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### CONTEXT
- Tonga is a small remote open economy in the South Pacific with a narrow production base and low connectivity, resulting in high transportation costs, limited economies of scale, and high fixed costs.
- Population broadly constant at around 100,000 due to large-scale emigration.
- One of the highest-level recipients of remittances as a share of GDP among all developing countries.
- Development challenges: dependence on remittances, foreign aid, tourism, energy imports, protracted slower growth in advanced and emerging market countries (particularly Australia and New Zealand), natural disasters, and El Niño-related weather events.
- Cyclone Ian in 2014 caused damages estimated at 11 percent of GDP.
- Government prepared Tonga Strategic Development Framework (TSDF II) for 2015–25 with a focus on governance, inclusion, and private sector development.
- Authorities’ progress: improving primary fiscal balance, raising revenues, improving PFM, zero non-concessional borrowing policy, cautious movement on FX transaction levy and departure fee, structural reforms in utilities, labor market, public enterprise reform, formalization of the informal sector, bankruptcy regime, an energy bill, and exports promotion via regional trade agreements.

### RECENT DEVELOPMENTS, OUTLOOK, AND RISKS
- Recent developments:
  - Growth: accelerated from 2.1 percent in FY2014 to 3.7 percent in FY2015, supported by construction, tourism, strong remittances, and strong private credit.
  - Inflation: declined from 0.2 percent (y/y) at end-June 2015 to -0.3 percent at end-February 2016; domestic component edged up due to higher prices of locally produced food.
  - Reserves: $142 million at end-February 2016, equivalent to more than 6 months of imports.
  - Exchange rates: From end-FY2014 to February 2016, NEER depreciated by 3.6 percent; REER depreciated by 6.1 percent.
- Outlook:
  - FY2016 real GDP growth projected at 3.1 percent, driven by recovery in agriculture and increased construction for the South Pacific Games (SPG).
  - Medium-term growth projected to fluctuate between 2.3 and 3 percent, before converging to about 1.8 percent by FY2021.
  - Inflation expected to increase to three percent in FY2019 (reflecting SPG demand).
  - Current account expected to widen in run-up to SPG; reserves expected to remain comfortable and external debt stable provided donor financing for SPG is realized.
- Risks (overall balance tilted to the downside):
  - External: Protracted slower growth in advanced and emerging market economies (notably Australia and New Zealand) could reduce aid, remittances, and tourism.
  - Domestic: Resurgence of strong credit growth threatening financial stability; large increases in current expenditure, particularly wage bill, risking higher public debt and debt sustainability; slippages in policy reforms affecting donor support; cost overruns for SPG leading to non-concessional borrowing; natural disasters and weather-related events.
  - Upside: continued low oil and food prices would benefit Tonga as a net energy and food importer.

### AUTHORITIES' VIEWS
- Authorities concurred with staff assessment of outlook and risks; projected only marginally higher growth than staff in run-up to SPG, citing construction by local churches and a major school anniversary in 2016.
- Main risks identified by authorities: delay in budget support, natural disasters, increase in public debt including from excessive wage growth.

### FISCAL POLICY — POSITION, RISKS, AND RECOMMENDATIONS
- Fiscal position and projection:
  - Overall balance: reverted from a 1.7 percent surplus in FY2014 to a 1.1 percent deficit in FY2015; staff projects a further increase in the deficit to 3.1 percent in FY2016.
  - Revenues projected to increase due to administrative improvements, increased excises and customs revenue.
  - Decline in budget support grants, shift toward higher share of loan-financing by donors, and strong increase in current spending led by wages will widen the deficit.
  - FY2016 deficit financing: foreign loans, domestic bonds, and drawdown of government deposits; larger share of loan-financing by donors will contribute to higher deficit in FY2016.
  - Medium term: spending pressures from wages and SPG preparations will continue; provided wages are held in check and grant-financing for SPG is secured, the deficit is projected to decline.
- Public debt and DSA:
  - Current public debt around 49 percent of GDP.
  - Authorities avoid new non-concessional debt per the new debt management strategy.
  - Staff DSA: public and external debt sustainable under baseline but significant risks from (i) high wage pressure, (ii) donor financing shortfalls and SPG cost overruns, and (iii) natural disasters.
  - Tonga’s overall risk of debt distress under the DSA is classified as moderate.
- Staff policy recommendations to mitigate fiscal risks:
  - Restrain wage growth to the level consistent with inflation to lower wage share in current spending and GDP (wages share: 14 percent in FY2016).
    - Develop a new formula for COLA as an annual target starting FY2017.
    - Undertake broader civil service reform informed by the remuneration review to rationalize government employment and align pay scales with responsibilities while maintaining public service quality.
  - Rationalize public spending on SPG and seek donor grants for capital spending.
    - Estimates of capital financing for SPG range from T$78 to T$93 million; staff supports seeking grant financing where possible given debt sustainability risks.
  - Build fiscal buffers for natural disasters and SPG operating costs.
    - Maintain fiscal reserves at three months of current spending as prudent.
    - Fiscal consolidation needed to build buffers estimated at about 1.1 percent of GDP per annum over the next three years.
    - Use savings from expenditure rationalization to accumulate fiscal buffers.
  - Revenue and PFM improvements:
    - Focus on collection of remaining tax arrears, reviewing tax exemptions, and broadening the tax base.
    - Tax administration improvements: risk-based supervision, stricter enforcement, reorganization along functional lines, and implementation of ASYCUDA in customs with PFTAC assistance.
    - PFM improvements: procurement reform program, revising chart of accounts, improved commitment controls (enhancing IFMIS), and better budget reporting.
    - Establish an Audit Oversight Committee of the Cabinet; ongoing e-government initiative.
  - Public enterprise reform: ADB-assisted program to improve governance and financial results.
- Authorities’ fiscal actions and views:
  - Begun reducing vacancies; not ready to commit to a specific wage-growth target pending organizational effectiveness review.
  - Committed to seek grant-financing for SPG.
  - Debt actions: refinancing expensive debt to the Retirement Fund Board via government bonds and negotiating debt relief with Bank of China; need to secure resources to service large debt to China starting in FY2019 and establishment of a sinking fund.

