## _cr11110

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### INTRODUCTION — Context and Key Findings
- Recession that began in 2008/09 continued in 2010 with declines in tourism, remittances, and exports.
- Financial conditions remained tight as banks raised lending standards following a large rise in nonperforming loans.
- Activity has bottomed out recently as growth has been supported by a recovery in tourism and expansionary fiscal policy financed by donor aid.
- Growth projections:
  - Growth is likely to rise to 1¼ percent in FY2010/11 (year ending June).
  - Growth is likely to rise to 1¾ percent in FY2011/12 and the medium term.
- Constraints to faster growth: limited private sector development, geographical isolation, and high public debt.
- Policy focus recommended: restore room for countercyclical macroeconomic policies, reduce risks to external and fiscal sustainability, and lay foundations for higher potential growth.

### RECENT DEVELOPMENTS — Activity, Prices, External Position, Politics
- Activity:
  - GDP continued to contract in FY2009/10 (year ending June) as financial conditions remained tight and tourism and remittances declined due to weak global demand from the United States, Australia, and New Zealand.
- Inflation:
  - CPI inflation averaged 2 percent in 2009/10.
  - CPI inflation rose to 6½ percent y/y in February 2011.
- External position:
  - Current account deficit narrowed to 7.8 percent of GDP in FY2009/10.
  - Reserves rose to near seven months of imports as of end-February 2011.
- Politics:
  - November 2010: first parliamentary elections under which a majority of seats were popularly elected; new prime minister and government.
  - New government priorities: structural reforms to promote private sector activity and restore fiscal sustainability.

### KEY MACRO INDICATORS (selected)
- Growth (percent): 2007/08 = 2.0; 2008/09 = -0.1; 2009/10 = -0.5
- Inflation (percent): 2007/08 = 9.8; 2008/09 = 5.0; 2009/10 = 2.0
- Current account (percent of GDP): 2007/08 = -8.9; 2008/09 = -14.7; 2009/10 = -7.8
- Gross reserves (US$ millions): 2007/08 = 48.2; 2008/09 = 67.7; 2009/10 = 88.7
- Gross reserves (in months of imports): 2007/08 = 3.2; 2008/09 = 4.7; 2009/10 = 7.1
- Real effective exchange rate (+ = appreciation): 2007/08 = 2.1; 2008/09 = 6.3; 2009/10 = 0.0

### OUTLOOK — Staff Views (Short-term and Medium-term)
- Short-term:
  - Growth projected to recover to 1¼ percent in FY2010/11, supported by stronger tourism activity and construction financed by donor aid and previously contracted loans.
  - Inflation likely to rise to around 6 percent.
- Medium-term:
  - Growth expected to remain at around 1¾ percent—consistent with the average of the past 15 years but about ¾ percentage points above the average of the past 10 years.
  - Medium-term outlook assumes stepped up capital spending, structural reform, improved fiscal management, and continued high emigration.
  - Growth expected to be mainly driven by tourism and agriculture.

### RISKS — Staff and Authorities’ Views
- Downside risks:
  - Protracted rise in world commodity and food prices would adversely affect inflation, growth, and the current account deficit.
  - A faltering global economy would reduce remittances, tourism, and exports, weakening activity and threatening reserves.
- Fiscal vulnerability:
  - Tonga’s high public debt leaves the country highly vulnerable to shocks and poses a risk to economic prospects.
- Limited policy tools:
  - Limited effectiveness of monetary policy given banks’ cautious lending reduces room for countercyclical macroeconomic policies.
- Policy implications:
  - Mitigating risks requires further progress on structural reforms, continued grants from donors, and steady fiscal consolidation.
- Authorities:
  - Ministry of finance considered staff GDP forecast somewhat optimistic and expected growth to remain negative in FY2010/11 at around -0.5 percent (authorities reviewed forecasts based on revised national accounts and inclusion of activity related to China EXIM Bank-funded reconstruction).
  - National Reserve Bank expected CPI inflation to reach 5¾ percent in FY2010/11 and ease to 4¼ percent in FY2011/12.

### FISCAL POLICY — Stance, Vulnerabilities, and Staff Recommendations
- FY2010/11 stance:
  - Policies remained loose; stepped-up capital expenditure mainly financed by previously contracted loans.
  - Generous grant inflows contributed to narrowing the fiscal deficit to an estimated 4¼ percent of GDP (from about 5¾ percent of GDP in FY2009/10).
  - Tonga is at a “high risk of debt distress” per World Bank‑IMF DSA.
  - Staff projects overall deficit (including grants) to widen to around 5¼ percent of GDP in FY2011/12 as capital projects roll out; primary deficit expected to reach 4¼ percent of GDP in FY2011/12.
- Staff recommendations (fiscal consolidation & transparency):
  - Avoid new borrowing.
  - Reduce current spending.
  - Carefully prioritize spending.
  - Improve tax administration.
  - Improve transparency.
  - Maintain wage bill at its 2010/11 level to help limit the deficit to 5¼ percent of GDP.
  - Reform salary/performance system (current system: two ratings, automatic annual increase ~4 percent in wage bill).
  - Improve customs classification and valuation; use unique tax identification numbers; increase customs training; complete automation of customs processing.
  - Streamline tax exemptions; consider replacing exemptions with explicit budget transfers.
  - Provide greater detail on composition and distribution of expenditures and revenue across line ministries in budget papers.

### DEBT, EXTERNAL LOANS, AND MEDIUM-TERM FISCAL OBJECTIVE
- China EXIM loans:
  - Two loans with face value totaling around 30 percent of GDP.
  - Signed November 2007 (central business district reconstruction) and February 2010 (roads).
  - Terms: interest rate 2 percent; grace period 5-year; maturity 20-year.
- Medium-term fiscal objective:
  - A primary surplus of 1 percent of GDP would be needed to put fiscal position on a more sustainable path and bring public debt to around 30 percent of GDP by the early 2020s.
- Recommended measures:
  - Continued expenditure restraint; improved expenditure prioritization; improved revenue administration.
  - Implement a comprehensive MTBF starting FY2011/12.
  - Better reporting by line ministries; allocate funds at more aggregated levels consistent with NSPF priorities; pilot MTBF in better performing ministries.
- Debt management recommendations:
  - Comprehensive debt management strategy needed.
  - Interim prudent actions: proceed cautiously with selection of private sector projects to be on‑lent with China EXIM loan proceeds to limit government credit risk and excess capacity.

### MONETARY POLICY — Stance, Contingencies, and Exchange Rate
- Monetary policy stance:
  - Geared toward jumpstarting bank lending.
  - NRBT remunerated banks’ exchange settlement account balances over TOP 1 million and maintained adequate liquidity in the system in FY2010/11.
  - Measures contributed to slowing pace of decline of credit to the private sector.
- Staff guidance:
  - NRBT should maintain current policy stance; with appropriate liquidity, little need for further loosening.
  - Pre-emptive tightening triggers/instruments if bank lending normalizes faster than anticipated:
    - Hikes in interest rates on the NRBT repo facility.
    - Issuance of central bank paper.
    - Reserve requirements.
  - Alternative scenario (global commodity shock): if core inflation remains stable, avoid monetary tightening and advance fiscal consolidation while providing targeted support to the poor.
- Exchange rate assessment and policy flexibility:
  - Exchange rate broadly in line with fundamentals.
  - If downward pressure on reserves emerges, NRBT may gradually depreciate the pa’anga within horizontal bands to safeguard external stability—accompanied by further fiscal restraint due to effects on public debt.
  - Basket weights considered broadly appropriate but should be reviewed and updated to reflect trade pattern changes and emergence of renminbi debt.
- Authorities:
  - Intend to act pre-emptively to control inflation risks and maintain reserves above NRBT comfort zone of 3–4 months of imports.
  - NRBT will use all instruments, with greater use of direct instruments such as reserve requirements, given limited impact of indirect instruments on credit growth.

### FINANCIAL SECTOR — Banking System Status, Constraints, and Reform Priorities
- Banking system status:
  - Banks making progress in repairing balance sheets; well capitalized.
  - Profitability remains well below past years owing to high provisioning; improved somewhat in recent months.
  - NPLs are declining.
  - Notional demand for credit estimated by staff to be over 7 percent the supply of credit.
- Interest rate transmission (monthly data 2000–2010):
  - A one percentage point increase in the repo rate:
    - raises the average bank lending rate by about ¼ percentage points;
    - reduces private sector credit growth by about 1½ percentage points.
  - Effects smaller than in other Pacific islands (e.g., PNG and Fiji).
- Structural constraints limiting pass-through:
  - Shallow domestic money market (broad money to GDP).
  - Limited collateralized interbank lending; no secondary markets for government/central bank paper.
  - No market for commercial paper, corporate bonds, equity, and foreign exchange products.
- Bank lending rates and profitability:
  - Lending rates recently averaged around 12 percent.
  - Net interest income averaged around 6 percent of average assets.
  - Non-interest income averaged over 5 percent of average assets.
  - Selected banks’ ratios reported:
    - Pre-tax Net Profits (percent of assets): 2008: 4.9; 2009: -6.1; 2010: 0.6
    - Operating Income (percent of assets): 2008: 11.9; 2009: 11.1; 2010: 3.1
    - Net Interest Income (percent of assets): 2008: 6.3; 2009: 6.3; 2010: 6.1
    - Non-Interest Income (percent of assets): 2008: 5.6; 2009: 4.9; 2010: 3.4
    - Loan-loss Reserve to Gross Loans 1/: 2008: 6.4; 2009: 9.6; 2010: 14.1
    - Risk Weighted CAR: 2008: 22.4; 2009: 26.5; 2010: 22.9
- Staff recommendations to normalize credit growth:
  - Enact Personal Property Security Act.
  - Institute a centralized credit bureau.
  - Modify legal framework for timely registration and recovery of collateral, including a secured bankruptcy protection law.
  - Effective supervision of banks; NRBT plans to adopt a standardized examination report format.
  - Continued PFTAC technical assistance and longer-term donor-financed assistance for supervisory capacity.
  - Developing a framework for secured lending to increase pass-through of interest rates.
- Authorities’ measures and views:
  - Agreed NPLs had peaked; lending should improve with recovery.
  - Ongoing discussions to create a credit bureau by end of this financial year.
  - NRBT required banks to disclose Effective Interest Rates charged to clients.

