.75.0 - Non-interest current account balance (in percent of GDP)8.86.23.6 - GDP deflator in U.S. dollar terms (annual percent change)0.82.93.6 - Primary deficit (in percent of GDP)0.3-0.4-0.5 ### External DSA: baseline findings and indicators - Under the baseline, the external debt trajectory breaches the policy-dependent threshold in 2009/10 before receding to below the threshold in 2018/19. - Public and publicly guaranteed (PPG) external debt averaged over 30 percent of GDP from 1998 to 2006 (the indicative threshold level). - With drawdown of the reconstruction loan the PV of PPG external debt is projected to increase to about 42 percent of GDP by 2012/13, 12 percent above the threshold, before dropping under the threshold in 2017 and declining to 11 percent of GDP by the end of the projection period. - External debt remains well above the PV of debt-to-export distress threshold: - The NPV of PPG external debt-to-exports ratio is 243 percent, well above the indicative threshold of 100 percent. - Remittances mitigate liquidity risks; remittances are expected to recover and stabilize at around 25 percent of GDP over the medium term. - Tonga: External Public Debt Indicators (as presented) - Indicative Thresholds 1/2008/09 - NPV of external debt - In percent of GDP3031 - In percent of exports100243 - In percent of revenues200141 - Debt service - In percent of exports1511 - In percent of revenues256 - 1/ Represents Low Income Country DSA indicative thresholds for Tonga that is classified as a poor performer under the World Bank's Country Policy and Institutional assessment. ### External DSA: stress tests and alternative scenarios - Stress tests show vulnerability to export slowdowns and depreciation: - An export shock stress test causes the present value of debt to reach 600 percent of exports and remain above the 100 percent threshold for the entire projection period. - Debt service to exports ratios rise above the 15 percent threshold, reaching over 40 percent in 2015 under the export shock. - A one time depreciation causes the present value of debt to rise to 60 percent of GDP and remain above the 30 percent threshold until 2022; it also causes the PV debt-to-revenue ratio to briefly breach the threshold. - Public sector borrowing on less favorable terms would keep debt levels above the indicative GDP threshold for a prolonged period and approach the revenue threshold. ### Public sector DSA: baseline and stress tests - The public sector DSA reinforces the external DSA conclusions. - Tonga's public debt to GDP ratio declined to around 34 percent of GDP in the last two fiscal years (consistent with FY07/08 outcome), but reconstruction borrowing reversed the trend: - Public debt builds up to 44 percent of GDP in 2010/11 under the baseline before declining steadily thereafter. - Stress tests indicate persistent vulnerabilities, especially to low GDP growth: - A permanent decline in GDP growth and a one-standard deviation decline in GDP growth cause the PV of debt to GDP ratio to rise above 50 percent of GDP. - An alternative scenario with additional large public sector borrowing for infrastructure causes prolonged increases in debt levels. ### Staff assessment and policy implications - Tonga remains at a high risk of external debt distress. - High remittance inflows are the largest source of foreign exchange earnings and help mitigate liquidity risks; remittances are expected to stabilize at around 25 percent of GDP over the medium term. - Public sector debt dynamics are elevated over the short term but show a decreasing trend over the longer run under the baseline, suggesting that debt dynamics are manageable but at high risk. - Policy emphasis in the baseline includes fiscal prudence, limiting new public borrowing (outside reconstruction), and drawing down the EXIM reconstruction loan over four years while minimizing additional external borrowing. *Source: IMF staff DSA prepared jointly with the World Bank for Tonga (excerpt).