- Tonga: FY2016 Budget and Staff Projections (in percent of GDP, unless otherwise noted)
  - Total revenue and grants: FY2015 Est. 28.6; Budget FY2016 33.3; Staff Proj. FY2016 27.3
  - Total revenue: FY2015 Est. 21.4; Budget FY2016 24.5; Staff Proj. FY2016 23.7
  - Current revenue: FY2015 Est. 21.4; Budget FY2016 24.5; Staff Proj. FY2016 23.6
  - Tax revenue: FY2015 Est. 18.3; Budget FY2016 20.2; Staff Proj. FY2016 20.4
  - Nontax revenue: FY2015 Est. 3.1; Budget FY2016 4.4; Staff Proj. FY2016 3.2
  - Capital revenue: FY2015 Est. 0.0; Budget FY2016 0.0; Staff Proj. FY2016 0.1
  - Grants (in cash): FY2015 Est. 7.2; Budget FY2016 8.7; Staff Proj. FY2016 3.6
  - Project grants: FY2015 Est. 4.5; Budget FY2016 6.5; Staff Proj. FY2016 1.5
  - Budget support: FY2015 Est. 2.7; Budget FY2016 2.2; Staff Proj. FY2016 2.0
  - Total expenditure and net lending: FY2015 Est. 29.3; Budget FY2016 35.2; Staff Proj. FY2016 30.4
  - Current expenditure: FY2015 Est. 25.8; Budget FY2016 30.9; Staff Proj. FY2016 27.8
  - Capital expenditure: FY2015 Est. 2.4; Budget FY2016 3.4; Staff Proj. FY2016 1.7
  - Total lending minus repayments: FY2015 Est. 1.1; Budget FY2016 0.9; Staff Proj. FY2016 0.9
  - Overall balance (incl. grants): FY2015 Est. -0.6; Budget FY2016 -2.0; Staff Proj. FY2016 -3.1
  - External financing: FY2015 Est. 0.6; Budget FY2016 1.0; Staff Proj. FY2016 1.4
  - Domestic financing: FY2015 Est. 0.1; Budget FY2016 0.9; Staff Proj. FY2016 1.7
  - Primary balance (incl. grants): FY2015 Est. 0.2; Budget FY2016 -1.1; Staff Proj. FY2016 -2.2
  - Primary balance (excl. grants): FY2015 Est. -5.9; Budget FY2016 -9.8; Staff Proj. FY2016 -5.8
  - Memorandum items:
    - Nominal GDP (in millions of pa'anga): FY2015 Est. 846.1; Budget FY2016 881.9; Staff Proj. FY2016 881.9
    - Grants in-kind (in percent of GDP): FY2015 Est. 7.9; Budget FY2016 9.7; Staff Proj. FY2016 9.7
    - Total external public debt outstanding (in percent of GDP): FY2015 Est. 44.2; Budget FY2016 43.1; Staff Proj. FY2016 43.1

### INTERNATIONAL RESERVES AND MONETARY POLICY
- International reserves and external stability:
  - Reserve cover: about 6 months of imports; assessed by staff as adequate and above NRBT’s target range of 3–4 months of import cover.
  - Staff estimate: reserves at around 6 months of imports are appropriate given Tonga’s vulnerability to external shocks and fiscal risks.
  - Staff recommendations if reserve pressure emerges:
    - NRBT should be ready to depreciate the Pa’anga against the basket of currencies to safeguard external stability.
    - More restrained fiscal policy could be needed to alleviate potential external pressures.
- Authorities’ view: agreed on need to maintain sufficient reserves but questioned whether current level is excessive given developmental needs and expected reserves to come down as investment projects scale up.
- Monetary policy stance and framework:
  - Monetary stance remained accommodative; staff judged no change warranted at this time.
  - Key aggregates:
    - Broad money (M2) growth: 18.2 percent (y/y) in February 2016, up from 9 percent (y/y) in June 2015.
    - Private credit growth: 14.6 percent (y/y) in February 2016, up from 8.6 percent in June 2015.
  - Drivers of credit growth: government-managed loan-subsidy scheme, lower lending rates, boom in construction, increase in commercial loans.
  - Staff view: recent credit growth started from a low level and shows no signs of overheating; monetary tightening not needed now but should be considered if overheating emerges.
  - Possible instruments for tightening: raising the reserve requirement or selling government bonds.
  - NRBT considering introducing a short-term policy interest rate; staff encouraged setting the neutral policy interest rate above the long run inflation rate and seeking IMF TA.
  - Inflation reference range:
    - Current reference range of 6-8 percent (introduced in 2011) undermined as inflation fell well below it.
    - Staff advised setting a reference rate at four percent, consistent with historic inflation and medium-term outlook.
- Authorities’ view: concurred with staff assessment; view raising reserve requirement as first defense against overheating; requested IMF TA to expand monetary policy toolkit; noncommittal on timelines for moving to a new inflation reference rate.

### FINANCIAL STABILITY, REGULATION, AND DEEPENING
- Banking sector:
  - Financial sector highly profitable and stable; banks have strong capital positions and are highly liquid.
  - NPLs remain elevated.
  - Average lending rate at 8 percent.
  - Credit-to-GDP ratio still under 30 percent.
- Macroprudential and supervisory measures:
  - Authorities willing to explore tools: loan-to-deposit ratio, loan-to-value ratio, caps on credit to specific sectors, caps on net interest margin.
  - Risks from government subsidy scheme with Tonga Development Bank minimal at this stage; lax lending standards could be a problem.
  - NBFIs: sector small and recently brought under NRBT supervision.
  - Legal reforms: amend NRBT Act and Banking Act to enable NRBT supervision of NBFIs, strengthen autonomy and accountability, provide powers to issue binding regulations, and clarify enforcement actions; adoption of Banking Act would improve banking resolution regime.
  - NRBT receives TA on risk-based supervision from PFTAC.
- De-risking: not yet an issue for Tonga; some money transfer operators closed, but remittance inflows remained stable and transaction costs decreased between 2014 and 2015; Tongan banks continue normal correspondence banking.