### DEBT SUSTAINABILITY ANALYSIS (DSA) — Stress Tests and Public Sector DSA
- External stress test results:
  - Export shock causes PV of debt to exceed 500 percent of exports and remain above 100 percent threshold for the entire projection period.
  - Debt service-to-exports ratio reaches almost 40 percent in 2017.
  - Large one-time depreciation causes PV of debt to rise to around over 55 percent of GDP and remain above the 30 percent threshold even after 2020.
  - PV of debt-to-revenue ratio persistently breaches its threshold under large depreciation.
  - Similar stresses when remittances considered.
  - Recent China EXIM loan and donor-financed construction projects create a larger current account balance than in the past, making future scenario more risky.
- Public sector DSA — Baseline:
  - Recent high public sector borrowing raises PV of debt to over 42 percent of GDP in 2011/12–2013/14 before declining thereafter under baseline.
- Alternative Fiscal Balance scenario:
  - Primary surplus assumed at average 1 percent of GDP after 2010/11.
  - A 30 percent depreciation results in PV of public debt rising and remaining above 50 percent of GDP until 2017/18; at 18½ percent of GDP in 2031.
- Staff assessment:
  - Tonga remains at a high risk of external debt distress.
  - Remittances mitigate liquidity risks but are insufficient to limit projected debt service risks.
  - Authorities exposed to currency mismatch on government balance sheet.
  - Despite high risk, debt dynamics are manageable if authorities avoid new PPG borrowing and commit to fiscal prudence.
- Policy priorities from DSA:
  - Sound macroeconomic policies to improve growth potential.
  - Export diversification.
  - Continued fiscal consolidation.
  - Increased utilization of donor grants and avoidance of further new borrowing until debt trajectory is downward.
  - Sound public debt management anchored in a medium-term debt management strategy.
  - Prioritize projects that generate high growth and employment in context of NSPF.

### BOX 1 — Key Assumptions (selected)
- Real GDP growth: projected to average around 1.7 percent over 2010/11–2015/16.
- Fiscal assumptions:
  - Current fiscal balance assumed to narrow from a deficit about 2½ percent of GDP in 2010/11 to surplus of 1 percent by 2015/16.
  - Resulting primary fiscal balance will average around 1 percent of GDP.
- Grants and borrowing:
  - Grants projected to decline from 5¼ percent of GDP to around 2½ percent of GDP over the longer term.
  - Following last disbursement of China Exim Bank loan (in 2012/13), all future external borrowing assumed from concessional IFI facilities (AsDB and World Bank).
  - No new domestic borrowing assumed until 2014/15.
- External sector:
  - External current account deficit projected to reach 10¾ percent of GDP in 2012/13 (up from 7¾ percent of GDP in 2009/10); medium-term around 7½ percent of GDP.
  - Net FDI projected to stabilize at around 5½ percent of GDP.
- Remittances and exports:
  - Remittances expected to recover with economies of the United States, Australia, and New Zealand.
  - Export base projected to remain narrow and relatively undiversified, focused on agricultural products.

### MEDIUM-TERM PROJECTIONS (selected)
- Real GDP (annual percent change): 2008/09 -0.1; 2009/10 -0.5; 2010/11 1.2; 2011/12 1.7; 2012/13 1.8; 2013/14 1.8; 2014/15 1.8; 2015/16 1.8
- Consumer prices (period average): 2008/09 5.0; 2009/10 2.0; 2010/11 6.0; 2011/12 5.8; 2012/13 3.9; 2013/14 6.0; 2014/15 6.0; 2015/16 6.0
- Gross international reserves (end of period, US$ millions): 2008/09 67.7; 2009/10 88.7; 2010/11 104.0; 2011/12 90.1; 2012/13 77.8; 2013/14 63.8; 2014/15 53.4; 2015/16 49.5
  - In months of imports: 2008/09 4.7; 2009/10 7.1; 2010/11 6.5; 2011/12 5.8; 2012/13 5.2; 2013/14 4.1; 2014/15 3.3; 2015/16 3.0
- Public sector external debt (percent of GDP, projections): 2008/09 32.5; 2009/10 36.6; 2010/11 43.3; 2011/12 44.3; 2012/13 45.3; 2013/14 44.4; 2014/15 41.9; 2015/16 39.7

### CENTRAL GOVERNMENT FINANCE (selected levels and percent of GDP)
- Nominal GDP (pa’anga, fiscal year begins July): 2006/07 611.0; 2007/08 661.4; 2008/09 663.2; 2009/10 681.4; 2010/11 752.9; 2011/12 810.2
- Total revenue and grants (percent of GDP): 2006/07 28.0; 2007/08 25.9; 2008/09 29.8; 2009/10 26.3; 2010/11 28.8; 2011/12 21.8
  - Total revenue (percent of GDP): 24.3; 24.6; 22.9; 21.0; 17.6; 17.6 (2006/07–2011/12)
  - Grants (percent of GDP): 3.7; 1.3; 6.9; 5.2; 11.2; 4.2
- Total expenditure and net lending (percent of GDP): 26.9; 24.3; 29.6; 31.9; 30.0; 27.0
  - Current expenditure (percent of GDP): 25.9; 23.9; 25.3; 26.2; 20.0; 19.8
  - Capital expenditure (percent of GDP): 0.9; 0.4; 3.0; 3.4; 10.5; 5.2
- Overall balance (percent of GDP): 1.0; 1.6; 0.1; -5.7; -4.2; -5.2

### EXTERNAL SECTOR (selected)
- Nominal GDP (2009/10): US$ 353.2 million
- Population (2009): 103,294
- GDP per capita (2009/10): US$ 3,419
- Trade balance (US$ millions): 2006/07 -95.3; 2007/08 -125.7; 2008/09 -124.6; 2009/10 -102.3; 2010/11 -139.0; 2011/12 -132.2
- Current account balance (percent of GDP): 2006/07 -8.3; 2007/08 -8.9; 2008/09 -14.7; 2009/10 -7.8; 2010/11 -11.0; 2011/12 -11.7
- Gross official foreign reserves (US$ millions, end period): 2006/07 47.1; 2007/08 48.2; 2008/09 67.7; 2009/10 88.7; 2010/11 104.0; 2011/12 90.1
  - In months of goods and services imports: 3.9; 3.2; 4.7; 7.1; 6.5; 5.8
- External debt (percent of GDP): 2006/07 26.8; 2007/08 24.9; 2008/09 32.5; 2009/10 36.6; 2010/11 43.3; 2011/12 44.3

### STRUCTURAL REFORMS TO RAISE MEDIUM-TERM GROWTH
- Staff recommendations to promote private sector activity:
  - Extend land leases to 99 years for all allotments and activities.
  - Reduce the number of business licenses.
  - Lower barriers to foreign investment.
  - Improve efficiency in delivery and generation of utilities (noting adoption of the Tonga Energy Road Map).
- Public enterprise reform:
  - Level the playing field between public and private enterprises; proceed with corporatization and privatization plans; amend regulatory structure to promote competition.
  - Recent measures: publish audited accounts of all public enterprises; change board composition; increase board accountability.
- Social protection:
  - Establish a contributory pension scheme and increase coverage of health insurance and workers’ compensation.
  - 2009 household income and expenditure survey shows increasing hardship during the past decade; declines in remittances and rising food prices hit outer islands and areas outside Nuku'alofa particularly hard.

### TECHNICAL ASSISTANCE, STATISTICS, AND INSTITUTIONAL SUPPORT
- PFTAC assistance since 2006: 27 advisory missions to Tonga across TA sectors; 63 officials sent to regional seminars/workshops (2006–March 2010).
- PFM and MTBF:
  - PFTAC supported introduction of midyear economic review and fiscal update; scoping mission on MTB in late March 2010; ADB initiated an MTB project thereafter.
- Tax administration and policy:
  - Passing of new Income tax and Customs Acts (self assessed); post implementation review of VAT; consumption tax introduced in 2005.
  - Revenue losses from trade liberalization through PICTA and PACER estimated as high as 27 percent of total revenue by external research.
- Banking supervision:
  - MCM and PFTAC assistance on prudential statements, off-site analysis, and supervisory capacity; peripatetic advisor visits scheduled for on-site examination capacity enhancement (March 2011 and May 2011).
- Statistics:
  - National accounts rebased (new series released June 2009, 2000/01 base); CPI basket from 2000/01 Household Income and Expenditure Survey.
  - Employment statistics not compiled since 2003; average earnings statistics not available.
  - Data generally described as "broadly adequate for surveillance" but with continuing deficiencies and long lags in data provision.
  - Key data observation/receipt dates preserved in the Table of Common Indicators (e.g., Exchange Rates: Date of latest observation Feb-11; Date received Mar-11).

