## _cr14240

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### The Macroeconomic Impact of the Cyclone: growth, inflation, external balance
- Real GDP growth:
  - Slowed to 0-1 percent in FY2012/13.
  - Expected to recover to 1½ percent in FY2013/14.
  - Expected to further recover to 3½ percent in FY2014/15.
  - Cyclone Ian expected to reduce growth by about ¾ percent in FY2013/14, but reconstruction activities would boost growth by about 1½ percentage points of GDP in FY2014/15.
  - Thereafter, growth expected to gradually converge to the historical trend of 1¾ percent, driven by remittances and tourism receipts, as well as credit growth.
- Risks to the near-term outlook:
  - Tilted to the downside from spillovers of slower growth in advanced and emerging economies or China, and from domestic slippages (e.g., election in late 2014) or cost overruns preparing for the 2019 South Pacific Games.
  - Greater frequency of natural disasters presents significant risks.
- Inflation:
  - NRBT reference range: 6−8 percent.
  - Headline CPI inflation has largely fluctuated between -1 and 2 percent since mid-2012.
  - Staff expects inflation to incrementally rise to 4-5 percent toward FY2018/19, with demand effects related to Games preparations also adding pressures.
- External sector and reserves:
  - International reserves increased about threefold since 2008—to about 8 months of imports estimated for FY2012/13.
  - Cyclone impact expected to reduce the current account deficit by about 1¾ percent of GDP in cumulative terms in FY2013/14 and 2014/15, with disaster-related grants and insurance payouts more than offsetting import increases.
  - In the medium term, cyclical recovery of imports and lower foreign grants would decrease international reserves to 7 months of imports by FY2018/19.
  - The real effective exchange rate is broadly in line with medium-term fundamentals.

### Authorities’ views and fiscal strategy
- Authorities’ priorities and stance:
  - Broad agreement that the economy is rebounding, but cautious about durability of recovery and reliance on disaster-related or externally funded project cycles.
  - FY2014/15 budget strategy: anchor fiscal position to the operating cash balance, contain growth of nonpriority expenditure, implement ‘Amended No New Loan Policy’ (no external commercial borrowing, cautious use of concessional loans, restrict domestic debt issuance in principle to refinancing).
  - Response to cyclone: identify available external grants and concessional loans and adjust spending accordingly; rephase or reprioritize cyclone spending if financing gap emerges.
  - Prudent management of the 2019 South Pacific Games: seek lower-cost options, avoid debt-creating funding.
  - Intend to lower wage bill from 50 percent to 45 percent of recurrent spending.
- Fiscal consolidation objectives:
  - Strengthen long-term budget position and rebuild policy buffers against future external shocks.
  - Improve estimation of funding ceilings based on realistic revenue, budget support and development assistance, and prudent borrowing.

### Fiscal impact of Cyclone Ian and reconstruction financing
- Damage and short-term fiscal effects:
  - Initial damage assessment: property damage of about 10 percent of GDP.
  - Estimated reduction of the overall fiscal balance by 1.5 percentage points of GDP, leading to a deficit of 0.6 percent of GDP in FY2013/14.
  - Cyclone impact expected to linger through FY2014/15, raising the overall deficit by 1 percentage point—to 0.7percent of GDP.
- Projected reconstruction financing:
  - Projected fiscal cost related to the cyclone: 7 percent of GDP; about 60 million pa’anga.
  - Confirmed funding composition: grants about 70 percent, loans about 20 percent, holdings of disaster trust funds about 10 percent.
- Waived/renegotiated loan:
  - Repayment of a large external loan equivalent to about 15 percent of GDP (provided in 2007) appears to have been waived pending renegotiation.
- Staff recommendations for financing and fiscal stance:
  - Meet projected cyclone-related fiscal cost largely with confirmed donor funding; if a gap emerges, reallocate fiscal resources or consider domestic bond financing.
  - Cautious use of domestic bonds for high-priority spending; example: a 25 million pa’anga increase in outstanding government bonds in the medium term would raise interest costs by 0.2 percentage points of GDP, assuming an interest rate of 5½ percent.
  - For FY2014/15, focus on accommodating reconstruction financing needs while maintaining a sound overall balance excluding cyclone-related spending; staff projects a small surplus for the non-cyclone overall balance.
  - Define new terms of the renegotiated loan repayments as soon as possible.
- Medium-term fiscal targets:
  - Anchor policy by the debt-to-GDP ratio; target to gradually increase the primary fiscal surplus to about 1 percent of GDP (average; over the longer-term), consistent with stabilizing external debt at about 30−35 percent of GDP.
  - Staff projects cash cushion will gradually increase to 2 months of recurrent spending (from the current level of 1 month) over the medium term.
  - Zero rating and exemptions in consumption tax and excises are estimated to result in about 4 percent of GDP loss in tax revenues.

### Banking, monetary policy, and financial intermediation
- Banking sector developments:
  - Deleveraging cycle of Tongan banks appears to be ending.
  - Bank lending to households increased by 2.2 percent in February 2014 despite continued NPL charge-offs and substitution to nonbanks.
  - Asset quality indicators improved; ratio of NPL expenses to total loans fell well below pre-global financial crisis average levels.
  - Business lending continues to decline, reflecting stagnant new lending and continued charge-offs.
- Monetary policy stance and constraints:
  - NRBT has maintained an accommodative stance to support liquidity given low inflation risk, comfortable reserves, and a credit squeeze.
  - Current basket peg of the pa’anga has served as a nominal anchor but constrains NRBT’s ability to influence domestic monetary conditions.
- Staff recommendations to support financial intermediation:
  - Carefully time withdrawal of monetary impulse; prepare to gradually withdraw liquidity and tighten monetary policy once signs of a credit cycle turnaround are confirmed.
  - Consider gradually increasing reserve requirement ratio to the levels prior to the global financial crisis.
  - Review NRBT’s inflation reference range given recent low inflation and constraints from basket peg commitment.
  - Commercialize the Tonga Development Bank (TDB) with safeguards (sound risk management and accountability framework); revise Tonga Development Bank bill and pursue peer review.
  - Expand NRBT’s regulatory mandate to include nonbank financial intermediaries and craft safeguards for policy lending schemes.
  - Continue structural reforms: improve credit information and creditor rights (receivership bill, improved credit bureau, land registry reform).

### Reinvigorating growth: structural policies and sectoral focus
- Growth constraints:
  - Tonga’s remoteness and weak infrastructure make tourism breakthroughs challenging.
  - Low job creation, particularly for youth; headline unemployment rate very low at 1¾ percent due to low labor force participation, high emigration, and large share of subsistence workers.
- Recommended growth model and sectoral actions:
  - Focus on services exports rather than goods exports.
  - Participate and expand seasonal worker programs with training as needed.
  - Maximize opportunities from new fiber-optic-cable-connection projects (e.g., call centers, online education).
  - Strengthen link between remittances and domestic investment via specialized financial products.
  - Promote tourism, agriculture, and fisheries; continue business environment improvements through judicious deregulation and confidence-building via sound macroeconomic policies.
  - Private-public sector partnerships and PFM improvements to address infrastructure and education bottlenecks.

### FDI promotion, investment incentives, and public sector performance
- FDI and incentives:
  - Recommendation: Promotion of FDI should focus on business-enabling structural reforms; the use of tax incentives should be minimized and well targeted.
  - Design guidance: link new incentives to retiring ad hoc ineffective incentives; periodic review of investment incentives based on measurable outcomes.
  - Revenue reform to broaden the tax base should help create fiscal space for targeted incentives.
- Public sector performance and PFM:
  - Continue civil service reform and integration of corporate planning and budgeting.
  - Finalize a public financial management road map and improve statistical data to better enable business decisions and policymaking.