### FINANCIAL DEEPENING, STRUCTURAL REFORMS, AND CLIMATE RESILIENCE
- Financial inclusion and access to finance:
  - NRBT implementing SME finance project and conducting Demand Side Survey on credit demand determinants.
  - Measures: mandated credit reporting, extension of credit bureau coverage to non-bank credit providers, revision of the Land Act to improve collateral, deposit insurance.
  - Government on-lending scheme via TDB: lends government funds to small enterprises at 1 to 4 percent per year plus a fixed fee; staff recommends simplifying scheme and considering comprehensive microfinance approach.
- Structural reforms to raise growth potential:
  - Progress in regulated utilities, labor market, public enterprise reform, formalization of informal sector, revising foreign investment act and work permit rules, receivership bill, bankruptcy policy, National Energy Act based on Tonga Energy Road Map 2010-20, promoting exports via regional trade agreements.
  - FDIs in FY2015 estimated at 2.7 percent of GDP.
  - Staff recommended preparing a comprehensive private sector development strategy covering governance, transparency, business climate, access to external markets, transport, communications, human capital, and tourism; build resilience to climate change shocks.
- Natural disaster preparedness and resilience:
  - Tonga ranked second on risk of natural disaster based on World Bank Risk Index.
  - Funding arrangements:
    - Ex ante cash emergency fund of T$5 million.
    - Additional T$1.5 million donor funded emergency financing for rapid response assistance.
  - Additional options: contingency budget, sovereign catastrophe risk and traditional disaster insurance.
  - Staff DSA risk scenario: integrating projected fiscal costs of future natural disasters shows external debt will remain sustainable, albeit at an elevated level.

### NATURAL DISASTERS, HISTORICAL LOSSES, AND DSA SCENARIOS
- Hazard exposure:
  - Tonga exposed to cyclones, floods, earthquake, droughts, and sea-level rise; increasing frequency and intensity in recent years.
  - UN University World Risk Index ranked Tonga second of 171 countries in 2015.
- Historical losses and impacts:
  - EM-DAT: damages and losses equivalent to about 1.9 percent of annual GDP over 1996–2015.
  - For damage and losses equivalent to 1 percent of GDP, growth drops by 0.7 percentage point in the year of the disaster; actual damages during 1980-2014 reduced trend growth by 0.7 percent.
  - A 90th percentile event can undo 3.7 years of average development.
  - Cyclone Ian (January 2014): estimated cost US$45.4 million or 11 percent of GDP; staff estimates weakening of current account by 2.5 percent of GDP in FY2014.
- DSA key points:
  - Risk of external debt distress: Moderate.
  - Baseline: external debt distress indicators remain below country-specific policy-based indicative thresholds.
  - Bound tests: combined shock to GDP, exports, U.S. dollar GDP deflator and non-debt creating inflows breaches three debt ratios, with two breaching significantly and on sustained basis → supports moderate risk rating.
  - Alternative SPG/disaster scenario:
    - Assumes about T$100 million borrowed to finance SPG capital costs during FY2016–19 on China EXIM Bank terms: 2 percent interest, 20-year maturity, 5-year grace period.
    - Assumes natural disasters once every 4 years with GDP decline by about 2 percentage points and additional recovery spending of about 1 percent of GDP in following years.
    - Compared to baseline, debt ratios increase and narrow distance to thresholds but do not breach them → moderate risk rating remains.
    - Note: most recent projections of SPG costs range from T$80 million to T$100 million.
  - Public sector DSA vulnerabilities:
    - If primary balance remains at 2016 level throughout projection period, public debt becomes unsustainable.
    - If public wage bill grows at average rate of past three years (7 percent) during projection period, public debt becomes unsustainable.
- Key macro assumptions (selected):
  - Real GDP (avg): 2014 DSA 2014-19 avg 2.26; 2015 DSA 2015-20 avg 2.44; 2016 DSA 2016-21 avg 2.40
  - GDP deflator (percent change): 2014 DSA 2.66; 2015 DSA 2.06; 2016 DSA 0.84
  - Overall fiscal balance (percent of GDP): 2014 DSA -0.15; 2015 DSA -0.90; 2016 DSA -1.11
  - Primary balance (percent of GDP): 2014 DSA 0.77; 2015 DSA 0.06; 2016 DSA -0.30
  - Current account (percent of GDP): 2014 DSA -3.63; 2015 DSA -5.16; 2016 DSA -7.28

### DATA, TECHNICAL ASSISTANCE, AND EXTERNAL PARTNERSHIPS
- Data issues:
  - Data broadly adequate for surveillance but quality and timeliness remain a concern.
  - Improvements needed in labor market, household survey, population census, GFS, FSIs, and FAS.
  - Weak capacity and understaffing at statistics office; authorities plan to seek TA from IMF and PFTAC.
  - Tonga participating in e-GDDS since May 30, 2006.
- PFTAC country strategy 2016–17 priorities:
  - PFM and fiscal management: accounting and reporting improvements, upgrade FMIS, develop MTBF, improve cash/debt management.
  - Revenue administration: compliance improvement strategy, function-based organizational restructure, legal assistance on Revenue Services Administration Act.
  - Statistics: national accounts, BOP (BPM6), use tax returns to estimate GDP, support rebase and quarterly GDP.
  - Financial sector supervision: standard prudential returns, enhanced off-site analysis, on-site supervision techniques, credit union oversight program.
  - Macroeconomic forecasting and modeling: TOP Model development and training, satellite revenue forecasting tool development.
- World Bank–IMF and AsDB collaboration:
  - Shared priorities: sustainable fiscal management, exchange rate flexibility to safeguard external stability, promoting private drivers of growth (tourism, agriculture, fisheries, mining), improving energy/water/telecom efficiency, strengthening lending institutions and creditor rights.
  - World Bank commitments: nearly US$140 million in IDA and Trust Fund commitments over past six years; World Bank budget support FY2011–FY2016 total US$27.8 million.
  - AsDB financing since 1972: 15 loans and 14 grants totaling US$146.08 million; 69 TA projects valued US$22.42 million.
  - Joint programs and planned TA across FY2016–FY2018 from Bank and Fund.