### STAFF APPRAISAL — Near-term Priorities and Final Recommendations
- Near-term forecasts:
  - Growth estimated to recover to 1¼ percent in FY2010/11 and 1¾ percent in FY2011/12.
  - Inflation likely to average around 6 percent in FY2010/11 and in FY2011/12.
- Near-term fiscal advice:
  - Fiscal consolidation to mitigate fiscal sustainability risks and expand fiscal space: avoid new borrowing, reduce current spending, prioritize expenditure, strengthen tax administration, and improve fiscal transparency.
- Monetary and financial sector advice:
  - Maintain current monetary stance; pre-emptive tightening if monetary conditions normalize faster than expected using repo rate hikes, issuance of central bank paper, and reserve requirements.
  - To normalize credit growth: enact Personal Property Security Act; establish centralized credit bureau; modify legal framework for collateral recovery; increase competition within prudential framework; improve consumer protection and financial literacy.
  - Resist pressure to administer interest rates.
- Exchange rate and external stability:
  - Exchange rate broadly in line with fundamentals; use flexibility in current arrangement to gradually depreciate if reserves come under pressure, accompanied by fiscal restraint.
  - Update currency basket weights to reflect trade patterns and renminbi debt emergence.
- Reiterated structural reform priorities:
  - Extend land leases to 99 years; advance public enterprise reform; reduce business licenses; lower barriers to foreign investment; accelerate reforms to free resources for social protection and address inequality and labor market policies.

*Source: _cr11110*

### INTRODUCTION _____________________________________________________________________ 3

### INTRODUCTION

### Context and Key Findings
- The recession that began in 2008/09 continued in 2010 with declines in tourism, remittances, and exports.
- Financial conditions remained tight as banks raised lending standards following a large rise in nonperforming loans.
- Activity has bottomed out recently as growth has been supported by a recovery in tourism and expansionary fiscal policy financed by donor aid.
- Growth projections:
  - Growth is likely to rise to 1¼ percent in FY2010/11 (year ending June).
  - Growth is likely to rise to 1¾ percent in FY2011/12 and the medium term.
- Constraints to faster growth: limited private sector development, geographical isolation, and high public debt.
- Policy focus recommended: restore room for countercyclical macroeconomic policies, reduce risks to external and fiscal sustainability, and lay foundations for higher potential growth.

### Recent Developments
- Activity:
  - GDP continued to contract in FY2009/10 (year ending June) as financial conditions remained tight and tourism and remittances declined due to weak global demand from the United States, Australia, and New Zealand.
- Inflation:
  - CPI inflation averaged 2 percent in 2009/10.
  - CPI inflation rose to 6½ percent y/y in February 2011, reflecting rising global food and oil prices, higher excises on tobacco and alcohol, and a modest depreciation of the pa’anga against the New Zealand dollar.
- External position:
  - The current account deficit narrowed to 7.8 percent of GDP in FY2009/10 as weak activity lowered imports and stepped up grants increased transfers.
  - Reserves rose to near seven months of imports as of end-February 2011.
- Politics:
  - In November 2010, Tonga held its first parliamentary elections under which a majority of seats were popularly elected, leading to a major cabinet reshuffle and appointment of a new prime minister and government.
  - The new government’s main policy priorities: pursue structural reforms to promote private sector activity and restore fiscal sustainability.

### Key Macroeconomic Indicators (as presented)
- Growth (percent): 2007/08 = 2.0; 2008/09 = -0.1; 2009/10 = -0.5
- Inflation (percent): 2007/08 = 9.8; 2008/09 = 5.0; 2009/10 = 2.0
- Current account (percent of GDP): 2007/08 = -8.9; 2008/09 = -14.7; 2009/10 = -7.8
- Gross reserves (US$ millions): 2007/08 = 48.2; 2008/09 = 67.7; 2009/10 = 88.7
- Gross reserves (in months of imports): 2007/08 = 3.2; 2008/09 = 4.7; 2009/10 = 7.1
- Real effective exchange rate (+ = appreciation): 2007/08 = 2.1; 2008/09 = 6.3; 2009/10 = 0.0

### Staff Views — Outlook
- Short-term:
  - Growth projected to recover to 1¼ percent in FY2010/11, supported by stronger tourism activity and construction financed by donor aid and previously contracted loans.
  - Inflation likely to rise to around 6 percent, reflecting higher global fuel and other commodity prices, particularly food.
- Medium-term:
  - Growth expected to remain at around 1¾ percent—consistent with the average of the past 15 years but about ¾ percentage points above the average of the past 10 years.
  - Medium-term outlook assumes implementation of government plans including stepped up capital spending, structural reform, improved fiscal management to support fiscal consolidation, and continued high emigration.
  - Growth expected to be mainly driven by tourism and agriculture.

### Staff Views — Risks
- Upside/downside factors:
  - A protracted rise in world commodity and food prices would adversely affect inflation, growth, and the current account deficit.
  - A faltering global economy would reduce remittances, tourism, and exports, weakening activity and threatening reserves.
- Fiscal vulnerability:
  - Tonga’s high public debt leaves the country highly vulnerable to shocks and poses a risk to economic prospects.
- Limited policy tools:
  - Limited effectiveness of monetary policy given banks’ cautious lending reduces room for countercyclical macroeconomic policies if downside risks materialize.
- Policy implications:
  - Mitigating risks requires further progress on structural reforms to raise growth potential, continued grants provision from donors, and steady fiscal consolidation.

### Authorities’ Views (on Outlook and Risks)
- Growth forecast:
  - Authorities (ministry of finance) considered staff GDP forecast somewhat optimistic and expected growth to remain negative in FY2010/11 at around -0.5 percent, noting much construction activity had little domestic impact because materials are imported and local hiring was limited.
  - Ministry of finance indicated it was reviewing its forecast based on revised historical national accounts showing higher contribution from current construction projects and including activity in mining and quarrying and treatment of Chinese workers in reconstruction financed by China EXIM Bank.
- Inflation:
  - National Reserve Bank expected CPI inflation to reach 5¾ percent in FY2010/11 and ease to 4¼ percent in FY2011/12.
- Risks:
  - Authorities agreed with staff that higher energy and food prices pose risks to inflation, including through second-round effects.

### Policy Discussions — Restoring Room for Countercyclical Macroeconomic Policies
- Macroeconomic stance in FY2010/11:
  - Policies remained loose to counter global financial crisis effects, banks’ credit crunch, and adverse weather-related shocks.
- Fiscal policy background:
  - In FY2010/11, stepped-up capital expenditure mainly financed by previously contracted loans helped offset weak private demand.
  - Generous grant inflows contributed to narrowing the fiscal deficit to an estimated 4¼ percent of GDP (from about 5¾ percent of GDP in FY2009/10).
  - Tonga is at a “high risk of debt distress” according to the World Bank-IMF debt sustainability analysis.
  - Staff projects the overall deficit (including grants) to widen to around 5¼ percent of GDP in FY2011/12 as capital projects are rolled out and grants return to lower levels.
  - The primary deficit is expected to reach 4¼ percent of GDP in FY2011/12.

- Staff recommendations on fiscal consolidation and transparency:
  - Prioritize mitigating risks to fiscal sustainability and create room to respond to future shocks by:
    - Avoiding new borrowing.
    - Reducing current spending.
    - Carefully prioritizing spending.
    - Improving tax administration.
    - Improving transparency.
  - Maintain the wage bill at its 2010/11 level to help limit the deficit to 5¼ percent of GDP; rapid rise in the wage bill since the 2006/07 redundancy program is hampering core public services and crowding out productive programs and social services.
  - Reform the salary/performance system:
    - Current performance-based system has only two ratings (“performing” vs. “nonperforming”), introduces an automatic annual increase of around 4 percent in the wage bill, and does not reflect actual staff performance distribution.
    - Staff endorses reforms to better align salary structure with performance and service efficiency.
  - Prioritize expenditures:
    - Align spending plans with the National Strategy Planning Framework (NSPF) and ensure line ministries adhere to budget plans and targets.
  - Improve revenue administration and collection:
    - Ensure proper classification and valuation of goods at customs.
    - Increase compliance through use of the unique tax identification number assigned to corporate taxpayers.
    - Increase training of customs officers.
    - Complete automation of customs processing to strengthen auditing and tax collection in the context of self-assessment.
    - Expand tax base by streamlining tax exemptions; consider replacing exemptions with transfers explicitly brought into the budget for transparency and fiscal control.
  - Enhance fiscal transparency:
    - Increase transparency in fiscal accounts to help secure donor support and alleviate adjustment burdens on government accounts.
    - Apply steps taken under the Tonga Energy Road Map to other fiscal activities.
    - Include greater detail on composition and distribution of expenditures and revenue across line ministries in budget papers for the upcoming fiscal year.

### Authorities’ Views on Policy Measures
- Authorities view the task as challenging but achievable and broadly agreed with staff recommendations.
- Commitments and views:
  - Government committed to maintaining the wage bill in FY2011/12 at its FY2010/11 level but acknowledged difficulties.
  - Progress in setting up a medium-term budgeting framework was noted, improving collaboration between the ministry of finance, line ministries, and the public service commission and facilitating expenditure prioritization in line with NSPF objectives.
  - Plan to replace the current 2-tier performance system during FY2011/12 with a 5-tiered system to better differentiate performance and improve efficiency.
  - Authorities see room for improvement in revenue administration and significant gains from better training of customs officers and full utilization of the new electronic system.
  - Authorities emphasized improved transparency in government operations and committed to improving dialogue with development partners.