### Debt sustainability, the Pacific Games risk scenario, and DSA findings
- Public debt dynamics:
  - Total debt stock (mainly external) rose from 30 percent of GDP in FY2007/08 to 42 percent of GDP in FY2012/13.
  - Two large loans from a bilateral donor contracted in 2007 and 2010 account for about 60 percent of outstanding external debt.
  - Public domestic debt is relatively small (about 4 percent of nominal GDP).
  - Public sector DSA baseline: PV of public debt-to-GDP ratio will remain slightly over 30 percent in the medium term, then steadily decline to about 20 percent over the projection period.
- DSA and stress tests:
  - Application of the updated DSA framework classifies Tonga as a large remittances case with CPIA three-year average score of 3.45 and uses a higher discount rate (5 percent).
  - Baseline external DSA: trajectories remain comfortably below thresholds after remittances adjustments.
  - Stress tests: a one-time depreciation shock causes the debt services-to-revenue indicator to breach the threshold slightly in FY2018/19 under certain assumptions; overall Tonga remains at a moderate risk of debt distress.
- Pacific Games high-cost scenario (illustration):
  - Authorities’ projection: Total projected expenditure US$70 million (about 15 percent of current nominal GDP and 50 percent of general government revenue); operating cost US$20 million; capital cost US$50 million; with nondebt financing covering costs, risk of debt distress not affected.
  - Hypothetical cost overrun with external debt financing of US$170 million (assumed loan terms: 2 percent interest rate, 20-year maturity, 5-year grace period) would change Tonga’s risk of debt distress from moderate to high.
  - Selected numeric scenario inputs: hypothetical cost overrun US$120 million; hypothetical external loan financing US$170 million; assumed loan interest rate 2 percent; maturity 20 years; grace period 5 years.
- Policy implications:
  - Build fiscal buffers and protect priority spending.
  - Improve debt management framework and consider hedging exchange risks on external debt.
  - Avoid debt-creating financing for potential cost overruns related to the Games.

### Risks, slippages, and policy implications (Risk Assessment Matrix / Slippages)
- Key risks and levels of concern:
  - Protracted slower growth in advanced and emerging economies: Overall level of concern High; Likelihood Medium/High.
  - Medium-term slowdown in China: Overall level of concern Medium; Likelihood Low/Medium.
  - Natural disasters (regional): Overall level of concern Low/medium; Likelihood High.
  - Cost overrun relating to the Games: Overall level of concern Medium; Likelihood High.
  - Slippages in delivering on Policy Reform Matrix: Risk overview includes low to high concerns depending on stakeholder support and capacity constraints; slippage can significantly affect budget support flows.
- Transmission channels and vulnerabilities:
  - Reform slippages reduce donor confidence and can directly affect budget support flows tied to reform matrix actions, creating gross financing gaps.
  - Capacity constraints: long delays in data provision; significant differences between BOP estimates compiled by the SD and the NRBT; labor market statistics weak.
- Recommended actions to reduce slippage risk:
  - Strengthen ownership and stakeholder support for reforms.
  - Prioritize capacity building (Statistics Department, PFM, cash/debt management, FMIS).
  - Maintain clear policy framework for new borrowing; ensure borrowing supports high priority investments and remains within sustainable limits.
  - Enhance donor coordination and conditionality monitoring.

### Selected quantitative projections and recent data (highlights)
- FY2013–14 growth: 1.4 percent (supplement); FY2014–15 growth: 3.4 percent (supplement).
- Cyclone damage estimate: 10 percent of GDP.
- Projected fiscal cost of cyclone: about 7 percent of GDP; about 60 million pa’anga.
- FY2014/15 total expenditures: 451 million pa’anga, including donor-supported in-kind expenditures of around 181 million pa’anga.
- FY2014/15 budget deficit: 13.7 million pa’anga.
- Gross official foreign reserves (end-May 2014): T$266.8 million = 9.4 months of imports (NRBT benchmark: 3 to 4 months).
- Total public debt (30 June 2014): $368.2 million (44 percent of GDP).
  - Total external debt (30 June 2014): T$338.7 million (40 percent of GDP).
  - Total domestic debt (30 June 2014): T$29.5 million (3 percent of GDP).
- Public sector targets and assumptions (Box 1 highlights):
  - Tax-to-GDP ratio expected to improve to 17.4 percent.
  - Current expenditures expected to decrease from about 27.2 percent of GDP in FY2013/14 to 22.5 percent over the medium term.
  - Capital expenditure: elevates to about 5 percent of GDP in FY2014/15 then returns to 2 percent over the medium term.
  - Primary fiscal balance will average about 1 percent of GDP in the longer term.
  - Remittances: increase from 15½ percent of GDP in FY2013/14 to about 19 percent of GDP over the medium term.
  - Tourism receipts: increase from 7 percent of GDP in FY2013/14 to about 10 percent over the medium term.

*Source: IMF staff report and Tongan authorities (content unit _cr14240).*

### 1. The Macroeconomic Impact of the Cyclone ___________________________________________________ 11

### 1. The Macroeconomic Impact of the Cyclone

### The macroeconomic situation: growth, inflation, external balance
- Real GDP growth:
  - Slowed to 0-1 percent in FY2012/13.
  - Expected to recover to 1½ percent in FY2013/14.
  - Expected to further recover to 3½ percent in FY2014/15.
  - Cyclone Ian expected to reduce growth by about ¾ percent in FY2013/14, but reconstruction activities would boost growth by about 1½ percentage points of GDP in FY2014/15.
  - Thereafter, growth expected to gradually converge to the historical trend of 1¾ percent, driven by remittances and tourism receipts, as well as credit growth.
- Risks to the near-term outlook:
  - Tilted to the downside from spillovers of slower growth in advanced and emerging economies or China, and from domestic slippages (e.g., election in late 2014) or cost overruns preparing for the 2019 South Pacific Games.
  - Greater frequency of natural disasters presents significant risks.
- Inflation:
  - NRBT reference range: 6−8 percent.
  - Headline CPI inflation has largely fluctuated between -1 and 2 percent since mid-2012.
  - Staff expects inflation to incrementally rise to 4-5 percent toward FY2018/19, with demand effects related to Games preparations also adding pressures.
- External sector and reserves:
  - International reserves increased about threefold since 2008—to about 8 months of imports estimated for FY2012/13.
  - Cyclone impact expected to reduce the current account deficit by about 1¾ percent of GDP in cumulative terms in FY2013/14 and 2014/15, with disaster-related grants and insurance payouts more than offsetting import increases.
  - In the medium term, cyclical recovery of imports and lower foreign grants would decrease international reserves to 7 months of imports by FY2018/19.
  - The real effective exchange rate is broadly in line with medium-term fundamentals.

### Authorities’ views (summarized)
- Broad agreement that the economy is rebounding, but cautious about durability of recovery and reliance on disaster-related or externally funded project cycles.
- Expect inflation to remain subdued; note strong influence of commodity prices and weak link between inflation and output gap.
- FY2014/15 budget strategy: anchor fiscal position to the operating cash balance, contain growth of nonpriority expenditure, implement ‘Amended No New Loan Policy’ (no external commercial borrowing, cautious use of concessional loans, restrict domestic debt issuance in principle to refinancing).
- Response to cyclone: identify available external grants and concessional loans and adjust spending accordingly; rephase or reprioritize cyclone spending if financing gap emerges.
- Prudent management of the 2019 South Pacific Games: seek lower-cost options, avoid debt-creating funding.
- Expect revenue-to-GDP ratio to increase over time (e.g., mineral tax); intend to lower wage bill from 50 percent to 45 percent of recurrent spending.