### CONCLUSION — STAFF APPRAISAL AND AUTHORITIES' COMMITMENTS
- Staff appraisal — main points:
  - Economic performance improved in FY2015: growth strengthened, inflation declined, gross reserves comfortable, and private credit accelerated.
  - Positive outlook expected to continue in FY2016 and medium-term with strong external inflows and low fuel prices supporting domestic demand, but downside risks exist.
  - Fiscal policy: policy should address fiscal risks and build buffers; set a limit on annual wage growth in line with average inflation; broader civil service reform needed.
  - Given debt sustainability risk, staff supports seeking grant financing to cover SPG costs, strict control over expenditure, debt relief and refinancing, and building fiscal buffers for SPG operational costs.
  - External and monetary policy: maintain gross reserve buffers at current level; be ready to depreciate the Pa’anga if pressures emerge; accommodative monetary stance appropriate but vigilance needed; NRBT should be ready to mop up excess liquidity and adopt macro-prudential tools.
  - IMF stands ready to continue providing TA to NRBT on financial sector legislation and supervision.
- Authorities’ commitments and views:
  - Broad agreement with staff on debt sustainability risks; committed to fiscal discipline, lowering fiscal deficit, building fiscal buffers, and implementing structural reforms.
  - Fiscal year: starts in July. CPIA three-year average score: 3.47.
  - NRBT estimates economic growth of 3.3 percent for FY2016 (from 3.7 percent in FY2015 and 2.1 percent in FY2014); growth forecast to moderate to 1.9 percent in FY2017.
  - Foreign reserves reported as TOP323 million at end-April 2016, equivalent to 9 months of imports; standard reserve requirement cited as 3-4 months.
  - Authorities pursuing energy targets (50 percent RE by 2020), agriculture modernization (TOP36 million), and climate resilience; seeking TA and partner support.
  - Recent legislative measures: Foreign Exchange Levy (Amendment) Act 2016 passed April 28, 2016 effective June 1, 2016; departure fee likely beginning July 2016 to help finance Games operational costs.
  - Banking system indicators: RWCR at 37 percent; NPLs around 10 percent; banks’ weighted lending rate 7.94 percent in March 2016; deposit rates 2.23 percent; loans-to-deposit ratio around 76 percent.
  - Authorities advancing supervisory, regulatory and legal frameworks and monitoring de-risking impacts on correspondent banking.
- Debt sustainability conclusion:
  - Risks to debt sustainability increased somewhat versus 2015 DSA; classification remains moderate for external and public debt distress.
  - Recent debt-management actions: negotiating debt forgiveness with the Bank of China (T$8 million), refinancing debt to the Pension Fund, and finalizing the Debt Management Policy.
  - Emphasis on no new non-concessional borrowing and building fiscal buffers for contingencies such as natural disasters.

*IMF staff report excerpt for Tonga (2016).*

### 2016. The team comprised Elena Loukoianova (head), Agnes

### TONGA

### CONTEXT
- Tonga is a small remote open economy in the South Pacific with a narrow production base and low connectivity, resulting in high transportation costs, limited economies of scale, and high fixed costs.
- Large-scale emigration has kept the population broadly constant at around 100,000.
- Tonga is one of the highest-level recipients of remittances as a share of GDP among all developing countries.
- Tonga’s development is challenged by dependence on remittances, foreign aid, tourism, energy imports, protracted slower growth in advanced and emerging market countries (particularly Australia and New Zealand), natural disasters, and El Niño-related weather events.
- Cyclone Ian in 2014 caused damages estimated at 11 percent of GDP.
- The government prepared the Tonga Strategic Development Framework (TSDF II) for 2015–25 with a focus on governance, inclusion, and private sector development.
- Authorities have progressed on: improving primary fiscal balance, raising revenues, improving PFM, zero non-concessional borrowing policy, cautious movement on FX transaction levy and departure fee, and structural reforms in utilities, labor market, public enterprise reform, formalization of the informal sector, bankruptcy regime, an energy bill, and exports promotion via regional trade agreements.

### RECENT DEVELOPMENTS, OUTLOOK, AND RISKS
- Recent developments:
  - Growth accelerated from 2.1 percent in FY2014 to 3.7 percent in FY2015, supported by construction, tourism, strong remittances, and strong private credit, despite weather-related agricultural disruptions.
  - Inflation declined from 0.2 percent (y/y) at end-June 2015 to -0.3 percent at end-February 2016; domestic component edged up due to higher prices of locally produced food.
  - Reserves at $142 million at end-February 2016, equivalent to more than 6 months of imports.
  - From end-FY2014 to February 2016, NEER depreciated by 3.6 percent; REER depreciated by 6.1 percent.
- Outlook:
  - FY2016 real GDP growth projected at 3.1 percent, driven by recovery in agriculture and increased construction for the South Pacific Games (SPG).
  - Medium-term growth projected to fluctuate between 2.3 and 3 percent, before converging to about 1.8 percent by FY2021.
  - Inflation expected to increase to three percent in FY2019 (reflecting SPG demand).
  - Current account expected to widen in run-up to SPG; reserves expected to remain comfortable and external debt stable provided donor financing for SPG is realized.
- Risks (overall balance tilted to the downside):
  - External: Protracted slower growth in advanced and emerging market economies (notably Australia and New Zealand) could reduce aid, remittances, and tourism.
  - Domestic: Resurgence of strong credit growth threatening financial stability; large increases in current expenditure, particularly wage bill, risking higher public debt and debt sustainability; slippages in policy reforms affecting donor support; cost overruns for SPG leading to non-concessional borrowing; natural disasters and weather-related events.
  - On the upside, continued low oil and food prices would benefit Tonga as a net energy and food importer.

### AUTHORITIES' VIEWS
- Authorities concurred with staff assessment of outlook and risks.
- They projected only marginally higher growth than staff in run-up to SPG, highlighting construction by local churches and a major school anniversary in 2016.
- Main risks identified by authorities: delay in budget support, natural disasters, increase in public debt including from excessive wage growth.