*Source: TONGA 2011 ARTICLE IV REPORT — INTRODUCTION section*

### 18.      Monetary   policy   is   geared   toward

### _cr11110 - 18.      Monetary   policy   is   geared   toward

### Monetary policy stance and recent actions
- Monetary policy is geared toward jumpstarting bank lending.
- In FY2010/11, the National Reserve Bank of Tonga (NRBT):
  - remunerated banks’ exchange settlement account balances over TOP 1 million;
  - maintained adequate liquidity in the system.
- These measures contributed to slowing the pace of decline of credit to the private sector.
- Credit by commercial banks remains constrained by:
  - banks’ continued tight lending standards as they restore the health of their balance sheets;
  - uncertainty about the economic outlook.

### Staff views — policy guidance and contingencies
- Recommendation:
  - NRBT should maintain its current policy stance.
- Rationale:
  - With appropriate liquidity in the banking system, there is little need for further policy loosening.
- Pre-emptive tightening triggers and instruments:
  - If bank lending normalizes faster than anticipated, the existing liquidity overhang could:
    - exacerbate inflation;
    - exert downward pressure on international reserves.
  - Then monetary policy should be pre-emptively tightened through a combination of:
    - hikes in interest rates on the NRBT repo facility;
    - issuance of central bank paper;
    - reserve requirements.
- Alternative scenario (global commodity shock):
  - Higher global commodity prices could cause inflation to rise above, and reserves to fall below, levels expected in the baseline outlook.
  - If core inflation remains stable, there would be no need for tightening of monetary policy; instead:
    - further advance fiscal consolidation while providing targeted support to the poor.
- Monitoring:
  - A firm recovery in Tonga’s main trading partners has been a leading indicator of pressure on reserves and domestic inflation; developments in those economies and in global commodity markets need careful monitoring.

### Exchange rate assessment and policy flexibility
- Staff assessment:
  - The exchange rate is broadly in line with fundamentals (Box 1).
- Contingency:
  - Should downward pressures on reserves emerge, NRBT will need to use the flexibility afforded by the pegged exchange rate within horizontal bands arrangement to gradually depreciate the pa’anga against the basket to safeguard external stability.
  - Such depreciation would need to be accompanied by further fiscal restraint because of effects on public debt.
- Basket weights:
  - The pegged exchange rate within horizontal bands system has served the country well.
  - Current weights in the currency basket are considered broadly appropriate but should be reviewed occasionally and updated to reflect changes in trade patterns and the emergence of renminbi debt.

### Authorities’ views and operational approach
- Readiness to act:
  - Authorities intend to act pre-emptively to control inflation risks and maintain reserves levels above the NRBT comfort zone of 3–4 months of imports.
- Instruments:
  - In tightening monetary policy, NRBT will use all instruments at its disposal, with greater use of direct instruments such as reserve requirements, given the limited impact indirect instruments have on credit growth (Box 2).
- Exchange rate regime:
  - NRBT agreed that downward pressure on reserves would warrant pre-emptive use of the flexibility of its current exchange rate regime to ensure external stability.
- Ongoing review:
  - Authorities are reviewing PFTAC technical assistance conclusions on the composition of the exchange rate basket and will introduce changes gradually to avoid undue volatility and disruptions.

### Exchange rate assessment — key quantitative findings (Box 1)
- Analytical methods used: macroeconomic balance and the purchasing power parity, based on a cross section of 184 economies.
- Macroeconomic balance approach:
  - Indicates the real exchange rate is around 10 percent above its medium-term value, with a confidence band of around −14 percent to around 40 percent.
  - Underlying point estimate: estimated current account norm of around −4½ percent of GDP, which could be as low as −13½ percent of GDP given remittances and foreign aid.
- Purchasing power parity approach:
  - Suggests the real exchange rate is currently undervalued by around 5 percent.
- Other indicators:
  - The current account deficit has been relatively stable in recent years, remaining around 8‒9 percent in previous years.
  - Foreign reserves have been stable or rising in recent years; NRBT was a net purchaser of foreign exchange in 2009/10, with net purchases around 10 percent of its total gross flows.
  - Domestic inflation has picked up in recent months owing to one-off and global factors, but there are no signs of sustained price pressure or changes in the real effective exchange rate.
  - The number of tourists has increased markedly in recent years; Tonga has gained market share as a tourist destination.
  - New export products, such as sea cucumber, have provided significant export earnings and helped offset declines from squash exports.

### Interest rate transmission — effectiveness and structural constraints (Box 2)
- Empirical findings (monthly data 2000–2010):
  - A one percentage point increase in the repo rate:
    - raises the average bank lending rate by about ¼ percentage points;
    - reduces private sector credit growth by about 1½ percentage points.
  - These effects are smaller than in several other Pacific islands (e.g., PNG and Fiji).
- Structural factors limiting pass-through:
  - Tonga’s domestic money market is shallow (measured by the ratio of broad money to GDP).
  - Collateralized interbank lending is not widely available.
  - Secondary markets for government and central bank paper are non-existent.
  - No market for commercial paper, corporate bonds, equity, and foreign exchange products.
- Policy implication:
  - Developing a framework for secured lending could help increase pass-through of interest rates to bank lending rates and bank credit.

### Banking system status, constraints, and reform priorities
- Background and current status:
  - Banks are making progress in repairing balance sheets.
  - Banks are well capitalized.
  - Profitability remains well below past years owing to high provisioning, but has improved somewhat in recent months.
  - NPLs are declining.
  - Notional demand for credit is estimated by staff to be over 7 percent the supply of credit.
- Staff recommendations to normalize credit growth:
  - Further improvements in banks’ balance sheets and the institutional framework for lending are needed.
  - Key reforms and measures:
    - Enactment of the Personal Property Security Act to provide lenders with information on borrowers’ collateralized assets.
    - Progress on instituting a centralized credit bureau.
    - Modifying the legal framework to ensure timely registration and recovery of collateral, including a secured bankruptcy protection law.
    - Effective supervision of banks to ensure financial stability (NRBT plans to adopt a standardized examination report format).
    - Continued PFTAC technical assistance and longer-term donor-financed assistance for supervisory capacity.
  - These measures have the potential to reduce borrowing costs, improve access to finance, and lay foundations for stronger economic growth.

### Bank lending rates, profitability, and policy considerations (Box 3)
- Lending rates and comparators:
  - Lending rates in Tonga have recently averaged around 12 percent.
  - This is lower than the Solomon Islands (15 percent), similar to Samoa, and broadly in line with the Pacific island average (~12 percent).
- Profitability and income composition:
  - Net interest income has averaged around 6 percent of average assets.
  - Non-interest income has averaged over 5 percent of average assets, mostly from foreign exchange activities (reflecting a large volume of international trade and remittance transactions).
  - Between 2000 and 2007, Tongan banks’ average return on assets was around 6 percent, driven substantially by foreign exchange earnings (around 60 percent of returns).
  - Recent large lending losses led to significant overall bank losses in Tonga during 2008–2009.
- Selected banks’ key financial ratios (reported)
  - Pre-tax Net Profits (percent of assets): 2008: 4.9; 2009: -6.1; 2010: 0.6
  - Operating Income (percent of assets): 2008: 11.9; 2009: 11.1; 2010: 3.1
  - Net Interest Income (percent of assets): 2008: 6.3; 2009: 6.3; 2010: 6.1
  - Non-Interest Income (percent of assets): 2008: 5.6; 2009: 4.9; 2010: 3.4
  - Loan-loss Reserve to Gross Loans 1/: 2008: 6.4; 2009: 9.6; 2010: 14.1
  - Risk Weighted CAR: 2008: 22.4; 2009: 26.5; 2010: 22.9
  - 1/ As reported in source.
- Additional measures to reduce borrowing costs:
  - Enhance legal framework for secured lending.
  - Promote a more stable macroeconomic environment.
  - Increase competition within an appropriate prudential and regulatory framework.
  - Improve consumer protection and financial literacy.
- Authorities’ views:
  - Authorities agreed NPLs had peaked and lending should improve with a recovery in activity.
  - They agreed on risks from regulating interest rates.
  - Ongoing discussions to create a credit bureau by the end of this financial year.
  - Measures taken to ensure banks comply with prudential requirements and disclosure of effective interest rates charged to customers.

*Source: 2011 ARTICLE IV REPORT TONGA (excerpts).*

### 26.      Tonga’s   indebtedness   has   increased

### 26.      Tonga’s   indebtedness   has   increased

### Indebtedness and external loans
- Tonga’s indebtedness increased markedly over the past two years, reflecting two loans from EXIM bank of China with a face value totaling around 30 percent of GDP.
- Loan details:
  - Signed: November 2007 (for reconstruction of the central business district) and February 2010 (for roads).
  - Interest rate: 2 percent.
  - Grace period: 5-year.
  - Maturity: 20-year.

### Staff views on fiscal policy and MTBF
- Medium-term fiscal objective:
  - A primary surplus of 1 percent of GDP would be needed to put the fiscal position on a more sustainable path.
  - This would bring down public debt to around 30 percent of GDP by the early 2020s.
- Recommended measures to achieve the fiscal path:
  - Continued expenditure restraint.
  - Improved expenditure prioritization.
  - Improved revenue administration.
  - Integrate the fiscal path, the annual budget, and the medium-term development objectives laid out in the NSPF within a single institutional medium-term budgeting framework (MTBF).
  - Implementation of a comprehensive MTBF should start in the FY2011/12 budget given Tonga’s vulnerability to shocks.
- Implementation requirements for a successful MTBF:
  - Better reporting by line ministries.
  - Improved capacity, fiscal control, and communication among agencies.
  - Allocate funds at more aggregated levels consistent with NSPF priorities.
  - Pilot the new budgeting program initially in better performing ministries to avoid loss of control.