* ### 13. Stress tests highlight key vulnerabilities to debt sustainability over the medium ### 13. Stress tests highlight key vulnerabilities to debt sustainability over the medium term, including lower GDP growth, major external shocks, and borrowing on less concessional terms. ### Key findings - Stress tests identify key vulnerabilities to debt sustainability over the medium term, including: - lower GDP growth; - major external shocks (including one-time depreciation and export shocks); - borrowing on less concessional terms. - Increased utilization of donor grants and limiting recourse to concessional financing is necessary to maintain manageable public debt dynamics and reduce the risk of external debt distress. - Sound public debt management is essential, anchored in a medium-term debt management strategy (MTDS) and aligned with the medium-term fiscal framework. - Priority should be given to projects that would help generate high growth and employment to help ensure debt service capacity in the future. ### Stress test scenarios and what yields the most extreme shocks - The most extreme stress test is defined as the test that yields the highest ratio in 2018. - In Figure 1: - panel b. (PV of debt-to-GDP ratio): the most extreme shock corresponds to a One-time depreciation shock; - panel c. (PV of debt-to-exports ratio): the most extreme shock corresponds to an Exports shock; - panel d. (PV of debt-to-revenue ratio): the most extreme shock corresponds to a One-time depreciation shock; - panel e. (Debt service-to-exports ratio): the most extreme shock corresponds to an Exports shock; - panel f. (Debt service-to-revenue ratio): the most extreme shock corresponds to a One-time depreciation shock. - Alternative scenarios analyzed include: - A1. Key variables at their historical averages in 2008-2028; - A2. New public sector loans on less favorable terms in 2008-2028 (assumes interest rate on new borrowing is by 2 percentage points higher than in the baseline, while grace and maturity periods are the same); - Bound tests B1–B6: shocks to real GDP growth, export value growth, US dollar GDP deflator, net non-debt creating flows, combinations of shocks, and a one-time 30 percent nominal depreciation relative to the baseline in 2009. ### Representative scenario outcomes (selected indicators from stress analyses) - PV of debt-to-GDP ratio (selected entries, in percent): - Baseline series (selected): 31, 37, 42, 43, 42, 41, 39, 36, 33, 30, 28, 11 (table 1a presentation). - A2 (less favorable terms): 31, 41, 50, 52, 51, 50, 48, 46, 44, 41, 39, 25. - B6 (one-time 30 percent nominal depreciation relative to baseline in 2009): 31, 52, 60, 61, 60, 58, 55, 51, 47, 43, 39, 16. - PV of debt-to-exports ratio (selected entries, in percent): - Baseline series (selected): 243, 277, 304, 308, 302, 293, 278, 259, 238, 218, 199, 81. - A2 (less favorable terms): 243, 310, 358, 371, 369, 362, 348, 331, 313, 295, 278, 181. - B2 (export value growth shock): 243, 390, 625, 632, 623, 606, 577, 542, 503, 465, 431, 184. - PV of debt-to-revenue ratio (selected entries, in percent): - Baseline series (selected): 141, 165, 188, 181, 171, 165, 151, 140, 129, 118, 108, 43. - A2 (less favorable terms): 141, 184, 221, 219, 209, 204, 188, 179, 169, 160, 151, 97. - B6 (one-time 30 percent real depreciation in 2009): 141, 233, 266, 257, 243, 234, 213, 199, 183, 167, 153, 62. - Debt service-to-exports ratio (in percent, selected historical/projected entries): - Listed values include 19.8, 24.7, 17.5, 19.6, 26.0, 23.2, 23.6, 20.0, 23.6, 23.6, 13.4 (table excerpt). - PPG (public and publicly guaranteed) debt service-to-exports ratio (in percent, selected): 10.8, 13.4, 10.0, 11.0, 17.8, 15.6, 16.3, 13.0, 16.7, 19.3, 10.0. - PPG debt service-to-revenue ratio (in percent, selected): 6.1, 5.9, 5.7, 6.4, 10.5, 9.6, 9.6, 7.3, 9.4, 10.4, 5.4. ### Public sector debt dynamics and key macro assumptions (selected values) - Public sector debt (percent of GDP, selected historical/projected entries): 39.8, 37.3, 34.4, 36.4, 39.8, 43.3, 43.9, 40.9, 37.6, 16.5 (table 2a). - o/w foreign-currency denominated (percent of GDP, selected): 29.1, 27.4, 25.4, 28.3, 32.3, 36.1, 35.4, 33.2, 30.6, 14.5. - Change in public sector debt (selected): -3.4, -2.5, -3.0, 2.0, 3.5, 3.5, 0.6, -3.0, -3.3, -0.2. - Primary deficit and identified debt-creating flows (selected): primary deficit series and identified flows are presented in the tables (e.g., identified debt-creating flows include values such as -0.8, -4.0, -4.5, -2.8, 4.1, 1.8, 0.7, -0.9, -1.0, -0.3). - Key macroeconomic assumptions (selected): - Real GDP growth (in percent, series): 0.3, -1.7, 2.6, 1.8, 2.0, 0.4, 0.3, 2.3, 1.7, 1.7, 1.7, 1.4, 1.7, 1.7, 1.7. - GDP deflator in US dollar terms (change in percent, series): 10.3, 5.7, 11.3, 