### POLICY DISCUSSIONS — FISCAL POLICY
- Fiscal position and projection:
  - Overall balance: reverted from a 1.7 percent surplus in FY2014 to a 1.1 percent deficit in FY2015; staff projects a further increase in the deficit to 3.1 percent in FY2016.
  - Revenues projected to increase due to administrative improvements, increased excises and customs revenue.
  - Decline in budget support grants, shift toward higher share of loan-financing by donors, and strong increase in current spending led by wages will widen the deficit.
  - Projected deficit higher than FY2016 budget implying delay in FX levy and departure fee implementation, and under-implementation of projects constrained by capacity.
  - The FY2016 deficit will be financed by foreign loans, domestic bonds, and drawdown of government deposits; larger share of loan-financing by donors will contribute to higher deficit in FY2016.
  - In the medium term, spending pressures from wages and SPG preparations will continue; provided wages are held in check and grant-financing for SPG is secured, the deficit is projected to decline.
- Public debt and DSA:
  - Current public debt around 49 percent of GDP.
  - Authorities avoid new non-concessional debt per the new debt management strategy.
  - Staff DSA: public and external debt sustainable under baseline but significant risks from (i) high wage pressure, (ii) donor financing shortfalls and SPG cost overruns, and (iii) natural disasters. If materialized, deficits could widen and non-concessional borrowing may be necessary.
  - Tonga’s overall risk of debt distress under the DSA is classified as moderate.
- Staff policy recommendations to mitigate fiscal risks:
  - Restrain wage growth to the level consistent with inflation to lower wage share in current spending and GDP (wages share: 14 percent in FY2016).
    - Develop a new formula for COLA as an annual target starting FY2017.
    - Undertake broader civil service reform informed by the remuneration review to rationalize government employment and align pay scales with responsibilities while maintaining public service quality.
  - Rationalize public spending on SPG and seek donor grants for capital spending.
    - Estimates of capital financing for SPG range from T$78 to T$93 million; authorities are identifying donors; some interest from China and PNG but commitments unconfirmed.
    - Staff supports seeking grant financing where possible given debt sustainability risks.
  - Build fiscal buffers for natural disasters and SPG operating costs.
    - Given uncertainty over departure fee and FX levy revenue, contingency measures are needed.
    - Maintain fiscal reserves at three months of current spending as prudent.
    - Fiscal consolidation needed to build buffers estimated at about 1.1 percent of GDP per annum over the next three years.
    - Savings from expenditure rationalization should be used to accumulate fiscal buffers.
- Structural reforms to support resilience and revenue:
  - Focus on collection of remaining tax arrears, reviewing tax exemptions, and broadening the tax base.
  - Tax administration improvements contingent on risk-based supervision, stricter enforcement, reorganization along functional lines, and implementation of ASYCUDA in customs with PFTAC assistance.
  - PFM improvements: procurement reform program, better accounting and reporting (revising chart of accounts), improved commitment controls (enhancing IFMIS), and budget reporting functions to support governance.
  - Establishment of an Audit Oversight Committee of the Cabinet to improve audit timeliness and follow-up; ongoing e-government initiative.
  - ADB-assisted public enterprise reform to improve governance and financial results.
  - Fiscal structural reforms intended to create fiscal space for growth-enhancing investment in infrastructure and human capital.
- Authorities’ fiscal views and actions:
  - Authorities broadly agreed with staff on fiscal outlook and risks; identified excessive wage growth and disaster spending as main risks.
  - Begun reducing vacancies; not ready to commit to a specific wage-growth target pending organizational effectiveness review.
  - Committed to seek grant-financing for SPG.
  - Efforts to lower debt burden include refinancing expensive debt to the Retirement Fund Board via government bonds and negotiating debt relief with Bank of China.
  - Noted need to secure resources to service large debt to China starting in FY2019 and establishment of a sinking fund for this purpose.

- Tonga: FY2016 Budget and Staff Projections (in percent of GDP, unless otherwise noted)
  - Total revenue and grants: FY2015 Est. 28.6; Budget FY2016 33.3; Staff Proj. FY2016 27.3
  - Total revenue: FY2015 Est. 21.4; Budget FY2016 24.5; Staff Proj. FY2016 23.7
  - Current revenue: FY2015 Est. 21.4; Budget FY2016 24.5; Staff Proj. FY2016 23.6
  - Tax revenue: FY2015 Est. 18.3; Budget FY2016 20.2; Staff Proj. FY2016 20.4
  - Nontax revenue: FY2015 Est. 3.1; Budget FY2016 4.4; Staff Proj. FY2016 3.2
  - Capital revenue: FY2015 Est. 0.0; Budget FY2016 0.0; Staff Proj. FY2016 0.1
  - Grants (in cash): FY2015 Est. 7.2; Budget FY2016 8.7; Staff Proj. FY2016 3.6
  - Project grants: FY2015 Est. 4.5; Budget FY2016 6.5; Staff Proj. FY2016 1.5
  - Budget support: FY2015 Est. 2.7; Budget FY2016 2.2; Staff Proj. FY2016 2.0
  - Total expenditure and net lending: FY2015 Est. 29.3; Budget FY2016 35.2; Staff Proj. FY2016 30.4
  - Current expenditure: FY2015 Est. 25.8; Budget FY2016 30.9; Staff Proj. FY2016 27.8
  - Capital expenditure: FY2015 Est. 2.4; Budget FY2016 3.4; Staff Proj. FY2016 1.7
  - Total lending minus repayments: FY2015 Est. 1.1; Budget FY2016 0.9; Staff Proj. FY2016 0.9
  - Overall balance (incl. grants): FY2015 Est. -0.6; Budget FY2016 -2.0; Staff Proj. FY2016 -3.1
  - External financing: FY2015 Est. 0.6; Budget FY2016 1.0; Staff Proj. FY2016 1.4
  - Domestic financing: FY2015 Est. 0.1; Budget FY2016 0.9; Staff Proj. FY2016 1.7
  - Primary balance (incl. grants): FY2015 Est. 0.2; Budget FY2016 -1.1; Staff Proj. FY2016 -2.2
  - Primary balance (excl. grants): FY2015 Est. -5.9; Budget FY2016 -9.8; Staff Proj. FY2016 -5.8
  - Memorandum items:
    - Nominal GDP (in millions of pa'anga): FY2015 Est. 846.1; Budget FY2016 881.9; Staff Proj. FY2016 881.9
    - Grants in-kind (in percent of GDP): FY2015 Est. 7.9; Budget FY2016 9.7; Staff Proj. FY2016 9.7
    - Total external public debt outstanding (in percent of GDP): FY2015 Est. 44.2; Budget FY2016 43.1; Staff Proj. FY2016 43.1

*IMF staff report excerpt for Tonga (2016).*

### 13.      The staff emphasized the need to maintain adequate level of international reserves.

### 13. The staff emphasized the need to maintain adequate level of international reserves.

### International Reserves and External Stability
- Current reserve cover is about 6 months of imports and is assessed by staff as adequate, balancing economic costs of external shocks against costs of holding reserves.
- This level is above the NRBT’s target range of 3–4 months of import cover.
- Exchange rate is in line with fundamentals and there are no signs of deteriorating competitiveness.
- Staff recommendation if reserve pressure emerges:
  - The NRBT should be ready to depreciate the Pa’anga against the basket of currencies to safeguard external stability.
  - More restrained fiscal policy could be needed to alleviate potential external pressures.
- Staff estimate: reserves at around 6 months of imports are appropriate for Tonga given its vulnerability to external shocks and fiscal risks.

*Authorities’ views on reserves*
- Authorities agreed with staff’s exchange rate assessment and on the need to maintain sufficient reserves, but questioned whether the current level is excessive.
- They argued the opportunity cost of holding reserves could be higher given large developmental needs and expected reserves to come down as investment projects scale up.