### Debt management recommendations
- Need for a comprehensive debt management strategy to limit large credit and currency risks in the government balance sheet.
- IMF (Staff) stands ready to assist and expects to provide technical assistance organized by PFTAC during FY2010/11.
- Interim prudent actions:
  - Proceed cautiously with selection of eligible private sector construction projects to be on-lent with China EXIM loan proceeds to limit government credit risk and the risk of excess capacity.
  - Limiting credit risk and excess capacity will free resources for NSPF development priorities.

### Authorities’ views on fiscal management
- Authorities recognize the need to reduce debt and the benefits of implementing the MTBF.
- Progress reported:
  - Setting up MTBF with some indications expected in upcoming budget.
  - Recent revision to the chart of accounts.
  - Shift in monitoring of budget execution to a more aggregated level.
  - Consolidation of the government’s numerous accounts to improve cash management.

### Structural reforms to raise medium-term growth prospects
- Background and baseline:
  - Staff expects medium-term growth to remain at around 1¾ percent.
  - Medium-term outlook assumes stepped-up capital spending, structural reform, improved fiscal management, and unchanged demographic trends including high emigration.
- Staff recommendations to promote private sector activity:
  - Extend land leases to 99 years for all allotments and activities.
  - Reduce the number of business licenses.
  - Lower barriers to foreign investment.
  - Improve efficiency in delivery and generation of utilities (noting adoption of the Tonga Energy Road Map).
- Public sector enterprise reform:
  - Level the playing field between public and private enterprises.
  - Move ahead with corporatization and privatization plans.
  - Amend regulatory structure to promote competition in goods and service markets.
  - Recent government measures: publish audited accounts of all public enterprises, change board composition, and increase board accountability.
  - Ensure public enterprises are run on a commercial basis to increase efficiency and reduce budget risks.
- Social protection and distributional concerns:
  - Accelerating reforms and fiscal consolidation will free resources for social protection programs.
  - Recommended social protection measures include establishing a contributory pension scheme and increasing coverage of health insurance and workers’ compensation.
  - Preliminary results of the 2009 household income and expenditure survey show increasing hardship during the past decade; declines in remittances and rising food prices have increased hardship, particularly in outer islands and outside Nuku'alofa.

### Staff appraisal: near-term outlook, risks, and policy priorities
- Near-term growth and inflation forecasts:
  - Growth is estimated to recover to 1¼ percent in FY2010/11 and 1¾ percent in FY2011/12.
  - Inflation is likely to average around 6 percent in FY2010/11 and in FY2011/12.
- Downside risks to the outlook:
  - Protracted rise in world commodity and food prices would increase inflation, weaken growth, and widen the current account deficit.
  - A faltering global growth outlook could reduce remittances, tourism, and exports, weakening activity and reserves.
  - High public debt limits fiscal space for responding to shocks and for future social and developmental spending.
- Near-term fiscal policy advice:
  - Fiscal consolidation is needed to mitigate fiscal sustainability risks and expand fiscal space.
  - Specific near-term actions: avoid new borrowing, reduce current spending, carefully prioritize expenditure, strengthen tax administration, and improve fiscal transparency.
- Debt management and technical assistance:
  - A comprehensive debt management strategy is needed; progress expected during FY2010/11 with PFTAC technical assistance.
- Monetary and financial sector policy:
  - Monetary policy should maintain its current stance in the months ahead.
  - If monetary conditions normalize faster than anticipated, pre-emptive tightening may be required via hikes in NRBT repo facility interest rates, issuance of central bank paper, and reserve requirements.
  - To normalize credit growth further, needed reforms include:
    - Enactment of the Personal Property Security Act.
    - Establish a centralized credit bureau.
    - Modify legal framework for timely registration and recovery of collateral, including a secured bankruptcy protection law.
    - Increase competition within an appropriate prudential and regulatory framework.
    - Improve consumer protection and financial literacy.
  - Resist pressure to administer interest rates to avoid credit rationing and hampering banks’ ability to price risk.
  - NRBT efforts to step up regulation and supervision and to adopt a standardized examination report format are welcome; continued technical assistance from PFTAC and longer-term donor-financed assistance will be required.
- Exchange rate and external stability:
  - The exchange rate is broadly in line with fundamentals.
  - If downward pressures on reserves emerge, NRBT should use flexibility in the current exchange rate arrangement to gradually depreciate the pa’anga against the basket to safeguard external stability.
  - Any depreciation would need to be accompanied by further fiscal restraint given effects on public debt.
  - Update the weights in the currency basket to be consistent with changes in trade patterns and the emergence of renminbi debt.
- Reiterated structural reform priorities:
  - Extend land leases to 99 years for all allotments and activities.
  - Advance public enterprise reform to level the playing field.
  - Reduce the number of business licenses and lower barriers to foreign investment.
  - Speeding up reforms will free resources for social protection and allow focus on inequality and labor market policies.

*Source: _cr11110 - 26.      Tonga’s   indebtedness   has   increased*

### 45.      It  is  recommended  that  the  next  Article  IV

### _cr11110 - 45. It is recommended that the next Article IV

### Recommendation
- It is recommended that the next Article IV consultation take place on a standard 12-month cycle.

### Key macroeconomic indicators (selected)
- Nominal GDP (2009/10): US$ 353.2 million
- Population (2009): 103,294
- GDP per capita (2009/10): US$ 3,419
- Quota: SDR 6.9 million
- Real GDP (annual percent change): 2006/07 -1.0; 2007/08 2.7; 2008/09 -0.1; 2009/10 -0.5; 2010/11 1.2; 2011/12 1.7
- Consumer prices (period average): 2006/07 5.1; 2007/08 9.8; 2008/09 5.0; 2009/10 2.0; 2010/11 6.0; 2011/12 5.8
- Consumer prices (end of period): 2006/07 5.6; 2007/08 12.2; 2008/09 1.2; 2009/10 2.6; 2010/11 10.4; 2011/12 1.7

### Central government finance (selected levels and percent of GDP)
- Nominal levels (in millions of pa’anga; fiscal year begins July): Nominal GDP 2006/07 611.0; 2007/08 661.4; 2008/09 663.2; 2009/10 681.4; 2010/11 752.9; 2011/12 810.2
- Total revenue and grants (percent of GDP): 2006/07 28.0; 2007/08 25.9; 2008/09 29.8; 2009/10 26.3; 2010/11 28.8; 2011/12 21.8
  - Total revenue (percent of GDP): 24.3; 24.6; 22.9; 21.0; 17.6; 17.6 (2006/07–2011/12)
  - Grants (percent of GDP): 3.7; 1.3; 6.9; 5.2; 11.2; 4.2
- Total expenditure and net lending (percent of GDP): 26.9; 24.3; 29.6; 31.9; 30.0; 27.0
  - Current expenditure (percent of GDP): 25.9; 23.9; 25.3; 26.2; 20.0; 19.8
  - Capital expenditure (percent of GDP): 0.9; 0.4; 3.0; 3.4; 10.5; 5.2
- Overall balance (percent of GDP): 1.0; 1.6; 0.1; -5.7; -4.2; -5.2
- Overall balance (excl. China's EXIM bank loans, percent of GDP): (not shown for 2006/07–2008/09) ...; 2009/10 0.4; 2010/11 -3.3; 2011/12 0.8; 2012/13 -2.3 (where presented in tables)

### Financing and fiscal flows (selected)
- External financing (net, percent of GDP): 0.1; 0.2; -0.1; 4.0; 9.2; 5.9
- Domestic financing (net, percent of GDP): -1.2; -1.7; 4.7; 1.6; -5.0; -0.7
- Disbursements (external, percent of GDP): 0.9; 1.3; 6.3; 7.2; 7.7; 4.7
- Repayments (external, percent of GDP): 0.8; 1.1; 0.7; 1.3; 0.8; 0.8

### Money, credit, and financial soundness (selected)
- Total liquidity (annual percent change): 13.3; 6.7; -1.1; 5.8; 5.2; -0.9
- Broad money (M2) (annual percent change): 11.9; 8.2; -1.8; 5.1; 5.7; -1.1
- Domestic credit (annual percent change): 12.2; 13.9; -5.2; -11.5; -18.5; 9.0
  - Private sector credit (annual percent change): 9.5; 17.1; -3.7; -15.6; -4.5; 9.4
- Depository corporations survey (end-period, in millions of pa’anga): Total liquidity 2006/07 286.9; 2007/08 306.0; 2008/09 302.6; 2009/10 320.2; 2010/11 336.9; 2011/12 334.0
  - Broad money (M2) levels (millions of pa’anga): 265.5; 287.2; 282.0; 296.4; 313.4; 309.9
- Financial soundness indicators (percent):
  - Total loans/GDP: 2006 40.1; 2007 46.9; 2008 47.9; 2009 50.5; 2010 54.7; 52.6; 44.9
  - Capital adequacy ratio (end-calendar year): 17.6; 16.3; 16.8; 20.7; 22.4; 26.5; 22.9
  - Non-performing loans (percent of total loans): 6.3; 5.3; 4.7; 5.1; 10.0; 23.7; 17.9