### Fiscal impact of Cyclone Ian and financing strategy
- Damage and short-term fiscal effects:
  - Initial damage assessment: property damage of about 10 percent of GDP.
  - Estimated reduction of the overall fiscal balance by 1.5 percentage points of GDP, leading to a deficit of 0.6 percent of GDP in FY2013/14.
  - Cyclone impact expected to linger through FY2014/15, raising the overall deficit by 1 percentage point—to 0.7percent of GDP.
- Waived loan:
  - Repayment of a large external loan equivalent to about 15 percent of GDP (provided in 2007) appears to have been waived pending renegotiation.
- Projected reconstruction financing:
  - Projected fiscal cost related to the cyclone: 7 percent of GDP; about 60 million pa’anga.
  - Confirmed funding composition: grants about 70 percent, loans about 20 percent, holdings of disaster trust funds about 10 percent.
- Staff recommendations for financing and fiscal stance:
  - Meet projected cyclone-related fiscal cost largely with confirmed donor funding; if a gap emerges, reallocate fiscal resources or consider domestic bond financing.
  - Cautious use of domestic bonds for high-priority spending; example calculation: a 25 million pa’anga increase in outstanding government bonds in the medium term would raise interest costs by 0.2 percentage points of GDP, assuming an interest rate of 5½ percent.
  - For FY2014/15, focus on accommodating reconstruction financing needs while maintaining a sound overall balance excluding cyclone-related spending; staff projects a small surplus for the non-cyclone overall balance.
  - Authorities should define new terms of the renegotiated loan repayments as soon as possible.
- Medium-term fiscal strategy:
  - Aim to gradually stabilize and then reduce the risk of debt distress, anchoring policy by the debt-to-GDP ratio.
  - Target to gradually increase the primary fiscal surplus to about 1 percent of GDP (average; over the longer-term), consistent with stabilizing external debt at about 30−35 percent of GDP.
  - Important measures: wage restraint (in line with authorities’ target), revenue reform (e.g., broadening the consumption tax base), preserve capital expenditures, and maintain a cash cushion.
  - Staff projects cash cushion will gradually increase to 2 months of recurrent spending (from the current level of 1 month) over the medium term.
  - Caution in managing fiscal costs associated with hosting the 2019 South Pacific Games; focus on avoiding cost overruns and debt-creating financing.
- Note on consumption tax exemptions:
  - Zero rating and exemptions in consumption tax and excises are estimated to result in about 4 percent of GDP loss in tax revenues.

### Reinvigorating financial intermediation: banking, monetary policy, and reforms
- Banking sector recent developments:
  - Deleveraging cycle of Tongan banks appears to be ending.
  - Bank lending to households increased by 2.2 percent in February 2014 despite continued NPL charge-offs and substitution to nonbanks (retirement funds and microfinance institutions).
  - Asset quality indicators improved; ratio of NPL expenses to total loans fell well below pre-global financial crisis average levels.
  - Business lending continues to decline, reflecting stagnant new lending and continued charge-offs.
- Monetary policy stance:
  - NRBT has maintained an accommodative stance to support liquidity given low inflation risk, comfortable reserves, and a credit squeeze.
  - Current basket peg of the pa’anga has served as a nominal anchor but constrains NRBT’s ability to influence domestic monetary conditions.
- Staff recommendations to support financial intermediation:
  - Careful timing of withdrawal of monetary impulse: prepare to gradually withdraw liquidity and tighten monetary policy once signs of a credit cycle turnaround are confirmed; consider gradually increasing reserve requirement ratio to the levels prior to the global financial crisis.
  - Avoid premature withdrawal that could hurt nascent recovery.
  - Review NRBT’s inflation reference range given recent low inflation and constraints from basket peg commitment.
  - Judicious use of supportive credit policies: commercialize the Tonga Development Bank (TDB) with safeguards against fiscal and governance risks (sound risk management and accountability framework); revise Tonga Development Bank bill and pursue peer review.
  - Expand NRBT’s regulatory mandate to include nonbank financial intermediaries; staff welcomes authorities’ plan to lower cost of credit through competition and expanded policy lending, but calls for carefully crafted safeguards (e.g., for risk-sharing facilities or policy lending schemes).
  - Continue structural reforms: address bottlenecks in credit information and creditor rights (receivership bill, improved credit bureau, land registry reform) to promote financial development and strengthen monetary policy effectiveness.
- Authorities’ stance on monetary policy and reforms:
  - Do not intend to tighten monetary policy at this time; wish to avoid interest rate increases that could dampen recovery.
  - Intend to use supportive credit policy instruments to lower cost of credit; view high interest spreads as resulting from weak competition and high staffing costs.
  - Will expedite commercialization of TDB with governance safeguards and NRBT prudential supervision; considering channeling excess liquidity to priority lending (agriculture, fishery, manufacturing) building on pilot policy lending schemes.
- TDB commercialization note:
  - Plan envisages TDB undertaking full range of commercial banking activities (deposit and foreign exchange services), expected to significantly expand lending book; currently finances operations mainly by wholesale borrowing and has not engaged in many activities allowed under its banking license.

### Reversing the trend of slower growth: structural policies and sectors
- Background constraints:
  - Tonga’s remoteness and weak infrastructure make tourism breakthroughs challenging.
  - Difficulties finding a private partner for the International Dateline Hotel (in receivership for years).
  - Low job creation, particularly for youth; headline unemployment rate very low at 1¾ percent due to low labor force participation, high emigration, and large share of subsistence workers.
- Staff recommendations for growth model:
  - Identify and strengthen engines of growth focused on services exports rather than goods exports given remoteness and small domestic market.
  - Participate and expand seasonal worker programs with training as needed.
  - Maximize opportunities from new fiber-optic-cable-connection projects (e.g., call centers, online education).
  - Strengthen link between remittances and domestic investment via specialized financial products.
- Sectoral policy focus:
  - Authorities intend to promote tourism, agriculture, and fisheries.
  - Continue business environment improvements through judicious deregulation and confidence-building via sound macroeconomic policies.
  - Ongoing consultations with the private sector through sector growth committees are noteworthy; examples of early results include a fumigation facility at the main port.

*Source: Tongan authorities; and IMF staff estimates.*

### 25.      The promotion of foreign direct investments (FDI) should focus on business-enabling

### The promotion of foreign direct investments (FDI) should focus on business-enabling structural reforms, while the use of tax incentives should be minimized and well targeted.

### FDI promotion and investment incentives
- Recommendation: Promotion of FDI should focus on business-enabling structural reforms; the use of tax incentives should be minimized and well targeted.
- Policy design guidance:
  - Introduction of new incentives could be linked to retiring existing incentives that are ad hoc and ineffective.
  - A periodic review of investment incentives based on measurable outcomes would be useful.
  - A robust revenue reform to broaden the tax base should help create fiscal space for targeted incentives.
- Authorities’ position:
  - Intend to carefully calibrate the balance between enticing priority FDI projects and protecting the revenue base.
  - New tourism roadmap takes an “integrated approach”—combining rules-based, targeted tax incentives and regulatory reforms.
  - Considering a thorough review of existing tax exemptions and a gradual phasing out of ad-hoc exemptions.

### Public sector performance and public financial management
- Ongoing priorities:
  - Continue efforts to enhance public sector performance given its relatively large contribution to the economy in microstates.
  - A robust public spending framework to buttress a private sector-led growth strategy by addressing bottlenecks (e.g., infrastructure and education).
- Specific reforms and actions:
  - Continue civil service reform—ample scope for efficiency gains in human resource management.
  - Continue gradual integration of corporate planning and budgeting; further enhance communication with and buy-ins of stakeholders.
  - Finalize a public financial management road map.
  - Improve statistical data by strengthening resources to better enable business decisions and policy making.

### Macroeconomic context and short-term priorities
- Cyclone Ian (January 2014) impacts and reconstruction:
  - The total damage to the Tongan economy is estimated to amount to about 10 percent of GDP.
  - The Ha’apai island group’s annual contribution to national output is about 6 percent.
  - Cyclone Ian affected around 5,000 residents and destroyed or damaged almost 1,000 houses and buildings.
  - With World Bank assistance, the government intends to build 550 permanent houses and support the repair of 400 damaged houses, with total construction costs amounting to 20 million pa’anga (2.5 percent of GDP).
- Macroeconomic effects of the cyclone (staff estimates):
  - Growth: Cyclone Ian has shaved ¾ percent off FY2013/14 GDP (relative to the pre-cyclone baseline forecast).
  - Reconstruction activities are expected to boost GDP by 0.4 percent in FY2014 (relative to the same baseline).
  - Inflation: Cyclone is not projected to affect official inflation data.
  - Balance of payments: Disaster-related grants and insurance payouts are expected to more than offset increases in imports, improving the current account balance in FY2013/14 by 2 percentage points of GDP.
  - During peak reconstruction in FY2014/15 increased imports of construction materials are projected to worsen the current account balance by ¼ percentage point of GDP.
- Short-term priority: Facilitate reconstruction spending; the projected fiscal cost relating to the cyclone will be broadly met by confirmed funding mainly from donor agencies. Authorities should accommodate cyclone-related financing needs while maintaining a sound position in the overall balance excluding cyclone effects.