### Monetary Policy
- Monetary stance remained accommodative; staff judged no change warranted at this time.
- Key monetary aggregates:
  - Broad money (M2) growth: 18.2 percent (y/y) in February 2016, up from 9 percent (y/y) in June 2015.
  - Private credit growth: 14.6 percent (y/y) in February 2016, up from 8.6 percent in June 2015.
- Drivers of credit growth: government-managed loan-subsidy scheme, lower lending rates, boom in construction, increase in commercial loans.
- Staff view:
  - Recent credit growth started from a low level and shows no signs of overheating; monetary tightening not needed now.
  - Monetary tightening should be considered if signs of overheating emerge, particularly if inflation spikes.
  - Possible instruments for tightening: raising the reserve requirement or selling government bonds.
- Medium-term framework enhancements:
  - NRBT is considering introducing a short-term policy interest rate to guide lending and deposit rates.
  - Staff encouraged setting the neutral policy interest rate above the long run inflation rate and to seek IMF TA on framework design and implementation.
- Inflation reference range:
  - Current reference range of 6-8 percent (introduced in 2011) has been undermined as inflation fell well below it.
  - Staff advised setting a reference rate at four percent, consistent with historic inflation and medium-term outlook while preserving a margin for shocks.
  - Any change in the reference rate should be publicly explained.

*Authorities’ views on monetary policy*
- Authorities concurred with staff assessment; view raising reserve requirement as first defense against overheating.
- They requested IMF technical assistance to expand monetary policy toolkit and were receptive but noncommittal on timelines for moving to a new inflation reference rate.

### Financial Stability and Macroprudential Policies
- Banking sector status:
  - Financial sector is highly profitable and stable; banks have strong capital positions and are highly liquid.
  - NPLs remain elevated.
  - Interest spreads declining; average lending rate at 8 percent.
  - Credit-to-GDP ratio is still under 30 percent.
- Macroprudential considerations:
  - Authorities willing to explore tools including loan-to-deposit ratio, loan-to-value ratio, caps on credit to specific sectors, and caps on net interest margin to prevent systemic risk buildup.
  - Risks from government subsidy scheme with Tonga Development Bank are minimal at this stage but lax lending standards could become a problem.
- Non-banking financial institutions (NBFIs):
  - NBFI sector remains small and was effectively unsupervised, though recently brought under NRBT supervision.
- Supervisory and legal reforms:
  - Ongoing work to amend the NRBT Act and the Banking Act to enable NRBT supervision of NBFIs, strengthen autonomy and accountability, provide powers to issue binding regulations, and clarify enforcement actions.
  - Adoption of the Banking Act would improve banking resolution regime (currently based on the Company Act).
  - NRBT continues to receive TA on risk-based supervision from PFTAC.
- De-risking:
  - De-risking of global banks has not yet become an issue for Tonga.
  - Some money transfer operators closed, but World Bank data indicate remittances inflows remained stable and transaction costs decreased between 2014 and 2015.
  - All Tongan banks have been able to continue normal correspondence banking activities with banks abroad.

*Authorities’ views on financial stability*
- Authorities concurred with staff assessment, committed to improving supervision and regulation with TA from PFTAC, and are monitoring de-risking risks.

### Financial Deepening, Structural Reforms, and Climate Change
- Financial inclusion and access to finance:
  - NRBT implementing SMEs finance project and conducting Demand Side Survey on credit demand determinants.
  - Measures: mandated credit reporting, extension of credit bureau coverage to non-bank credit providers, revision of the Land Act to improve collateral, deposit insurance—aimed to support access to finance and financial stability.
- Government on-lending scheme via TDB:
  - Scheme lends government funds to small enterprises in selected sectors at low interest rate, currently 1 to 4 percent per year, and a fixed fee.
  - Anecdotal evidence suggests difficulty accessing funding for small businesses with no credit history or collateral.
  - Staff recommendation: simplify scheme for small businesses and consider a comprehensive microfinance approach for the informal sector and unbanked population.
- Structural reforms to raise growth potential:
  - Progress in regulated utilities, labor market, public enterprise reform, formalization of informal sector, revising foreign investment act and work permit rules, receivership bill, bankruptcy policy, National Energy Act based on revised Tonga Energy Road Map 2010-20, promoting exports via regional trade agreements.
  - FDIs in FY2015 estimated at 2.7 percent of GDP.
  - Staff recommended preparing a comprehensive private sector development strategy.
- Natural disaster preparedness and resilience:
  - Tonga ranked second on risk of natural disaster based on the World Bank Risk Index.
  - Ongoing initiatives under TSDF II: rural electrification; energy efficiency; Disaster Risk Management training and improved communication; completion of specialized hazard maps and detailed analysis.
  - Funding arrangements:
    - Ex ante cash emergency fund of T$5 million.
    - Additional T$1.5 million donor funded emergency financing for rapid response assistance.
    - Ex post: flash appeal, bilateral and multilateral donor assistance, capital budget realignment.
  - Additional options to consider: contingency budget, sovereign catastrophe risk and traditional disaster insurance.
  - Staff DSA risk scenario: integrating projected fiscal costs of future natural disasters shows external debt will remain sustainable, albeit at an elevated level.

### Other Issues and Staff Appraisal
- Data issues:
  - Data broadly adequate for surveillance but quality and timeliness remain a concern.
  - Improvements needed in labor market, household survey, population census, government finance statistics (GFS), financial soundness indicators (FSIs), and financial access survey (FAS).
  - Weak capacity and understaffing at statistics office; authorities plan to seek TA from IMF and PFTAC.
  - Tonga participating in the Enhanced General Data Dissemination System (e-GDDS) since May 30, 2006.
- Staff appraisal — main points:
  - Economic performance improved in FY2015: growth strengthened, inflation declined, gross reserves comfortable, and private credit accelerated.
  - Positive outlook is expected to continue in FY2016 and the medium-term with strong external inflows and low fuel prices supporting domestic demand, but downside risks exist.
  - Fiscal policy:
    - Fiscal position expected to improve in the medium-term; policy should aim at addressing fiscal risks and building buffers.
    - Staff welcomes commitments to rein in the wage bill and recommends setting a limit on annual wage growth in line with average inflation.
    - Broader civil service reform needed for wage efficiency.
    - Given debt sustainability risk, staff supports seeking grant financing to cover SPG costs, strict control over expenditure, debt relief and refinancing, and building fiscal buffers for operational costs of the SPG.
    - Contingency measures may be needed if revenue from new taxes (FX levy and departure fee) falls below projections; monitor FX levy compliance with Article VIII.
    - Continued structural reforms and good debt management important to maintain fiscal sustainability.
    - Government should adhere to no non-concessional borrowing and seek opportunities to lighten debt burden.
    - Structural reforms should broaden the tax base, improve tax administration and PFM with TA from development partners and IMF (PFTAC).
  - External and monetary policy:
    - Maintain gross reserve buffers at the current level to safeguard external stability; be ready to depreciate the Pa’anga if external pressures emerge.
    - Current accommodative monetary stance appropriate given low inflation and strong external position, but vigilance needed to guard against macro-financial risks.
    - NRBT should be ready to mop up excess liquidity should signs of overheating emerge and adopt macro-prudential tools as needed.
    - IMF stands ready to continue providing TA to NRBT on financial sector legislation and supervision.