3.6, 9.7, -3.7, 2.4, 1.0, 1.4, 1.8, 1.9, 0.8, 2.9, 2.9, 2.9. - Effective interest rate (percent, series): 0.7, 0.7, 1.2, 1.0, 0.3, 1.8, 2.0, 2.7, 2.9, 2.8, 3.0, 2.5, 3.0, 2.7, 2.9. - Growth of exports of G&S (US dollar terms, in percent, series): 2.6, -19.8, 50.6, 5.0, 26.4, -13.6, 5.8, 8.2, 3.2, 3.5, 3.6, 1.8, 4.7, 4.7, 4.7. - Growth of imports of G&S (US dollar terms, in percent, series): 11.7, -6.1, 22.1, 7.5, 17.5, -4.3, -0.7, 1.9, 0.3, -4.8, 2.9, -0.8, 4.7, 4.7, 4.7. - Grant element and grant-equivalent financing (selected): - Grant element of new public sector borrowing (in percent) series include values: 30.4, 43.9, 44.0, 47.8, 61.0, 61.0, 48.0, 52.0, 48.0, 54.0 (table excerpts). - Grant-equivalent financing (in percent of GDP, selected): 3.8, 1.3, 8.0, 11.6, 11.5, 6.3, 4.3, 4.0, 2.1, 1.4, 2.1. - Grant-equivalent financing (in percent of external financing, selected): 67.5, 61.5, 62.0, 75.4, 90.2, 89.5, 74.3, 60.0, 74.8. ### Policy implications and recommendations - Maintain sound macroeconomic policies to improve growth potential on a sustainable basis. - Continue fiscal consolidation efforts to strengthen debt sustainability. - Increase utilization of donor grants and limit recourse to less concessional borrowing to maintain manageable public debt dynamics and reduce external debt distress risk. - Strengthen public debt management, anchored in a medium-term debt management strategy (MTDS) aligned with the medium-term fiscal framework. - Prioritize public investment projects that generate high growth and employment to support future debt service capacity. ### Assumptions, methodology, and definitions (selected) - Revenues are defined inclusive of grants. - Endogenous debt dynamics formula: derived as [r - g - r(1+g)]/(1+g+r+gr) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate; and r = growth rate of GDP deflator in U.S. dollar terms. - Residual includes exceptional financing (changes in arrears and debt relief), changes in gross foreign assets, valuation adjustments, and for projections also includes contribution from price and exchange rate changes. - PV of private sector debt is assumed equivalent to its face value for the PV calculations. - Effective interest rate definition: current-year interest payments divided by previous period debt stock. - A2 (less favorable financing) assumes that the interest rate on new borrowing is 2 percentage points higher than in the baseline while grace and maturity periods remain the same. - B6 and related bound tests define depreciation as percentage decline in dollar/local currency rate, such that it never exceeds 100 percent. B2 assumes exports values remain permanently at the lower level while the current account as a share of GDP returns to baseline after the shock (implicitly assuming offsetting adjustment in import levels). - Memorandum items include nominal GDP (Billions of US dollars) and nominal dollar GDP growth series as shown in the staff simulations. *Source: Staff projections and simulations, IMF staff report informational annex (Staff Report for the 2009 Article IV Consultation—Informational Annex).* ### ANNEX III. TONGA: RELATIONS WITH THE WORLD BANK GROUP ### ANNEX III. TONGA: RELATIONS WITH THE WORLD BANK GROUP ### Membership and overall IDA financing - Tonga became a member of the World Bank Group in 1985. - Since membership, the World Bank has approved six IDA credits and grants worth a total of SDR 18.6 million (equivalent to approximately USD 28 million based on exchange rates at the time of each loan approval). - Given Tonga’s debt position, all new IDA support for Tonga is provided on grant terms. - Tonga has an indicative IDA-15 (FY09–FY11) envelope of SDR 4.9 million (approximately USD 7.5 million), none of which has yet been committed. - In addition to the IDA-15 envelope, the World Bank is in FY10 anticipating committing approximately AUD 3 million in funds for Tonga provided through the Pacific Regional Infrastructure facility (PRIF), financed predominantly by Australia and New Zealand. ### Key components of current World Bank engagement - Health - Tonga Health Sector Support Project: an IDA credit of USD 10.9 million equivalent approved in 2003. - Supported improvements in the functioning of Vaiola hospital in Nuku’alofa and reforms to Tonga’s health financing system. - Health sector investments have supported progress toward the MDGs of