### External sector and balance of payments
- Trade balance (millions of U.S. dollars): 2006/07 -95.3; 2007/08 -125.7; 2008/09 -124.6; 2009/10 -102.3; 2010/11 -139.0; 2011/12 -132.2
  - Exports, f.o.b. (millions of U.S. dollars): 13.3; 12.4; 5.5; 5.9; 7.1; 7.8
  - Imports, f.o.b. (millions of U.S. dollars): -108.6; -138.1; -130.1; -108.2; -146.1; -140.0
- Services (net, millions of U.S. dollars): -17.9; -3.3; -2.6; -4.1; -4.3; -5.6
- Investment income (net, millions of U.S. dollars): 3.5; 3.4; 4.6; 2.7; 2.7; 2.6
- Current transfers (net, millions of U.S. dollars): 84.2; 94.7; 75.8; 76.2; 99.7; 90.4
  - Private transfer receipts (millions of U.S. dollars): 93.3; 106.7; 84.0; 81.7; 79.2; 87.1
- Current account balance (millions of U.S. dollars): -25.5; -30.9; -46.9; -27.4; -40.9; -44.8
  - Current account balance (percent of GDP): -8.3; -8.9; -14.7; -7.8; -11.0; -11.7
- Capital and financial account balance (millions of U.S. dollars): 26.9; 36.3; 55.6; 29.9; 56.2; 32.0
  - Official capital flows (net, millions of U.S. dollars): 9.8; 11.9; 17.7; 14.7; 45.6; 26.2
    - Of which: China’s EXIM bank loans noted in projections and tables (explicit loan amounts shown in detailed tables)
  - Private capital flows (net, millions of U.S. dollars): 17.1; 24.4; 37.9; 15.2; 10.5; 5.8
- Overall balance (change in gross official foreign reserves, millions of U.S. dollars): 4.2; -1.4; 22.6; 17.7; 15.3; -12.9
- Gross official foreign reserves (millions of U.S. dollars, end period): 47.1; 48.2; 67.7; 88.7; 104.0; 90.1
  - In months of goods and services imports: 3.9; 3.2; 4.7; 7.1; 6.5; 5.8
- External debt (percent of GDP): 26.8; 24.9; 32.5; 36.6; 43.3; 44.3

### Medium-term scenario and projections (2008/09–2015/16, selected)
- Real GDP (annual percent change) projections: 2008/09 -0.1; 2009/10 -0.5; 2010/11 1.2; 2011/12 1.7; 2012/13 1.8; 2013/14 1.8; 2014/15 1.8; 2015/16 1.8
- Consumer prices (period average) projections: 2008/09 5.0; 2009/10 2.0; 2010/11 6.0; 2011/12 5.8; 2012/13 3.9; 2013/14 6.0; 2014/15 6.0; 2015/16 6.0
- Central government (percent of GDP, projections):
  - Total revenue and grants: 2008/09 29.8; 2009/10 26.3; 2010/11 28.8; 2011/12 21.8; 2012/13 21.0; 2013/14 20.2; 2014/15 21.9; 2015/16 21.7
  - Total expenditure and net lending: 29.6; 31.9; 30.0; 27.0; 22.5; 21.7; 23.1; 22.3
  - Overall balance (percent of GDP): 0.1; -5.7; -4.2; -5.2; -1.5; -1.5; -1.3; -0.6
- Balance of payments projections (millions of U.S. dollars):
  - Exports, f.o.b.: 5.5; 5.9; 7.1; 7.8; 8.5; 9.4; 10.5; 11.9
  - Imports, f.o.b.: -130.1; -108.2; -146.1; -140.0; -132.7; -138.4; -144.1; -145.7
  - Current account balance (millions of U.S. dollars): -46.9; -27.4; -40.9; -44.8; -42.5; -40.5; -37.0; -29.5
  - Current account balance (percent of GDP): -14.7; -7.8; -11.0; -11.7; -10.7; -9.9; -8.7; -6.8
- Gross international reserves (end of period, millions of U.S. dollars): 67.7; 88.7; 104.0; 90.1; 77.8; 63.8; 53.4; 49.5
  - In months of imports (goods and services): 4.7; 7.1; 6.5; 5.8; 5.2; 4.1; 3.3; 3.0
- Public sector external debt (percent of GDP, projections): 32.5; 36.6; 43.3; 44.3; 45.3; 44.4; 41.9; 39.7

### Fund relations, technical assistance, and institutional issues
- Membership: Joined September 13, 1985; Article VIII.
- Quota and SDR holdings (as of March 31, 2011): Quota SDR 6.90 million; Total holdings of currency 5.19 (SDR million); Reserve position in the Fund 1.71 (SDR million)
- Outstanding Purchases and Loans: None. Financial Arrangements: None.
- Last Article IV Consultation: Staff discussions March 2010; Executive Board discussed staff report (IMF Country Report No. 10/112) on May 6, 2010.
- Previous Fund recommendations emphasized: fiscal consolidation; establishing a medium-term budget framework; supportive monetary policy; prioritizing current spending; improving revenue enforcement (especially customs); setting up a debt management strategy.
- Technical assistance: 
  - LEG provided assistance on AML/CFT issues for Pacific island countries including Tonga.
  - PFTAC provided assistance on budgetary management; tax administration; banking legislation and supervision; and balance of payments and national accounts statistics.
- Resident Representative: None.
- Exchange Rate Arrangement: Pa’anga value determined by weighted basket of the U.S., Australian, and New Zealand dollars with U.S. dollar as intervention currency; Japanese yen added to basket in July 2000; monthly maximum adjustment limit raised to 5 percent (from 2 percent in March 1998). Tonga has accepted obligations under Article VIII, Sections 2(a), 3 and 4.

*Source: _cr11110 - 45. It is recommended that the next Article IV consultation take place on a standard 12-month cycle (IMF staff report content, April 20, 2011; canonical URL: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11110.pdf).*

### ANNEX II. TONGA: RELATIONS WITH THE PACIFIC

### ANNEX II. TONGA: RELATIONS WITH THE PACIFIC

### Financial Technical Assistance Centre (PFTAC) — Overview
- Assistance to Tonga since 2006 included 27 advisory missions across all technical assistance (TA) sectors.
- During 2006–March 2010, Tonga has sent 63 officials to the Centre’s regional seminars, workshops and training courses, and six attachments were organized.
- (As of March 2011.)

### Public Financial Management (PFM)
- Since 2003, PFTAC's missions focused on complementing assistance provided by other TA agencies through:
  - Introduction of a midyear economic review and fiscal update.
  - Reconciliation of monetary and fiscal data.
  - Changes in budget documentation.
- For the 2003/04 and 2004/05 budgets, assistance was provided in presenting final aggregate budget figures on a GFSM 2001 basis.
- In 2004, PFTAC arranged for a Tongan official to participate on a delegation of Pacific Island officials to the Australian Commonwealth Ministry of Finance.
- During 2005:
  - The PFTAC PFM Advisor participated in a joint donor/government Feasibility Study related to a proposed long-term Financial and Economic Management Program (FEMP).
  - Worked with the Ministry of Finance on assessing the financial implications of the proposed civil service wage increase.
- Peripatetic advisor assistance provided in 2006 and 2007 to assist in revenue estimation work.
- PFM Advisor delivered lectures on PFM to all CEOs in late April 2007.
- Joint PFTAC mission on revenue estimation visited Tonga in mid-March 2008.
- PFTAC mission on decentralization visited Tonga in May 2008 and made several recommendations.
- Scoping mission on Medium Term Budgeting (MTB) took place in late March 2010; ADB initiated an MTB project in Tonga thereafter.
- PFTAC PFM Advisor visited Tonga twice to work with the ADB team on MTB, delivered lectures on PFM to line ministries in May 2010, and worked with the Australian Department of Finance to develop a training program for Tongan officials in Australia.

### Tax Administration and Policy
- Tonga has improved revenue policy and administration; key outcomes include:
  - Passing of new Income tax and Customs Acts, both self assessed.
  - A post implementation review of the value-added tax (VAT) and substantial change to tax administration, principally with the introduction of self assessment.
  - This progress complemented the introduction of the consumption tax in 2005.
- IMF/PFTAC Tax Policy and Administration mission in March 2008:
  - Objective: review tax policy issues in small Pacific island countries, consider fiscal challenges posed by prospective trade liberalization, and assess VAT experience.
  - Mission visited Fiji, Kiribati, Samoa, Solomon Islands, and Tonga.
  - In Tonga, mission found the consumption tax catalytic to improved revenues where there was political will to reform and dissatisfaction with performance of some existing taxes.
- Revenue losses from trade liberalization through PICTA and PACER estimated as high as 27 percent of total revenue by external research.
  - This presents an immediate issue for Tonga to replace lost revenues.

### Banking Sector Regulation and Supervision
- During 2008 and 2009, MCM peripatetic advisors provided assistance to:
  - Upgrade prudential statements (regulations) to implement the FIA.
  - Strengthen analysis of prudential returns.
  - Provide guidance on dealing with problem banks.
  - Upgrade supervisory program for foreign exchange dealers.
  - Provide staff training on relevant issues.
- In 2010, two PFTAC missions:
  - January 2010: assisted Financial Institutions Supervision Department in reviewing bank profitability and interest rates; training in off-site analysis, identification of key ratios and numbers, and use of levels and trends in monitoring and assessing CAELS components.
  - June 2010: focused on harmonizing prudential returns with reporting requirements of other Pacific Islands countries and reviewing adequacy of off-site monitoring reports.
- PFTAC arranged two visits by a peripatetic advisor to enhance FID capacity for on-site examinations of banking institutions:
  - First visit scheduled to commence in March 2011; second visit in May 2011 when additional TA needs will be determined.