*Italic: IMF staff report section 13 summary as provided in the source content.*

### 34.      Staff supports the NRBT’s plan to strengthen its monetary policy framework. Staff

### 34.      Staff supports the NRBT’s plan to strengthen its monetary policy framework. Staff

### Monetary policy framework
- Staff welcomes the authorities’ intention to move away from the current inflation reference range, which "lost its usefulness as a guide for monetary policy," to a new indicative reference rate of inflation, set to be consistent with inflation outlook in the medium-term.
- Staff sees merit in introducing a policy interest rate to guide lending and deposit rates.
- Staff strongly encourages the NRBT to follow best international practices in setting the policy interest rate and developing the monetary instruments.
- Staff welcomes the NRBT’s TA request to MCM on:
  - enhancing monetary policy framework,
  - improving FX reserve management,
  - introducing macroprudential policies and instruments.

### Raising growth potential and private sector development
- Raising Tonga’s growth potential requires improving opportunities for private sector development.
- Staff commends the government’s initiative to improve financial access to support inclusive growth, but warns against excessive reliance on administrative methods of credit allocation.
- While supporting private sector via government lending schemes, such as in TDB, could be beneficial, caution is needed to ensure that public resources are applied effectively, and international experience should be studied in this regard.
- Staff notes progress on reforms to improve the business climate, including in the areas of regulation of utilities, labor market, and foreign investment.
- Staff encourages the authorities to prepare a comprehensive private sector development strategy to guide reform implementation in the medium term; such strategy should encompass:
  - governance,
  - transparency,
  - business climate,
  - access to external markets,
  - investing in transport, communications, human capital (health and education), and tourism,
  - building on the TSDF II.
- To ensure sustainability of the growth, a comprehensive national strategy along the lines presented by staff is needed build Tonga’s resilience to climate change shocks.
- Such strategy should encompass measures, including ongoing under TSDF II, to mitigate the risks and to cope once a disaster strikes.
- Staff welcomes efforts that are already underway to address climate change shocks.

### Improving economic data
- Improving economic data remains a high priority.
- Given the importance of data timeliness and quality for formulation of sound macroeconomic policies, staff encourages the authorities to strengthen capacity of the Tonga Department of Statistics, including through improving staffing, and seek technical assistance from the IMF’s Statistics Department and PFTAC on:
  - (i) the System of National Accounts, including developing quarterly GDP and moving compilation to SNA 2008,
  - (ii) external sector statistics,
  - (iii) GFS,
  - (iv) FSIs.

### Article IV consultation timing
- It is recommended that the next Article IV Consultation takes place on the standard 12-month cycle.

*TONGA  
INTERNATIONAL MONETARY FUND*

### Box 1. Tonga: Exchange Rate and Competitiveness

### Box 1. Tonga: Exchange Rate and Competitiveness

### Exchange rate assessment
- Tonga’s real effective exchange rate (REER) is broadly in line with medium-term fundamentals.
- Current account approach indicators:
  - Overvaluation: around 2.2 percent.
  - Current account gap: -0.2 percent.
- REER and nominal effective exchange rate (NEER) have been depreciating since September 2011, suggesting an improvement in external competitiveness.

### Other indicators of competitiveness
- Reserves
  - Gross international reserves remain adequate at about 6 months of the prospective imports in FY2016.
  - This is marginally above the target of 5.6 months of imports calculated using the IMF reserve adequacy template.
- Exports
  - Exports recovered quickly from a slump during the global financial crisis and have grown moderately in recent years.
  - In the medium term, exports are projected to grow at about two/three percent, in line with the overall economic growth.
  - Continued lower commodity prices are projected to negatively affect exports, but higher demand for agricultural products (squash and root crops) will compensate for this.
- Number of tourists
  - The number of tourists has increased steadily as Tonga attempts to become an attractive tourist destination.
- Costs of doing business
  - Tonga remains competitive compared with other PICs, according to the World Bank’s Doing Business 2016 report.
  - Relative strengths include: getting credit and electricity, dealing with construction permits, and starting a business.
  - Areas for improvement include: registering property and resolving insolvency.

*Prepared by Agnes Isnawangsih and Anh Lee (both APD).*

### Appendix I. Risk Assessment Matrix

### Appendix I. Risk Assessment Matrix

### External risks
- Structurally weak growth in key advanced economies
  - Scenario: An economic slowdown in key advanced countries (New Zealand, Australia, and the U.S.) hosting Tongan overseas workers could weaken remittance inflows. Tonga's exports would be also significantly affected.
  - Policy response to minimize impact: Preserve fiscal and external policy space to cope with adverse shocks in the short term. In the longer term, boost public investment, and pursue structural reforms to improve the investment climate and reduce dependence on aid and remittances.
  - Likelihood: High/Medium
  - Impact: Medium/High

- Significant China slowdown
  - Scenario: Tonga would be affected indirectly through China's trade links with New Zealand/Australia, and directly through a slowdown in Chinese official development assistance.
  - Likelihood: Low/Medium
  - Impact: Medium

- Persistently lower energy prices
  - Scenario: Tonga would on balance benefit from the lower energy prices. However, persistently lower oil prices would discourage certain investments, including in seabed mining and renewable energy.
  - Likelihood: High
  - Impact: Low

- Reduced financial services by global/regional banks (“de-risking”)
  - Scenario: Stricter global regulatory requirements could further push MTO to close down, which could potentially increase the cost of inward remittances.
  - Likelihood: Medium
  - Impact: Low

### Domestic risks
- Slippages in the execution of policy reform
  - Scenario: Slippages in the reform process could derail critical reforms agreed with development partners. Such an outcome could affect grant flows for budget support, resulting in a significantly larger gross financing gap.
  - Policy response to minimize impact: Take early remedial actions, including stronger commitment to ensure fiscal prudence, renewed reform efforts, and streamlining the Games, to redress impaired confidence and re-energize support by the donors.
  - Likelihood: Low
  - Impact: High