reducing child mortality and improving maternal health, both of which are likely to be achieved. - The project is scheduled to finish shortly, and will be fully disbursed. - Education - Tonga Education Support Project: an IDA credit of U.S. dollars 1 million equivalent approved in 2005 in conjunction with a New Zealand grant of USD 4.1 million. - Introduced a successful schools grants program allocated on a capitation formula to ensure equitable and flexible funding for maintenance and educational materials. - The program has supported Tonga’s progress toward universal primary education, where the country remains broadly on track. - Transport - Tonga Transport Sector Consolidation Project (TSCP): an IDA grant of USD 5.4 million equivalent approved in July 2008. - Aims to assist the government to unify transport sector policy, planning and regulation in the newly established Ministry of Transport, and to improve civil aviation and maritime safety and security. - With anticipated grant support through PRIF, the TSCP will assist the government to directly contract local firms for urgent road maintenance to ensure local participation and strengthen the local industry, and to support maritime and air transport investments. - Private sector development - The World Bank Group (including IFC and IDA) are collaborating to support government efforts to streamline business-enabling legislation and regulation and remove regulatory impediments to private sector growth. - Energy - The Bank is working with the Tongan government and other development partners to develop a Tonga Energy Roadmap: integrated investments and reforms to improve access and reduce the cost of electricity supply, and to minimize vulnerability to oil price shocks by increasing use of renewable energy. - The process is noted as a strong example of development coordination in the Pacific region. - It is anticipated the Bank will support the final roadmap—with other development partners and potentially private sector investors—using current unallocated IDA resources and support through PRIF. ### World Bank credits, grants and disbursement status (as presented) - Total: USD 28.2 million - Of which FY09 disbursements: USD 0.5 million - Undisbursed: USD 7.1 million - Of which: FY10 expected disbursement: USD 6.0 million *Prepared from ANNEX III. TONGA: RELATIONS WITH THE WORLD BANK GROUP (as of July 10, 2009).* ### 3. The authorities have recently announced agreement on the further large ### _cr09292 - 3. The authorities have recently announced agreement on the further large ### Infrastructure loan announcement - The Prime Minister announced that in principle agreement had been reached with China on the US$45 million infrastructure loan (referenced in paragraph 10 of the staff report). - When finalized the loan is expected to be on similar terms to the US$60 million loan for the reconstruction of Nuku’alofa. ### Background and recent economic developments - IMF Public Information Notice (PIN) No. 09/122; FOR IMMEDIATE RELEASE; September 22, 2009. - IMF Executive Board concluded the 2009 Article IV Consultation with Tonga on September, 4, 2009. - Recovery from the 2006/07 contraction and domestic political disturbance has been halted by the global economic slowdown. - Growth history and recent estimates: - Following a contraction of 1¾ percent in 2006/07, the economy rebounded by 2½ percent the following year. - Growth is estimated to have been less than ½ percent in 2008/09. - Inflation: - Reached 12 percent in mid-2008; moderated to around 2 percent by the time of the report. - Remittances and reserves: - Remittances fell by around 15 percent in 2008/09. - Reserves increased slightly to over 4 months of import cover in late 2008 due to strong investment and capital flows. ### Fiscal developments and stance - 2008/09 outcomes: - Fiscal revenue fell considerably below budget targets in 2008/09 due to reductions in tax rates, slowing growth and declines in imports. - Tight expenditure control and significant increases in grants enabled the government to deliver a fiscal surplus that will be used to establish a disaster and natural emergency fund. - 2009/10 budget aims: - Aim to achieve a surplus excluding reconstruction borrowing by improving revenue performance, while raising public sector pay and increasing expenditure on infrastructure and social services. - Loan-financed