### Medium-term fiscal and monetary strategy
- Fiscal strategy:
  - Aim at gradually stabilizing and then reducing Tonga’s risk of debt distress, anchoring policy by the debt-to-GDP ratio.
  - Rebuild fiscal buffers, including by maintaining a prudent level of public debt given large exposure to natural disasters.
  - Aim at gradually increasing the primary fiscal surplus to stabilize the debt ratio in the medium term, and reducing it thereafter.
  - Wage restraint and revenue reform will be needed to accomplish this.
- Monetary and banking policy:
  - The deleveraging cycle of Tongan banks appears to be ending.
  - The NRBT should prepare to gradually withdraw liquidity and tighten monetary conditions once current signs of credit growth are confirmed.
  - Authorities plan to lower the cost of credit through supportive credit policies, including by commercializing the TDB; robust safeguards should be put in place to implement these plans sustainably.

### Growth strategy and structural adjustment
- Structural constraints:
  - Tonga’s remoteness limits a growth model relying mainly on exports of goods; small domestic market narrows import-substitution opportunities.
- Recommended focus:
  - Significantly strengthen services exports.
  - Continue participation in seasonal worker programs, providing training as needed.
  - Maximize opportunities from new fiber-optic-cable-connection projects.
  - Strengthen the link between remittance flows and domestic investment (e.g., through specialized financial products).
  - Continue promoting tourism, agriculture, and fisheries and strengthen the business environment and confidence to mitigate challenges from remoteness and smallness.

### Pacific Games hosting risk scenario
- Authorities’ preliminary projection for hosting the 2019 Pacific Games:
  - Total projected expenditure: US$70 million, which represents about 15 percent of current nominal GDP and 50 percent of general government revenue.
  - Operating cost: US$20 million (envisaged to be covered with Games revenue).
  - Capital cost: US$50 million (envisaged to be covered with donations and franchises).
  - With nondebt financing covering the entire costs, the plan would not affect Tonga’s risk of debt distress (which is moderate).
- Risk illustration (simulation):
  - Hypothetical higher-cost scenario with cost overruns financed by an external debt of US$170 million shows Tonga would be at high risk of debt distress.
- Policy caution: Authorities should be cautious about the risk of cost overrun, with particular care to avoid debt financing.

### Exchange rate and competitiveness
- Exchange rate assessment:
  - Tonga’s real effective exchange rate (REER) is broadly in line with medium-term fundamentals.
  - Purchasing power parity approach suggests the pa’anga is above its long-run equilibrium level by about 3 percent.
  - The equilibrium real exchange rate approach (IMF’s standard exchange rate assessment model) indicates an overvaluation of 7 percent.
- Other indicators:
  - Export growth is expected at about 8 percent in the medium term as the economy recovers and programs to boost exports (including tourism and agriculture) yield results.
  - Tonga made good progress in improving the business environment under the World Bank’s Doing Business 2014 report and is in the top ranking among Pacific island countries.
  - Further improvements to the business climate (e.g., easing tax payment) and enhanced policy coordination will be important to overcome geographical disadvantages.

*Source: IMF staff appraisal (excerpt).*

### Box 4. Tonga: Previous Fund Recommendations

### Box 4. Tonga: Previous Fund Recommendations

### 2013 staff report: key policy priorities emphasized by staff
- Preserving cash buffers and a credible fiscal consolidation.
- Continuing to expedite financial sector reform to renew credit growth.
- Improving the business environment to strengthen investor confidence.

### Authorities' follow-up actions reported
- The authorities continued to manage prudent fiscal policy stance focusing on protecting cash buffers and restraining non-priority spending. They also continued to adopt No New Loan policy while amending it to allow taking of concessional budget support loans provided by IFIs (which is in line with the recommendations from the 2013 staff report).
- The authorities continued to strengthen risk-based supervision, including through PFTAC technical assistance, and expect to enact the Receivership bill this year.
- After removing the annual renewal requirement for the headline business license, the authorities are advancing ancillary licensing reforms, e.g., by easing immigration VISA renewal process.
- The authorities are finalizing legislative process for a presumptive tax regime for SMEs and a natural resource tax regime.

*International Monetary Fund*

### Appendix I. Risk Assessment Matrix

### Appendix I. Risk Assessment Matrix

### Protracted period of slower growth in advanced and emerging economies
- Nature/Source of Main Threats:
  - For advanced economies, could result from failure to address the legacies of the financial crisis.
  - For emerging markets, could reflect the maturing of the cycle, investment misallocation, or incomplete structural reforms.
- Overall Level of Concern:
  - High
- Likelihood of Severe Realization of Threat in the Next one–three Years:
  - Medium/High
- Expected Impact if Threat is Realized:
  - Tonga would be significantly affected by economic slowdown in the U.S., Australia, and New Zealand, mainly via lower remittances and exports.
- Policy Response:
  - Allow moderation of growth, and delay withdrawal of monetary impulse.
  - Pressures on the BOP could be met by combining depreciation and intervention.
  - The fiscal impulse caused by the post-cyclone activities will help cushion the shock, and the pace of post-reconstruction consolidation can be cautiously fine-tuned, if crucial.

### Medium term growth slowdown in China
- Nature/Source of Main Threats:
  - Buildup of excess capacity eventually resulting in large financial and fiscal losses.
- Overall Level of Concern:
  - Medium
- Likelihood of Severe Realization of Threat in the Next one–three Years:
  - Low/Medium
- Expected Impact if Threat is Realized:
  - Tonga would be affected mainly through China’s trade links with Australia, as well as Chinese ODAs.
- Policy Response:
  - Same as the above.

### Natural disasters (regional)
- Nature/Source of Main Threats:
  - Natural disasters similar to the latest cyclone could take significant human and economic tolls.
- Overall Level of Concern:
  - Low/medium
- Likelihood of Severe Realization of Threat in the Next one–three Years:
  - High
- Expected Impact if Threat is Realized:
  - Such an event could have far reaching effects, such as damages to infrastructure and the production base, and an increase in the fiscal financing gap, which can potentially be very large.
- Policy Response:
  - Design disaster recovery and financing strategy with a view to bolster confidence (particularly by donors) and protecting debt space.
  - Getting ready for next disaster will need a comprehensive approach that makes use of multiple emergency capacities. The capacities include:
    - (i) fiscal space and international reserve buffer,
    - (ii) catastrophic insurance schemes (Tonga already participates in one initiative coordinated by the World Bank), and
    - (iii) toolkits provided by global financial safety nets.

### Cost overrun relating to the Games (country-specific)
- Nature/Source of Main Threats:
  - Overly optimistic initial estimates and/or implementation challenges in construction projects may lead to significant cost overrun, which is not improbable in view of the experiences of other countries.
- Overall Level of Concern:
  - Medium
- Likelihood of Severe Realization of Threat in the Next one–three Years:
  - High
- Expected Impact if Threat is Realized:
  - Such an overrun will cause worsening of debt sustainability and investor/development partner confidence in the short run, and corrective fiscal consolidation in the longer run—harming growth.
- Policy Response:
  - Avoiding such an outcome by early remedial actions.
  - Tonga will need much stronger commitment to fiscal consolidation to redress impaired confidence and re-energize support by the donors.

*Source: Appendix I. Risk Assessment Matrix*

### 6. Slippages in delivering on Policy Reform Matrix (country-specific)

### 6. Slippages in delivering on Policy Reform Matrix (country-specific)

### Risk overview
- Low: Weakening of stakeholder supports, capacity constraints, and slippages in the reform process could derail critical reforms agreed with development partners.
- High: Such an outcome could significantly affect budget support flows, leading to a significantly large gross financing gap.
- Note: The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline. The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.