### Economic and Financial Statistics
- In 2002, two reviews were undertaken in accordance with the GDDS and the Data Quality Assessment Framework: one on BOP statistics and the other on the wider statistical system.
- Subsequent 2004 missions:
  - Finalized GDDS metadata.
  - Provided training in BOP concepts and practices.
  - Developed a new BOP business survey.
  - Reviewed national accounts data.
- 2005: partial update of the 2002 statistical system review focused on outputs of the Statistics Division of the Ministry of Finance.
- Further assistance provided to peer review GDP and BOP estimates prior to publication.
- GDDS metadata approved and published in 2006 on the Data Dissemination Bulletin Board.
- TA missions on BOP statistics undertaken in 2007, 2008, 2009 and 2010, resulting in:
  - Revised BOP estimates based on BPM5 standards.
  - Improved methodology and use of source data.
  - Mapping of these statistics to BPM6 classification.
- National accounts statistics missions in 2008, 2009 and 2010:
  - Implemented significant improvements in NAS methodology and use of source data.
  - Resulted in substantial improvements in estimates and an expanded range of NAS statistics.
- TA expert missions to develop producer price indexes undertaken in 2008 and 2009.
- Mission planned for February 2011 to brief new resident economic statistics advisor on PFTAC TA and assist in planning ongoing developments.

### Macroeconomic Management
- PFTAC provided a short-term expert to assist the National Reserve Bank of Tonga review the weights in its currency basket in April 2010.

*Source: ANNEX II. TONGA: RELATIONS WITH THE PACIFIC (As of March 2011).*

### ANNEX V. TONGA: STATISTICAL ISSUES

### ANNEX V. TONGA: STATISTICAL ISSUES

### Overall assessment and technical assistance
- Economic statistics are "broadly adequate for surveillance", but "data deficiencies continue to complicate the monitoring of economic conditions and policy formulation."
- The Statistics Department (SD) and the Ministry of Finance (MOF) have received regular technical assistance in national accounts, government finance, and balance of payments (BOP) statistics from STA and PFTAC; nevertheless, "data provision to the Fund continues with long delays."
- Main data sources: the Quarterly Bulletin of the National Reserve Bank of Tonga (NRBT), and annual and semi-annual budget reports from the MOF.
- Tonga has been participating in the GDDS since May 30, 2006; metadata are posted on the Fund’s DSBB.
- Institutional change: the SD "will also become part of the MOF over the next year," expected to improve communication and coordination between the two agencies.

### Real sector statistics
- National accounts:
  - A new series of national accounts was released in June 2009 following PFTAC assistance in 2008 and 2009.
  - The new series retains a 2000/01 base year and has been revised to improve coverage and estimation techniques.
  - Source data remain weak and need improvement to allow a long overdue rebase of the national accounts.
  - The SD obtained a statistical advisor from New Zealand to implement PFTAC recommendations and expects "improvments in the classifiation and valuation of inputs into the national accounts data."
- Consumer Price Index:
  - The CPI is based on a basket from the 2000/01 Household Income and Expenditure Survey.
  - Technical assistance was provided in 2008 on development of an import price index.
- Labor market data:
  - Employment statistics "have not been compiled since 2003."
  - Average earnings statistics are not available.

### Government finance statistics
- Since the FY 2002/03 Budget Statement, fiscal data presentation follows the 2001 Government Finance Statistics Manual methodology.
- Remaining issues:
  - Improvements are needed to ensure accurate and reliable fiscal data.
  - Proper classification of transactions is needed to permit reconciliation with monetary financing data.
  - Lags in updating the accounting system should be shortened.
  - Published data are often subject to significant revisions.
  - "No data are reported for publication in the IFS or GFS Yearbook."

### External sector statistics
- Official BOP statistics:
  - Compiled annually by the SD with long lags.
  - Monthly trade figures from customs are available with a three-month lag.
- NRBT practices:
  - Unofficially, NRBT compiles monthly BOP statistics based on Overseas Exchange Transactions records with a one-month lag.
  - There are "significant differences" between SD and NRBT BOP estimates.
  - Large errors and omissions suggest possible under recording of imports.
- PFTAC assistance:
  - With PFTAC assistance in March 2009, the SD developed revised draft BoP statistics and methodology and made recommendations for further improvements.
  - A follow-up mission took place in March 2010.
- MOF reporting: a system provides detailed information on official sector external disbursements and debt service.

### Monetary and financial statistics
- NRBT reports data for the central bank, other depository corporations, and monetary aggregates using the standardized report forms (SRFs).
- These data were published for the first time in the March 2008 issue of IFS and IFS Supplement on Monetary and Financial Statistics.
- NRBT needs to allocate resources to improve MFS quality by obtaining source data suitable for SRFs, in line with recommendations of the Monetary and Financial Statistics Manual.
- Technical assistance will be needed to improve classification and sectorization of accounts once the new prudential reporting system is introduced.

### Table of Common Indicators Required for Surveillance (as of April 11, 2011) — selected entries preserved exactly
- Exchange Rates: Date of latest observation Feb-11; Date received Mar-11; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- International Reserve Assets and Reserve Liabilities of the Monetary Authorities: Date of latest observation Feb-11; Date received Mar-11; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- Reserve/Base Money: Date of latest observation Jan-11; Date received Mar-11; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- Broad Money: Date of latest observation Jan-11; Date received Mar-11; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- Central Bank Balance Sheet: Date of latest observation Jan-11; Date received Mar-11; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- Consolidated Balance Sheet of the Banking System: Date of latest observation Jan-11; Date received Mar-11; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- Interest Rates: Date of latest observation Jan-11; Date received Mar-11; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- Consumer Price Index: Date of latest observation Jan-11; Date received Mar-11; Frequency of Data M; Frequency of Reporting M; Frequency of Publication M.
- Revenue, Expenditure, Balance and Composition of Financing – General Government: Date of latest observation NA; Date received NA; Frequency of Data NA; Frequency of Reporting NA; Frequency of Publication NA.
- Revenue, Expenditure, Balance and Composition of Financing – Central Government: Date of latest observation Feb-11; Date received Mar-11; Frequency of Data M; Frequency of Reporting Q; Frequency of Publication Q.
- Stocks of Central Government and Central Government-Guaranteed Debt: Date of latest observation Feb-11; Date received Mar-11; Frequency of Data A; Frequency of Reporting A; Frequency of Publication A.
- External Current Account Balance: Date of latest observation Q4/2010; Date received Mar-11; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q.
- Exports and Imports of Goods and Services: Date of latest observation Q4/2010; Date received Mar-11; Frequency of Data Q; Frequency of Reporting Q; Frequency of Publication Q.
- GDP/GNP: Date of latest observation 2009/10; Date received Mar-11; Frequency of Data A; Frequency of Reporting A; Frequency of Publication A.
- Gross External Debt: Date of latest observation 2010; Date received Mar-11; Frequency of Data A; Frequency of Reporting A; Frequency of Publication A.
- International Investment Position: Date of latest observation NA; Date received NA; Frequency of Data NA; Frequency of Reporting NA; Frequency of Publication NA.

*Source: ANNEX V. TONGA: STATISTICAL ISSUES*

### 9.      Stress  tests  show  the  vulnerability  of

### _cr11110 - 9.      Stress  tests  show  the  vulnerability  of

### Stress test results (external)
- The export shock stress test causes the present value of debt to exceed 500 percent of exports and remain above the 100 percent threshold for the entire projection period.
- The debt service-to-exports ratio rises even further above the 15 percent threshold, reaching almost 40 percent in 2017.
- A large one-time depreciation causes the present value of debt to rise to around over 55 percent of GDP and remain persistently above the 30 percent threshold even after 2020.
- A large depreciation also causes the present value of debt-to-revenue ratio to persistently breach its threshold.
- Several other potential shocks would also see debt levels remain above the indicative GDP and export thresholds for a prolonged period.
- Similar stresses emerge when remittances are considered.
- The future scenario is more risky than the historical trends would indicate because the recent China EXIM loan and donor financed construction projects have caused a larger current account balance than in the past.
- If the current account deficit were at historical levels, debt could be reduced more quickly, although these smaller current account deficits are unlikely in coming years as the remaining construction projects are rolled out and the existing projects are completed.

### Public sector DSA — Baseline
- The public sector DSA reinforces the conclusions of the external DSA.
- The recent high level of public sector borrowing for road building and reconstruction of the capital raises the present value of debt to over 42 percent of GDP in 2011/12–2013/14 before it declines steadily thereafter under the baseline scenario.
- This highlights the importance of fiscal prudence, and a commitment to limit new PPG borrowing.

### Alternative scenario and stress tests (public)
- In the Fiscal Balance scenario, the primary surplus is assumed to be kept at an average of 1 percent of GDP after 2010/11.
- Stress tests indicate that vulnerabilities remain throughout the projection period, especially to a sizable depreciation.
- Among the stress tests performed, a 30 percent depreciation results in the largest rise in the overall public debt burden.
  - The PV of public debt would rise and remain above 50 percent of GDP until 2017/18 and would be at 18½ percent of GDP in 2031.
- Maintaining the primary balance at its 2010 level brings debt down faster because the defi given the large deficits implied by the Exim bank-financed construction.
- The externally financed capital expenditure will require larger longer-term primary surpluses (of around 1 percent of GDP) to ensure debt in line with our baseline.

### Staff assessment
- Tonga remains at a high risk of external debt distress.
- While Tonga benefits from very high and relatively stable remittance inflows, which clearly mitigate its liquidity risks, remittances are insufficient to limit risks from projected debt service payments.
- The authorities have exposed themselves to a currency mismatch on the government’s balance sheet which, if left unchecked, could pose an additional risk to Tonga’s debt dynamics.
- Despite being at high risk, Tonga’s debt dynamics are manageable.
  - Tonga is able to service its current obligations.
  - The overall public sector debt situation, while elevated over the short term, shows a downward trend over the longer run assuming the authorities avoid taking on additional debt.