reconstruction of the central business district will lead to an overall deficit of around 3 percent of GDP. - External debt: - External debt declined to around 29 percent of GDP in 2007/08. - Initial drawdowns of a large reconstruction loan saw debt increase to around 31 percent of GDP at the end of 2008/09. - Further loan utilization will see debt levels rise further in coming years. - Authorities’ fiscal package and financing (authorities’ statement): - 2009/10 budget envisaged an estimated surplus of 17.4 million pa’anga in 2009/10 resulting from total revenues and grants of 220.1 million pa’anga compared to 202.7 million in expenditure. - This surplus will be utilized to pay off external debts of 12.3 million pa’anga, leaving a balance of 5.1 million pa’anga for infrastructure projects under construction. - Government lined up funding from extra external grants and concessional loans, amounted to 47.9 million pa’anga in cash and 39.4 million pa’anga in kind. - Authorities expect donor partners including Australia, New Zealand, European Union, Asian Development Bank, and assistance from the People’s Republic of China (including concessional loan for Nuku’alofa CBD reconstruction). - Policy recommendations and authorities’ actions: - Authorities cut 2008/09 expenditures by around 30 percent (rescheduling payments and cutting less prioritized expenses) to limit fiscal deterioration; expected to result in a minor overall deficit of around 1.25 percent of GDP for 2008/09 (authorities’ projection). - Fiscal strategy for 2009/10 emphasizes intensifying collection of reformed revenue bills (Customs, Excise and Income Tax), reducing government purchases of goods and services, and improving effectiveness of public expenditure reforms. - Authorities committed to prudent implementation of the 2009/10 budget and readiness to consider additional measures if needed. ### Executive Board assessment and IMF recommendations - Directors’ observations: - Tonga’s recovery has been hampered by global and domestic conditions; remittances are declining and domestic banks are curtailing credit due to a build-up of bad loans. - Downward risks include a sharper-than-projected decline in remittances. - Constraints on policy response: - Fiscal policy constrained by high public debt. - Scope for monetary expansion circumscribed by relatively low international reserves. - Endorsements and cautions: - Endorsed authorities’ strategy of pursuing reconstruction while aiming for a small surplus in the non-reconstruction budget, and relaxing reserve requirements to ease pressures on domestic borrowers. - Continued donor support is important. - Cautioned that revenue shortfalls may compromise planned stimulus spending; encouraged greater attention to improving revenue enforcement, especially customs collections. - Urged careful prioritization of expenditures and consideration of a more gradual implementation of planned public wage increases. - Welcomed authorities’ contingency plan if revenues are lower than budgeted. - Reconstruction loan guidance: - Noted the large reconstruction loan will place a heavy debt burden, acceptable only if: loan-financed expenditure proves productive; GDP continues to grow over the medium term; and the budget remains balanced. - Urged vetting of proposed reconstruction projects, approving only economically viable ventures. - Recommended financing future infrastructure investments rely as much as possible on domestic revenues and grants. - Monetary and financial sector guidance: - With reserves likely to remain in the lower part of the Reserve Bank’s comfort zone, Directors encouraged maintaining a cautious monetary policy stance and readiness to tighten should credit growth re-accelerate and the outlook for reserves and inflation deteriorate. - Noted staff assessment that the exchange rate remains consistent with external stability and that projected external current account deficits are sustainable. - Welcomed intention to use the adjustment band within the current exchange rate peg if needed to safeguard reserve coverage. - Encouraged further efforts to enhance banking supervision and remain vigilant against surges in high-risk lending. - Structural and statistical recommendations: - Underscored importance of structural reform guided by the Strategic Planning Framework. - Congratulated authorities on recent steps to