### Tonga-specific transmission channels and vulnerabilities
- Reform slippages reduce donor/development partner confidence and can directly affect:
  - Budget support flows tied to progress on budget support reform matrix actions.
  - Availability of grants and concessional financing that supplement domestic fiscal efforts.
- Capacity constraints in the authorities (including statistical and PFM capacity) exacerbate risk of slippages:
  - Data provision to the Fund continues with long delays; capacity of the Statistics Department (SD) could be increased.
  - Significant differences exist between BOP estimates compiled by the SD and the NRBT; large errors and omissions point to possible under-reporting of imports.
- Interaction with shocks:
  - External shocks (e.g., a significant depreciation and slowdown in exports) generate the highest debt ratios under stress tests, highlighting fragility to external developments.

### Potential fiscal and financing impacts
- Direct effects of reform slippages:
  - Significant reduction in budget support flows from development partners.
  - Emergence of a significantly large gross financing gap for the budget.
- Indirect effects:
  - Increased risk of fiscal unsustainability if reconstruction financing needs (e.g., following a cyclone) and payroll pressures are not managed alongside reforms.
  - Need to ensure renewed borrowing supports high priority investments and remains within sustainable limits.

### Development partner and policy context relevant to slippages
- Donor coordination and conditional budget support:
  - IMF analysis provides a vital framework to the ongoing budget support program; IMF assessments are used as the basis for decisions regarding the appropriateness of the overall macroeconomic policy framework.
  - World Bank and Fund share common reform priorities: sustainable fiscal management, making use of flexibility in the exchange rate arrangement, and promoting private drivers of growth.
- Technical assistance and reform support that mitigate slippage risk:
  - PFTAC TA across PFM, revenue administration, banking supervision, balance of payments and national accounts statistics aims to support implementation of actions in the development partners’ budget support reform matrix.
  - IMF/PFTAC assistance to NRBT for enhanced off-site analysis and on-site bank supervision supports financial sector stability.
  - World Bank Group provided TA on tax expenditures, investment incentives, privatization, commercialization of state assets, and a Debt Management Reform Plan.

### Key findings and indicators cited (as presented)
- Membership Status: Joined September 13, 1985; Article VIII.
- Quota and holdings (as presented): Quota 6.90        100.00; Total holdings of currency   5.1975.20; Reserve position in the Fund 1.7124.81
- SDR Department (as presented): Net cumulative allocation 6.58        100.00; Holdings 7.09107.73
- Exchange rate arrangement: pegged exchange rate within horizontal bands; value of the pa’anga determined based on a weighted basket comprising the United States, Australian, and New Zealand dollars, with the U.S. dollar as the intervention currency; Japanese yen was added to the basket in July 2000; monthly maximum adjustment limit raised to 5 percent from 2 percent.
- Statistical and data issues that heighten slippage risk:
  - Long delays in data provision to the Fund.
  - Labor market statistics weak: employment statistics have not been compiled since 2003; average earnings statistics are not available.
  - BOP and IIP compilation: quarterly IIP data expected to become available only in late 2014 due to capacity constraints.
- Debt sustainability context:
  - Tonga remains at a moderate risk of debt distress. Reconstruction needs from a recent cyclone worsened underlying debt dynamics; technical changes under the new DSA framework (higher discount factor and stronger focus on debt absorptive capacity of remittances) affected the rating.
  - Stress tests show significant depreciation and slowdown in exports generate the highest debt ratios.

### Policy implications and recommended priorities to reduce slippage risk
- Strengthen ownership and stakeholder support for reforms to secure continued budget support flows.
- Prioritize capacity building where slippages are most likely to occur:
  - Increase capacity of the Statistics Department to reduce data lags and improve the quality of National Accounts, BOP, and GFS.
  - Continue PFTAC and Fund assistance on PFM roadmap completion, cash/debt management, and FMIS improvements.
- Maintain clear policy framework for any new borrowing:
  - Ensure new borrowing supports high priority investments and remains within sustainable limits.
  - Complement borrowing with improved revenue administration, tighter expenditure prioritization, and structural reforms.
- Enhance donor coordination and conditionality monitoring to ensure reform benchmarks in the budget support reform matrix are met and credible.

*Source: _cr14240 - 6. Slippages in delivering on Policy Reform Matrix (country-specific)*

### 1. Tonga is a small open economy with a narrow production base. It exports a few

### _cr14240 - 1. Tonga is a small open economy with a narrow production base. It exports a few

### Key economic outlook and growth projections
- Tonga is a small open economy with a narrow production base; it exports a few agricultural and fishery products, and imports food and services of numerous types.
- High reliance on remittances and foreign aid, which are subject to large fluctuations, poses challenges.
- Real GDP growth:
  - Recorded between 0 and 1 percent in FY2012/13.
  - Projected to recover to 1½ percent in FY2013/14.
  - Projected to rise to 3½ percent in FY2014/15, led by reconstruction from the January 2014 tropical cyclone and supported by rising agricultural production and an improving outlook for tourism.
  - Over the longer-term, growth is expected to gradually converge to the historical trend of 1¾ percent, driven by remittances, tourism receipts, as well as credit growth.
- Risks to the near-term outlook are tilted to the downside.

### Fiscal impact of Cyclone Ian and fiscal outlook
- Cyclone impact:
  - Property damage of about 10 percent of GDP.
  - Widening of the overall fiscal balance by 1.5 percentage points of GDP to a deficit of 0.6 percent of GDP in FY2013/14.
  - Lingering effect through FY2014/15, raising the overall deficit by about 1 percentage point compared to the no-cyclone forecast—to 0.7 percent of GDP.
  - Projected fiscal cost relating to the cyclone: about 7 percent of GDP or 60 million pa’anga, broadly met by funding from donor agencies.
  - Post-cyclone funding composition: grants (about 70 percent), loans (about 20 percent), and disaster trust fund (about 10 percent).
- Medium-term fiscal balance:
  - Overall fiscal balance expected to return to a moderate surplus starting in FY 2017/18.
  - On current policies, debt-to-GDP ratio would gradually decline to around 30–35 percent towards the end of the DSA timeframe (2034).

### Public debt and external debt dynamics
- Total debt stock (mainly external) rose from 30 percent of GDP in FY2007/08 to 42 percent of GDP in FY2012/13.
- Debt composition and notable loans:
  - Two large loans from a bilateral donor contracted in 2007 and 2010 account for about 60 percent of outstanding external debt.
  - Long-term loans from international financial institutions (IFIs) account for only about 35 percent.
  - The 2007 loan to support reconstruction of Nuku’alofa: repayment terms under discussion; baseline scenario builds in an additional 5-year grace period.
  - Loan terms for the 2007 and 2010 loans: 2 percent interest rate, 5-year grace period, and 20-year maturity. (Footnote detail present in source.)
- Public domestic debt is relatively small (about 4 percent of nominal GDP).
- Public sector DSA baseline:
  - PV of public debt-to-GDP ratio will remain slightly over 30 percent in the medium term, then steadily decline to about 20 percent over the projection period.
  - Debt services-to-revenue ratio exhibits a hump shape.