### Key medium-term vulnerabilities and policy priorities
- Medium-term vulnerabilities:
  - lower GDP growth,
  - major external shocks,
  - currency mismatches,
  - credit risks to the government’s balance sheet., and
  - borrowing on less concessional terms
- Policy priorities and recommendations:
  - Sound macroeconomic policies to improve Tonga’s growth potential on a sustained basis.
  - Export diversification.
  - Continued efforts in fiscal consolidation.
  - Increased utilization of donor grants and avoiding further new borrowing until the debt is put on a downward path to reduce the risk of external debt distress.
  - Sound public debt management, anchored in a medium-term debt management strategy and in line with the medium-term fiscal framework, to guide future development financing in Tonga.
  - Priority given to projects which would help generate high growth and employment, especially in the context of the NSPF, to help ensure debt service capacity in the future.

*Source: 2011 ARTICLE IV REPORT—DEBT SUSTAINABILITY ANALYSIS TONGA (excerpt).*

### Box 1 Key Assumptions

### Box 1 Key Assumptions

### Real GDP growth
- Real GDP growth is projected to average around 1.7 percent over the period 2010/11–2015/16.
- Longer-term growth is expected to be marginally higher, but will remain around its long-run average.

### Fiscal assumptions and public wage policy
- Current fiscal balance is assumed to narrow from a deficit about 2½ percent of GDP in 2010/11 to surplus of 1 percent by 2015/16.
- The projected surplus is to result from:
  - Restraint in wage expenditures following recent public sector restructuring.
  - Tax administration gains.
  - Alignment of government ministries under a medium-term budget framework.
- Policy emphasis: ensure salary structure of civil servants adequately reflects performance and contributes to increasing efficiency in service delivery.
- A current fiscal balance of around 1 percent of GDP is assumed over the longer-term.
- Current revenue and expenditure are assumed to be broadly stable as a percent of GDP.
- Resulting primary fiscal balance will average around 1 percent of GDP.

### Grants, external and domestic borrowing
- Grants projected to decline from current high levels of 5¼ percent of GDP, but remain significant at around 2½ percent of GDP over the longer term.
- Assumption: grants and projected disbursements from concessional loans are spent entirely on development projects and associated maintenance.
- Following the last disbursement of the current China Exim Bank loan (in 2012/13), all future external borrowing is assumed to be from concessional IFI (AsDB and World Bank) facilities.
- Domestic borrowing assumptions:
  - No new domestic borrowing until 2014/15 as consolidation advances and debt is brought down.
  - Domestic borrowing thereafter limited to filling any financing gap.

### External sector projections
- External current account deficit is projected to reach 10¾ percent of GDP in 2012/13, up from 7¾ percent of GDP in 2009/10, driven primarily by large construction-related imports.
- Over the medium term, the current account deficit should return to around 7½ percent of GDP.
- Net FDI is projected to stabilize at around 5½ percent of GDP.

### Remittances and exports
- The decline in remittances appears to have bottomed out as economic activity in the United States, Australia, and New Zealand has begun to recover.
- Remittances are expected to recover along with the economies in these three countries and as Australia reviews its seasonal worker program for Pacific Islanders to facilitate greater utilization of the scheme.
- Export base projected to remain narrow and relatively undiversified with a focus on agricultural products.
- Proper operation of the fumigation facility should help gradually increase exports as the products will meet New Zealand’s bio-security requirements.

### Debt and financing context (selected projections and indicators cited in the Box)
- Grants: current high levels of 5¼ percent of GDP declining to around 2½ percent of GDP over the longer term.
- External current account deficit: 7¾ percent of GDP in 2009/10; projected 10¾ percent of GDP in 2012/13; medium-term ~7½ percent of GDP.
- Net FDI: stabilized at around 5½ percent of GDP.
- No new domestic borrowing assumed until 2014/15.

*Source: Box 1 Key Assumptions, 2011 ARTICLE IV REPORT—DEBT SUSTAINABILITY ANALYSIS: TONGA*

### 1.      On behalf of the Tongan authorities, we would like to thank staff for the constructive

### _cr11110 - 1.      On behalf of the Tongan authorities, we would like to thank staff for the constructive

### Economic Developments in FY 2010/11
- Authorities broadly agree with staff that the economy is showing some signs of improvement.
- Projected GDP growth for FY2010/11 is still being finalized but is expected to surprise on the upside and come into positive territory, compared to earlier estimates of -0.5%.
- Upward revision mainly due to higher-than-expected contribution from construction activity, largely financed from overseas; limited immediate positive spillover to the indigenous economy because projects used imported materials and hired mostly foreign workers.
- Increase in capital stock (reconstructed central business district and improved roads) expected to facilitate longer-term business activity.
- Remittance inflows have stabilized in recent months; a near-term resurgence is unlikely given the uncertain external environment.
- Tourism receipts have picked up significantly since the year ended June 2010; exports remained subdued.
- Near-term GDP growth expected to be driven mainly by the construction sector and recovery in remittances, though continued tightness in credit conditions is expected to weigh on growth.
- Price developments:
  - CPI inflation rose to 6.5 percent y-o-y in February on rising food and oil prices and one-off effects from higher excises on imported tobacco and alcohol.
  - Authorities’ latest estimates show inflation to come in at 6.6% and 4.3% in FY2010/11 and 2011/12 respectively.
- Political context: new government elected in November 2010 (Tonga’s first parliamentary elections); committed to reforms to promote private sector activity, diversify the economic base, reduce reliance on remittances, and restore policy space for countercyclical responses.

### Fiscal Policy
- Authorities broadly agree with staff’s assessment on fiscal policy and recognize need to rebuild fiscal headroom, particularly given forthcoming increase in debt service burden from FY2013/14.
- Recent reforms and PFM strengthening initiatives:
  - Improving auditing and procurement.
  - Implementing a Treasury Manual.
  - Consolidation of government accounts.
  - Strengthening macroeconomic forecasting.
  - New IT systems to computerize tax records and data to strengthen tax compliance and bolster revenue collection.
  - Public Expenditure Reviews with donor funding to analyze resource utilization effectiveness.
  - Enhanced collaboration between the Ministry of Finance, line ministries, and the Public Service Commission to strengthen expenditure prioritization.
- Near-term fiscal focus: restore fiscal space to accommodate envisaged rise in debt servicing costs (principal repayments for the Reconstruction and Roads Projects with the EXIM Bank of China commence in FY2013/14).
- FY 2011/12 Budget measures under preparation to control public finances:
  - Revenue measures (subject to economic conditions).
  - Expenditure measures including endeavouring to contain the wage bill and linking resource allocation to core activities.
  - Plans to review and rationalize public sector activities, potentially resulting in staff redeployment and merging or relocation of ministries to reduce costs.
- Longer-term: establish a Medium Term Budgeting Framework (MTBF) integrated with the National Strategic Planning Framework (NSPF); ministries developing three-year corporate plans (CP) and annual management plans (AMP) linked directly to the annual budget.
- Continued collaboration with PFTAC on outstanding measures.

### Monetary Policy
- The National Reserve Bank of Tonga (NRBT) will stay vigilant to price developments and stands ready to respond to contain inflation risks.
- Credit conditions remain constrained as banks maintain tight lending standards due to a spate of NPLs over the past two years and economic uncertainty.
- NRBT policy to jumpstart lending:
  - Paid 1% remuneration on banks’ Exchange Settlement Account balances that are above 1 million pa’anga.
  - Policy has had some success: bank interest rates declined by 0.25-1% since January 2010.
- Private sector credit growth (excluding loans from the EXIM bank of China) continued to decline by 7.1 % over the year ending March 2011, compared to -14.1% in the preceding year.
- Overall: envisaged stimulus to economic activity from NRBT measures has yet to materialize.

### Financial Sector
- Authorities note staff’s view that incentivizing credit flow is more effective via measures that directly tackle impediments to bank lending rather than administering interest rates, which can have distortionary effects.
- Structural and regulatory measures to improve access to finance and lower borrowing costs:
  - Enactment of the Personal Property Security Act envisaged to help bring down borrowing costs and enhance access to bank finance.
  - NRBT required banks to disclose the Effective Interest Rates charged to clients to address public concerns about lending vs deposit rate changes.
- Supervisory focus on credit risk management due to heightened level of NPLs stemming from loose lending prior to the global financial crisis, economic malaise, and decline in remittances.
- Identified improvements in credit risk management:
  - Strengthening stress testing regimes to reflect interest rates and commodity prices.
  - Updating outmoded asset valuation methods.
- Technical assistance and initiatives:
  - Work with the World Bank IFC to establish a credit bureau and promote electronic checks.
  - Technical assistance from the IMF and PFTAC to fortify supervisory framework, design new prudential returns, and enhance offsite monitoring tools.

### Structural Policy
- Authorities concur that lifting medium-term growth prospects is challenging given Tonga’s geographic isolation and narrow economic base.
- Implemented measures to promote private sector activity and broaden growth sources:
  - Repaired High Temperature Forced Air machine at the airport and established quarantine facilities to meet import standards for agricultural exports.
  - Tourism marketing activities and establishment of the Tonga Institute of Sports.
  - Tonga Submarine Cable project envisaged to strengthen communication links.
  - Tonga Energy Road Map to raise energy efficiency and identify options for non-renewable energy sources to lower business costs and galvanize private sector activity.

### Final Remarks
- The Tongan economy has shown signs of improvement, but a recovery is yet to be entrenched.
- The new government is committed to advancing the reform agenda, recognizing results will take time to materialize.
- Given capacity constraints, domestic efforts need supplementation by support from multilateral institutions and other countries.
- Authorities express gratitude to the Fund, the World Bank, and PFTAC for invaluable technical guidance.

*Source: _cr11110*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2011/_cr11110.pdf_