rationalize public enterprises and encouraged further progress to improve the business climate. - Recommended strengthening the statistical framework to match advances in compilation with improvements in underlying data. ### Monetary policy actions and outlook (authorities’ statement) - NRBT actions: - National Reserve Bank of Tonga eased monetary policy in mid-2009 by ceasing the issue of NRBT notes and reducing Statutory Required Reserves to 5 percent from 10 percent. - Easing based on outlook for foreign reserves and benign inflation, while committing to closely monitor credit growth to avoid prior credit blowouts. ### External sector and remittances - Exports and challenges: - Main export products (squash and fish) performed poorly due to limited market access, volatile prices, lack of new technology, lack of cargo space, and harsh weather. - Government initiatives to boost export diversification and develop new markets. - Remittances and imports: - Historically strong correlation between remittances and imports; remittances normally represented 85% of imports but have been declining. - Slowdown in remittances led to lower consumer imports and may narrow the current account deficit. - Tourism: - Tourism had shown strong growth up to Q1 2009 and could benefit from redirection of tourists toward Pacific destinations; tourist arrivals have held up well to date. - Reserves: - Foreign reserves had accumulated significantly equivalent to over 4 months of import cover (as noted elsewhere). ### Selected economic indicators (2005/06–2009/10) — key figures preserved exactly as reported - Real GDP (percent change): 0.3-1.72.60.40.3 - Consumer prices (period average): 7.05.19.84.71.7 - Central government finance (in percent of GDP): - Total revenue and grants: 26.828.626.528.628.3 - Total expenditure and net lending: 29.627.524.927.332.2 - Overall balance (incl. reconstruction loan): -2.81.11.71.3-3.9 - Overall balance (excl. reconstruction loan): -2.81.16.52.92.1 - External financing (net): 0.40.10.21.04.2 - Domestic financing (net): 2.4-1.2-1.9-2.3-0.3 - Money and credit (in percent change): - Total liquidity 2/: 13.313.35.0-0.52.4 - Of which: Broad money (M2): 16.611.96.4-1.02.5 - Domestic credit: 25.811.612.8-4.31.5 - Private sector credit: 22.69.518.00.42.0 - Balance of payments (in millions of U.S. dollars): - Exports, f.o.b.: 15.413.312.48.08.4 - Imports, f.o.b.: -122.2-108.6-138.1-126.4-127.8 - Services (net): -7.8-17.9-3.3-9.5-4.8 - Income (net): 2.83.53.429.24.2 - Services and income (net): -5.0-14.40.119.7-0.6 - Transfers (net): 88.984.294.877.469.9 - Current account balance (excl. reconstruction loan): -22.8-25.5-30.8-19.4-34.3 - Current account balance (incl. reconstruction loan): -22.8-25.5-30.8-21.3-50.1 - (In percent of GDP): -8.0-8.5-9.0-6.5-14.8 - Gross international reserves: - In millions of US dollars: 40.447.148.259.545.6 - In months of total imports: 3.13.93.24.23.2 - External debt (in percent): - External debt (in percent of GDP): 35.732.628.930.833.6 - Debt service ratio 3/: 1.11.11.41.32.3 - Exchange rate (period average): - Pa'anga per U.S. dollar: 2.02.01.92.1... - Real effective exchange rate (1990=100) 4/: 103.6104.5104.2114.0... - Nominal effective exchange rate (1990=100) 4/: 70.568.466.067.5... - Sources noted in the table: The Tongan authorities; IMF staff estimates and projections. *IMF Public Information Notice (PIN) No. 09/122; IMF Executive Board concluding statement and authorities’ statement as provided in the source content.* ### 5.4 months of imports at the end of July 2009, owing mainly to private capital inflow from ### _cr09292 - 5.4 months of imports at the end of July 2009, owing mainly to private capital inflow from ### Reserves, imports, and exchange rate - Gross foreign reserves: 5.4 months of imports at the end of July 2009, owing mainly to private capital inflow from the sales of government assets and capital injection into the banking system. - Import payments: in downward trend and expected to remain at lower level as long as oil and food prices remain constant at the current level. - Remittances: threats of lower remittances noted; NRBT committed to maintain foreign reserves at an adequate level. - Nominal Effective Exchange Rate: has appreciated this year, mostly due to the pa'anga significant appreciation against NZD and AUD, as these two currencies depreciated swiftly when