### Box 1 — Key macroeconomic and fiscal assumptions
- Real GDP growth: 1½ percent in FY2013/14; 3½ percent in FY2014/15; reverting to historical trend of 1.7 percent in the long term.
- Drivers of convergence: remittances, tourism receipts, and credit growth.
- Fiscal assumptions and trajectories:
  - Overall fiscal balance: expected deficit in the near term (5 percent public sector salary increase in FY2013/14 and cyclone costs) but gradually moving into a small surplus toward the end of the medium term led by wage restraint and revenue reform.
  - Tax-to-GDP ratio expected to improve to 17.4 percent.
  - Current expenditures expected to decrease from about 27.2 percent of GDP in FY2013/14 to 22.5 percent over the medium term.
  - Capital expenditure: elevates to about 5 percent of GDP in FY2014/15 then returns to 2 percent over the medium term.
  - Long-term levels: current expenditures about 21½ percent of GDP; capital expenditures about 2 percent of GDP.
  - Primary fiscal balance will average about 1 percent of GDP in the longer term.
- External financing and borrowing:
  - Grants and projected loan disbursements assumed mostly spent on development projects and maintenance.
  - External financing from the World Bank and the Asian Development Bank expected to continue as a 50 percent grant and 50 percent loan mix in the first eight years or so.
  - Domestic borrowing assumed mainly led by gross financing requirement.
- Current account:
  - Projected to decline from 5½ percent of GDP in FY2012/13 to 3¼ percent in FY2013/14, driven by higher remittances and official transfers offsetting higher imports.
  - Expected to increase to about 6 percent in FY2015/16—2016/17 mainly owing to hosting of the Games.
  - Afterwards, expected to steadily decline to average of 3 percent in the long term.
- Trade shares:
  - Exports of goods projected to remain stable at around 4 percent of GDP over the medium term.
  - Imports of goods projected to reach 34 percent of GDP in the medium term and increase to around 40 percent of GDP in the long term.
- Remittances and tourism:
  - Remittances: increase from 15½ percent of GDP in FY2013/14 to about 19 percent of GDP over the medium term.
  - Tourism receipts: increase from 7 percent of GDP in FY2013/14 to about 10 percent over the medium term.
- Note: Unwinding of cyclone response cost and decrease in project grants account for about three quarter of the decline in current expenditures, and wage restraint the remainder.

### External DSA findings, scenarios, and sensitivity tests
- Application of the updated DSA framework (DSF) for the first time; Tonga classified as a large remittances case with CPIA three-year average score of 3.45.
- Technical changes under the new DSF:
  - Greater emphasis on remittances as source of foreign exchange and use of a higher discount rate (5 percent versus 3 percent previously).
- Baseline external DSA:
  - Trajectories of external debt and debt service indicators remain comfortably below thresholds after remittances adjustments.
- Stress tests and sensitivity:
  - Debt services-to-revenue ratio: a onetime depreciation shock causes the indicator to breach the threshold slightly in FY2018/19 when the assumed extended grace period of the 2007 external loan is assumed to end; considered a borderline case.
  - For other indicators, no breach of thresholds even in the most extreme shock scenario.
  - Probability approach adopted for borderline cases where largest breach or near breach falls within a 10-percent band around the threshold — stress tests indicate a moderate risk of debt distress.
- Large-event illustration:
  - Authorities’ estimate for South Pacific Games cost: US$70 million (operating cost US$20 million; capital cost US$50 million) with planned financing mainly by franchises and donations.
  - Hypothetical cost overrun scenario: simulated DSA assuming a cost overrun financed by an external debt of US$170 million (actual cost US$190 million exceeding official estimates US$70 million by about 3 times) shows Tonga would be at high risk of debt distress.

### Public sector DSA alternative scenarios and vulnerabilities
- Alternative scenarios:
  - With primary balance fixed at FY2013/14 level, or with both real GDP growth and primary balance fixed at historical averages, PV of public debt fails to decline over the medium term.
  - Demonstrates need for consolidating the primary balance and resisting reversion to historical low growth and fiscal imbalance.
- Stress tests show public debt positions are particularly vulnerable to a significant depreciation; all indicators increase substantially under such a shock.

### Staff assessment and policy recommendations
- Overall risk rating: Tonga remains at a moderate risk of debt distress.
  - Underlying external debt dynamics worsened somewhat due to reconstruction needs from the cyclone, but the rating remains moderate partly due to technical changes in the DSF (higher discount factor and emphasis on remittances).
- Key vulnerabilities: external shocks — significant currency depreciation and slowdown in exports generate the highest debt ratios.
- Policy recommendations:
  - Promote export growth and diversification.
  - Hedge against exchange risks on external debt; develop a comprehensive debt management strategy, including financial instruments to hedge exchange risks.
  - Prioritize fiscal space for high-impact growth-enhancing projects while sustaining and expanding service delivery.
  - Continue improving public expenditure framework to attain higher efficiency.
  - Continue efforts in improving tax policy and administration.
- Note on the Games: while the authorities’ financing plan for the Games is fiscally prudent if nondebt financing covers entire costs, cost overruns could pose significant risks to external debt sustainability (illustrated by the US$170 million external debt overrun simulation leading to high risk of debt distress).

*Source: IMF staff report text provided in the content unit.*

### 20. The authorities agreed with the staff’s assessment. They recognized that in addition to

### _cr14240 - 20. The authorities agreed with the staff’s assessment. They recognized that in addition to

### Authorities' assessment and policy stance
- The authorities agreed with the staff’s assessment.
- They recognized that in addition to the existing debt burden, the cyclone damage potentially put more pressure on debt sustainability.
- They agreed with the need to build fiscal buffers and protect priority spending.
- The authorities intend to improve debt management framework.

### Debt sustainability analysis (general)
- Sources: Country authorities; and staff estimates and projections.
- The DSA presents indicators of public and publicly guaranteed external debt and probability of debt distress under alternative scenarios for 2014-2034.
- Notes on stress tests:
  - "The most extreme stress test is the test that yields the highest ratio on or before 2024."
  - In figures, most extreme shocks correspond variously to: One-time depreciation shock; Exports shock; and in combinations as specified.

### High-cost scenario (2019 Pacific Games) — assumptions
- Hypothetical cost overrun: US$120 million.
- Hypothetical external debt financing: US$170 million.
- Assumed loan terms (similar to recent China EXIM bank loans): 2 percent interest rate, 20-year maturity, and 5-year grace period.
- Macroeconomic assumptions remain broadly similar to baseline, with:
  - Temporary boost to GDP from pre-Games construction and tourist inflows in 2019.
  - Rapid decline in growth afterward reflecting post-construction cooling.

### High-cost scenario — outcomes and risks
- The simulated DSA causes Tonga’s rating to change from moderate to high risk of debt distress.
- The present value of public and publicly guaranteed debt to GDP plus remittances ratio would breach its threshold for 3-4 years under the baseline (Figure A1. High-cost).
- Under stress tests, four out of five debt and debt service indicators would breach the relevant thresholds.
- In addition, the PV of public debt to GDP also breaches the threshold under a stress scenario.

### Selected numeric indicators and projections (as presented)
- Hypothetical cost overrun: US$120 million.
- Hypothetical external loan financing: US$170 million.
- Assumed loan interest rate: 2 percent.
- Assumed loan maturity: 20-year maturity.
- Assumed loan grace period: 5-year grace period.
- Projection horizon covered in figures and tables: 2014-2034 (multiple series and scenarios).
- DSA sensitivity and stress-test framework includes scenarios and bound tests such as:
  - One-time 30 percent nominal depreciation relative to the baseline in 2015.
  - Real GDP growth at historical average minus one standard deviation in 2015-2016.
  - Export value growth at historical average minus one standard deviation in 2015-2016.
- Grant element of new public sector borrowing reported in tables: 54.1 (present where specified as percent).
- Memorandum item examples (from tables):
  - Nominal GDP (Millions of US dollars) sample values include: 423.0, 471.6, 464.5, 482.2, 505.8, 527.0, 545.9, 566.3, 582.1, 716.8, 1087.3.
  - Gross workers' remittances (Millions of US dollars) sample values include: 87.5, 66.8, 68.8, 74.2, 77.6, 86.3, 94.6, 103.0, 110.0, 147.2, 244.3.
  - PV of PPG external debt (in Millions of US dollars) sample values include: 135.2, 138.8, 142.7, 143.7, 144.9, 146.8, 141.8, 126.1, 201.3.
  - PV of PPG external debt (in percent of exports) sample values include: 137.6, 147.9, 141.1, 130.5, 120.3, 115.4, 106.9, 74.9, 74.9.
  - PPG debt service-to-revenue ratio (in percent) sample values include: 6.2, 7.3, 9.6, 8.2, 9.2, 9.8, 9.3, 8.5, 14.4, 11.4, 4.5.
  - Total gross financing need (Millions of U.S. dollars) sample values include: 8.0, 29.9, 13.7, 8.8, 8.7, 26.1, 28.2, 6.0, 3.6, 15.4, 16.7.
  - Real GDP growth (in percent) sample values include: 2.9, 0.7, 0.3, 0.9, 2.4, 1.4, 3.4, 2.5, 1.7, 1.7, 2.8, 2.3, 1.7, 1.7, 1.6 (as shown across periods).
  - Effective interest rate (percent) sample values include: 2.0, 1.5, 2.2, 1.6, 0.7, 1.6, 1.6, 1.5, 1.5, 1.5, 1.4, 1.5, 1.2, 0.9, 1.0.
  - Growth of exports of G&S (US dollar terms, in percent) sample values include: 51.9, 13.6, 20.2, 10.0, 19.0, -3.8, 8.2, 9.4, 9.5, 5.8, 4.4, 5.6, 4.8, 4.2, 4.8.
  - Growth of imports of G&S (US dollar terms, in percent) sample values include: 17.8, 20.5, -14.5, 8.3, 13.3, 8.2, 11.0, 7.2, 3.9, 3.3, 1.5, 5.9, 4.9, 4.1, 5.0.
  - Aid flows (in Millions of US dollars) sample values include: 28.8, 44.2, 25.2, 58.7, 61.3, 40.1, 28.5, 42.0, 41.3, 50.0, 75.3.
  - Grant-equivalent financing (in percent of GDP) sample values include: 11.5, 11.2, 7.0, 4.6, 6.8, 6.5, 5.7, 5.5, 5.7 (as shown for projection years where specified).
- Public sector debt indicators (sample historic and projected averages from tables):
  - Public sector debt 1/ sample values: 41.3, 46.5, 45.1, 44.5, 44.3, 43.8, 43.6, 42.3, 40.3, 32.4, 37.6.
  - Of which foreign-currency denominated sample values: 36.0, 41.9, 41.4, 41.0, 40.3, 39.0, 37.9, 37.0, 35.2, 28.6, 35.4.
  - Identified debt-creating flows sample values: -2.8, 1.8, 2.7, 0.4, -0.7, 2.6, 3.2, -0.7, -2.7, -0.3, 0.3.
  - Net current transfers (negative = inflow) sample values: -27.8, -27.4, -17.3, -30.1, 5.3, -23.0, -25.5, -22.9, -21.5, -24.8, -25.3, -24.6, -26.7, -25.8 (as shown across series).
  - Debt service-to-exports ratio (in percent) sample values: 7.1, 7.7, 8.6, 7.9, 8.7, 9.2, 8.3, 7.5, 12.5, 9.6, 3.7.
  - PV of external debt (sample series): 28.9, 28.8, 28.3, 27.5, 26.8, 26.2, 24.7, 17.7, 18.7 (as shown for projection years where specified).
- Sensitivity analysis tables present many scenario-specific numeric outcomes for PV of debt-to-GDP ratio, PV of debt-to-exports ratio, PV of debt-to-revenue ratio, and debt service-to-revenue ratio across baseline, alternative scenarios, and bound tests for years including 2014, 2015, 2016, 2017, 2018, 2019, 2024, 2034.

### Policy implications emphasized in the text
- Need to build fiscal buffers to increase resilience to shocks (including cyclone damage and event-related cost overruns).
- Protect priority spending while managing the existing debt burden and new financing risks.
- Improve the debt management framework to better assess and mitigate fiscal and debt risks.

*Prepared by Asia and Pacific Department. Sources: Country authorities; and staff estimates and projections.*

### 1.      This supplement to the staff report summarizes the main developments since the

### _cr14240 - 1.      This supplement to the staff report summarizes the main developments since the

### Main update and staff position
- This supplement summarizes developments since the staff report was issued on June 24, 2014. Staff projections and the thrust of the staff appraisal remain unchanged.
- On June 24, the Parliament passed the FY2014/15 government budget.
  - Total expenditures estimated for FY2014/15 amount to 451 million pa’anga, including donor-supported in-kind expenditures of around 181 million pa’anga.
  - The budget entails a moderate deficit (13.7 million pa’anga).

### Recent macroeconomic indicators (June 2013–May 2014)
- CPI inflation (year-on-year by month): 0.2, 0.2, 0.9, 1.4, 1.4, 0.6, 0.8, 4.2, 4.7, 4.7, 3.9, 3.0.
- International reserves (months of imports by month): 9.1, 8.8, 9.0, 8.8, 9.1, 9.3, 9.8, 9.9, 9.9, 9.6, 9.3, 9.4.
- Source: Tongan authorities.

### IMF Article IV findings, projections, and risks
- Cyclone impact and growth:
  - A major cyclone in January 2014 caused damage estimated at 10 percent of GDP and depressed GDP growth in FY2013–14 (to June 30) by about 1 percent.
  - After sluggish growth of 0-1 percent in FY2012–13, growth is projected at 1.4 percent in FY2013–14 and 3.4 percent in FY2014–15, led mainly by post-cyclone reconstruction.
  - Medium-term growth expected to gradually converge to the historical trend of 1.7 percent, driven by remittances, tourism receipts, and credit growth.
  - Risks to the near-term outlook are tilted to the downside.
- Inflation outlook:
  - Headline CPI inflation largely fluctuated between 1 to 2 percent since mid 2012; expected to incrementally increase to 4-5 percent toward FY2018–19.
  - Risk to the inflation outlook assessed as low.
- Financial sector:
  - The deleveraging cycle of the Tongan banks appears to be ending, with both lending and asset quality indicators substantially improving.
- External sector and reserves:
  - External current account projected to show a deficit close to 3 percent of GDP in FY2013–14 and FY2014–15, largely financed by FDI inflows.
  - International reserves increased about threefold since 2008—to about 8 months of prospective imports; medium-term reserves expected to slightly decrease to 7 months of imports.

### Executive Board assessment and recommendations
- Near-term focus: reconstruction; medium-term priority: build buffers to enhance resilience to shocks and pursue business-enabling structural reforms for sustainable and robust growth.
- Fiscal policy recommendations:
  - Maintain overall fiscal prudence while accommodating cyclone-related financing needs.
  - Gradually increase the primary surplus and reduce the debt-to-GDP ratio over the medium term.
  - Continue revenue reform and wage restraint, strengthen debt management, and avoid cost overruns associated with the South Pacific Games.
- Monetary and financial sector recommendations:
  - Current accommodative monetary policy stance considered appropriate; NRBT should consider tightening monetary conditions when signs of credit growth firm up.
  - Expand NRBT’s regulatory mandate to include nonbank financial institutions.
  - Address bottlenecks in credit information and creditor rights.
  - Commercialization of Tonga Development Bank should be accompanied by robust safeguards.
- Growth and structural policy:
  - Encourage identification and strengthening of new engines of growth given geographic remoteness and exposure to natural disasters.
  - Promote FDI through business-enabling structural reforms; minimize and well-target tax incentives.

### Authorities’ stance and actions (Statement by Tonga’s representatives)
- Economic outlook and recovery:
  - Authorities broadly agree with the staff report and emphasize recovery following Cyclone Ian and need for sustainable long-term growth.
  - Authorities noted estimated nominal GDP for 2012-13 of T$802.4 million (US$446.1 million) and GDP per capita of T$7,771 (US$4,320).
  - NRBT revised forecast: economy to grow by 2.0 per cent in 2013-14; authorities expect around 3.2 per cent in 2014-15.
- Inflation and reserves:
  - Year-ended inflation rose from 1.1 percent in February 2013 to 4.7 percent in February 2014; fell to 3.0 per cent in May 2014.
  - Authorities project year-ended headline inflation around 4.0 percent in June 2014.
  - Gross official foreign reserves stood at T$266.8 million at end-May 2014, equivalent to 9.4 months of import cover (NRBT benchmark: 3 to 4 months).
- Monetary policy settings:
  - NRBT will maintain expansionary conventional monetary policy: not pay banks interest on exchange settlement account balances; not issue NRBT securities; maintain Statutory Required Deposit ratio at 5 per cent of deposits.
  - Policies to increase competition (opening of Pacific International Commercial Bank) and support commercialization of Tonga Development Bank; amendments enacted to Tonga Development Act from July 2014.
  - Authorities agree to tighten monetary policy once credit growth is sustained.
- Fiscal and debt management:
  - Total public debt estimated at $368.2 million (44 percent of GDP) at 30 June 2014.
    - Total external debt T$338.7 million (40 percent of GDP), nearly two thirds owed to EXIM Bank.
    - Total domestic debt T$29.5 million (3 percent of GDP); 56 percent held by financial institutions and over 24 percent by retirement funds.
  - Authorities agree with staff on need for policies to strengthen growth and improve fiscal management to enhance debt sustainability and to build fiscal buffers while protecting priority spending.
  - IMF upgraded Tonga from high debt distress to medium; World Bank and ADB project and budget support changed from 100 percent grant to 50 percent grant and 50 percent loan.