the global financial market has deleveraged its position to safe haven instruments. - Exchange rate policy: - Authorities aim to maintain the exchange rate flexibility around +/- 5% band supported by monetary operation to secure its competitiveness, sustainable macro stability and economic growth. - Authorities broadly agree with staff’s assessment on the exchange rate and assure the Board members that the existing adjustment band would be used to maintain external stability. - Authorities would appreciate the Fund’s assistance on reviewing the exchange rate basket. ### Financial sector stability and supervision - Banking system condition: - Banking system remains struggling to consolidate their financial position after the sharp increase of impaired loans last year. - Significant amount of bad debts were mandated to be charged in their provisions and their profit has dropped quite substantially. - Two out of three commercial banks, which are foreign owned, currently, are running on reasonable amount of losses in their book, while the level of their capital remains sufficient. - The only domestic owned bank, Tonga Development Bank, is quite successful in managing its operation and merit a commendation since it has been able to maintain its profitable position for quite some time with a lesser support from the government. - The prudential measure on account of the credibility of foreign banks is key to promote the financial stability and to ensure healthy lending process going forward. - Supervision enhancements and capacity needs: - NRBT has enhanced its banking supervision framework by issuing six new prudential statements to ensure strong risk management. - Banks compliance will be monitored offsite and more frequent onsite visits are planned to monitor the build up of bad loans. - Authorities are cognizant of the need to build capacity in the banking supervision department. - Most of the bank supervision staff are all new with less than 1 year experience; authorities would continue to require technical assistance for capacity building. ### China reconstruction program and debt management - Program status and financing: - The China reconstruction program, which has already been delayed since the last couple of years, is projected to ramp up this year. - Authorities have disbursed quite a significant amount of loan from this program and secured additional concessional loan amounted of USD 45 millions for infrastructure development recently. - Given the unprecedented postponement in the recent past, it is realized that the disbursement schedule needs to be modified to avoid the increase in risk of debt distress. - The Chinese government has been supportive and vigilant to discuss and renegotiate the term of loan as the economic condition remains challenged by growing uncertainties. - Growth and import effects: - This program will apparently become the main inducement of economic growth, while the development in infrastructure and the enhancement of facilities would always be imperative to facilitate new investment and business in Tonga. - Because materials and services related to this activity are ostensible to be mostly imported from China, there is such a risk that growth effect will be fairly limited in the short-term perspective. - Authorities are mindful that this increasing tendency of import due to this reconstruction program will also influence the Tongan foreign reserves, especially in term of the months of import ratio, as the trade account will ramp up. - Looking forward, the Tongan authorities need to improve their debt and reserves management capabilities in managing such a long-term program loan. ### Final remarks and acknowledgements - Authorities recognize the challenges and significant risks under the current global economic crisis. - Outlook: The road ahead will be challenging but with strong political will, and assistance from other countries, and multilateral institutions, the authorities are hopeful of addressing some of Tonga’s challenges and moving the economy forward. - Acknowledgements: Tongan authorities express their sincere gratitude to the Pacific Financial Technical Assistance Center (PFTAC), the Fund and the Bank more generally, for the technical guidance received over the years. *IMF staff report content unit _cr09292* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2009/_cr09292.pdf_