### Key quantitative projections and indicators (selected)
- FY2013–14 growth: 1.4 percent.
- FY2014–15 growth: 3.4 percent.
- Cyclone damage estimate: 10 percent of GDP.
- FY2014/15 total expenditures: 451 million pa’anga.
- FY2014/15 donor-supported in-kind expenditures: around 181 million pa’anga.
- FY2014/15 budget deficit: 13.7 million pa’anga.
- CPI inflation: decelerated from 4.7 percent in March to 3.0 percent in May.
- International reserves: declined to 9.4 months of current imports through May from 9.9 months at the beginning of the year.
- Gross official foreign reserves (end-May 2014): T$266.8 million = 9.4 months of imports.
- Total public debt (30 June 2014): $368.2 million (44 percent of GDP).
- Total external debt (30 June 2014): T$338.7 million (40 percent of GDP).
- Total domestic debt (30 June 2014): T$29.5 million (3 percent of GDP).
- Historical and projected GDP growth (selected years): Real GDP 2008/09 = 3.2, 2009/10 = 3.3, 2010/11 = 2.9, 2011/12 = 0.7, 2012/13 = 0.3, 2013/14 = 1.4, 2014/15 = 3.4.
- Consumer prices (period average) projections: 2013/14 = 1.5, 2014/15 = 1.7.
- Overall balance (in percent of GDP) projections: 2013/14 = -0.6, 2014/15 = -0.7.
- Current account balance (in percent of GDP) projections: 2013/14 = -3.3, 2014/15 = -3.0.
- Gross official foreign reserves (in months of next year's goods and services imports): 2013/14 = 7.8, 2014/15 = 7.3.
- Remittances (in percent of GDP) 2013/14 = 15.4, 2014/15 = 15.3.
- Nominal GDP (millions of T$) 2013/14 = 830.4, 2014/15 = 873.2.
- Population (thousands) 2013/14 = 103.7, 2014/15 = 103.9.

*Source: IMF staff report supplement and associated materials as provided in the content unit.*

### 13. To  strengthen  fiscal  management,  the  authorities  remain  committed  to  its  fiscal  consolidation

### 13. To strengthen fiscal management, the authorities remain committed to its fiscal consolidation

### Fiscal consolidation strategy and objectives
- Authorities remain committed to the fiscal consolidation strategy started two years ago, aimed at ensuring better management of public finances and returning to a more sustainable position.
- Consolidation objectives:
  - Strengthen the long-term position of the budget.
  - Rebuild policy buffers against future external shocks.
- Implementation steps:
  - Improve estimation of funding ceilings based on realistic assessments of revenue raising capacity, budget support and development assistance, and where appropriate prudent borrowing.

### Revenue reform measures
- Revenue reform warranted to improve the fiscal position while preserving capital expenditures and maintaining contingency funds.
- Planned revenue measures:
  - Continued improvements to revenue collection while avoiding the burden on businesses and consumers.
  - Limit erosion of the revenue base from exemptions by applying clear policy guidance rather than ad hoc decisions (taking account of target sectors, addressing structural disadvantages, improving performance of business, non-discretionary, fairness and transparency and protecting the revenue base).
  - Seek predictable levels of budget support to support sound budgeting.
  - Increase the revenue base through increased non tax revenue sources, e.g. offshore companies.
  - Improve returns from Government assets.

### Debt management and fiscal risk
- Efforts to further enhance prudent debt management:
  - Ensure that the sustainable debt policy remains up to date.
  - Manage the currency composition of debt to avoid over exposure to any one currency, or one source of funding.
- Medium-term fiscal strategy noted to ensure gradual stabilizing and reducing the risk of debt stress.
- Policy measures to anchor the fiscal position prioritized, including:
  - Policy of no new external commercial borrowing.
  - Cautious use of concessional loans only on a limited basis.
- Fiscal risk considerations:
  - Authorities mindful of fiscal risk from potential cost overruns and lower cost options to build South Pacific Game facilities.
  - Debt-related financing for the game facilities is not an option the authorities are considering, as the authorities do have the fiscal space available as buffer to absorb the downside risk.

### Financial sector developments and policy
- Recent lending and forecasts:
  - Total bank lending balances increased by 10.9 per cent over the year to May 2014.
  - This follows a 11.2 increased over the year in April 2014.
  - NRBT is forecasting lending to grow by around 10 per cent in 2013-14.
  - Faster growth expected in financial year 2015.
- Drivers of lending growth:
  - Imminent drawdown of some large loan commitments.
  - Expected fall in interest rates.
  - Anticipated improvement in economic conditions.
- Interest rate and margin statistics:
  - Tonga’s weighted average interest rate spread was less than 6.9 percentage points in May 2014.
  - This is the lowest in at least 36 months of comparable records since at least January 2001.
  - The weighted average deposit rate increased over the year to May 2014 by 9 basis points.
- Structural constraints and risks:
  - Lending rates are low by past-decade standards but unable to decline further due to structural issues contributing to high risk in lending, such as land administration issues and lack of bankruptcy laws.
- Authorities’ policy stance on liquidity and supervision:
  - Agree excess liquidity needs to be reduced gradually to support economic growth and prudent lending.
  - Unsafe and unsound practices through aggressive competition should be avoided to ensure financial stability and avoid increases in interest rates that could hamper recovery.
  - Intend to introduce growth friendly policy measures and continuously seek means to enhance support for credit growth given limited monetary policy instruments.
  - NRBT oversight to focus on banks’ credit risk management systems and enhanced oversight over the new bank and TDB’s commercialization process.

### Structural reforms and social protection
- Private-public sector partnership:
  - Authorities committed to strengthening private-public sector partnership to increase competition, improve quality and lower prices for consumers.
  - Promote FDI through business-enabling structural reforms while striking the right balance between promoting FDI projects and protecting the revenue base.
  - Seek to improve the business enabling environment so that government regulations and revenue reforms are more efficient and reduce regulatory burden on businesses.
- Social protection measures:
  - Measures to protect the vulnerable include expanding support to the elderly by lowering the starting point for aged welfare payments from 75 to 70 years.
  - New policies to protect the most vulnerable are in the process of being designed with support from a number of Tonga’s development partners.
- Public sector management reforms underway:
  - Public financial management reform.
  - Improving corporate plans related to budgets of ministries.
  - Strengthening staff performance management system with job descriptions aligned to ministry outputs.
  - Improving monitoring and evaluation of progress at all levels.
  - Emphasis that sound governance is essential for building public confidence and trust needed for good public-private partnerships.

### Final remarks and external support
- Authorities committed to safeguarding the Tongan economy and the financial system against shocks while maintaining monetary and fiscal prudence.
- Continued implementation of structural reform measures is essential to secure growth momentum in the medium and long-term.
- Authorities acknowledge considerable challenges ahead and that results will take time to materialize.
- Given Tonga’s capacity constraints, domestic efforts need to be supplemented by support from multilateral institutions and other countries.
- Authorities express sincere gratitude to the Fund, the World Bank, ADB, PFTAC and donors for their invaluable technical guidance and support over the years.

*Source: _cr14240 - 13. To strengthen fiscal management, the authorities remain committed to its fiscal consolidation*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14240.pdf_