- Cost overrun relating to the 2019 South Pacific Games and wage pressure
  - Scenario: Excessive wage growth and/or underestimating the true cost of construction works could make it necessary to mobilize additional resources and might necessitate corrective fiscal consolidation in the long run.
  - Likelihood: Medium/High
  - Impact: High

- Natural disasters (regional)
  - Scenario: Natural disasters similar to the recent cyclone could take significant toll on Tonga, such as damages to infrastructure and production base.
  - Policy response to minimize impact: (i) building fiscal space and maintaining international reserve buffers, (ii) participating in catastrophic insurance schemes; and (iii) following disasters, using programs and funds available through global financial safety nets.
  - Likelihood: Low/medium
  - Impact: High

### Risk assessment notes
- The Risk Assessment Matrix (RAM) shows events that could materially after 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 ("low" is meant to indicate a probability below 10 percent, "medium" a probability between 10 and 30 percent, and "high" a probability of 30 percent or more).
- 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.

### Appendix II. Frequency and Impact of Natural Disasters in Tonga

### Hazard exposure and recent events
- Tonga faces a high risk to natural disasters and is exposed to cyclones, floods, earthquake, droughts, and sea-level rise.
- In the past five years, Tonga was affected by natural disasters more frequently than previously, with average sustained winds of cyclones passing through Tonga increasing.
- In early 2016, cyclone Ula battered northern islands of Tonga with minimum damage. In February, tropical cyclone Winston double hit Tonga within a week, leaving some minor damage and power outage.
- The United Nation University’s World Risk Index ranked Tonga second of 171 countries in 2015, up one rank from 2014 on account of deteriorating adaptive capacities.

### Historical losses and long-term effects
- Across the Pacific, Tonga is among the most affected by disasters over the past 20 years.
- According to the EM-DAT database, Tonga suffered damages and losses to property, crops, and livestock equivalent to about 1.9 percent of annual GDP over the period from 1996 to 2015.
- This is second only to Vanuatu, which experienced massive losses in 2014 after Cyclone Pam.
- For damage and losses equivalent to 1 percent of GDP, growth drop by 0.7 percentage point in the year of the disaster, according the IMF recent research.
- Actual damages and losses during 1980-2014 reduced trend growth by 0.7 percent.
- Post-cyclone incomes do not recover for 20 years, effectively pushing the GDP trajectory downwards.
- A 90th percentile event (i.e. wind speeds of up to 19.5 meters per second) can effectively undo 3.7 years of average development.
- Recent cyclone Ian in January 2014 is estimated to cost 45.4 million US$ or 11 percent of GDP.
- Staff estimates a weakening of current account by 2.5 percent of GDP in FY2014.

### Selected historical disaster entries from EM-DAT (Natural Disasters in Tonga, 1961-2015)
- Storm — 16-Mar-61 — Total damage: ... — Total affected (persons): 8000 — Total deaths (persons): 2
- Storm — 04-Dec-73 — Total damage: 500... — Total affected (persons): 3
- Earthquake — 23-Jun-77 — Total damage: 1200 — Total affected (persons): 550 — Total deaths (persons): 51
- Storm — 27-Dec-77 — Total damage: 1100 — Total affected (persons): 1000 — Total deaths (persons): 5...
- Storm — 03-Mar-82 — Total damage: 21200 — Total affected (persons): 1465 — Total deaths (persons): 126
- Storm — 30-May-82 — Total damage: 1100 — Total affected (persons): ... — Total deaths (persons): 1
- Storm — 02-Apr-90 — Total damage: 2500 — Total affected (persons): 310 — Total deaths (persons): 31
- Storm — 16-Mar-97 — Total damage: ... — Total affected (persons): 3000 — Total deaths (persons): ...
- Storm — 26-Dec-98 — Total damage: ... — Total affected (persons): 3071 — Total deaths (persons): ...
- Storm — 31-Dec-01 — Total damage: 513000 — Total affected (persons): 16500 — Total deaths (persons): ...
- Earthquake — 29-Sep-09 — Total damage: 95000 — Total affected (persons): ... — Total deaths (persons): 9
- Storm — 25-Jan-11 — Total damage: 13000 — Total affected (persons): ...... — Total deaths (persons): ...
- Storm — 06-Jan-14 — Total damage: 31000 — Total affected (persons): 40141 — Total deaths (persons): 1

### Estimated fiscal and balance-sheet impact (Example: Cyclone Ian)
- Estimated impact of Cyclone Ian:
  - Total expenditure and net lending: Pre FY 2014 = 26.3; Post FY 2015 = 25.7; Difference = -0.6
  - Total expenditure and net lending: Pre FY 2014 = 26.8; Post FY 2015 = 29.3; Difference = 2.5
  - Current account (in percent of GDP): Pre = -5.4; Post = -7.9; Difference = -2.5
  - Current account (in percent of GDP): Pre = -2.7; Post = -11.8; Difference = -9.1

*Prepared by Agnes Isnawangsih (IMF) and Johannes Wolf (AsDB).*

### 9.1 percent in FY2015 and an increase in total expenditure by 2.5 percent of GDP in FY2015.

### _cr16178 - 9.1 percent in FY2015 and an increase in total expenditure by 2.5 percent of GDP in FY2015.

### Fund relations: membership, resources, and exchange arrangement
- Membership: Joined September 13, 1985; Article VIII.
- General Resources Account (SDR Million / Percent Quota):
  - Quota 13.80 100.00
  - Total holdings of currency 10.36 75.10
  - Reserve position in the Fund 3.44 24.90
- SDR Department (SDR Million / Percent Allocation):
  - Net cumulative allocation 6.58 100.00
  - Holdings 5.37 81.54
- Outstanding Purchases and Loans: None
- Financial Arrangements: None
- Projected Obligations to Fund*: Charges/Interest 0.00 for 2015, 2016, 2017, 2018, 2019; Total 0.00 for 2015–2019
- Exchange arrangement: Pegged exchange rate within horizontal bands; pa’anga determined on weighted basket of U.S., Australian, and New Zealand dollars with U.S. dollar as intervention currency. July 2014: Fijian dollar added replacing Japanese yen. July 2010: monthly maximum adjustment limit raised to 5 percent from 2 percent.
- Last Article IV Consultation: Staff discussions February 2015; Executive Board concluded April 24, 2015 (IMF Country Report No. 15/107).
- Technical assistance highlights:
  - LEG assistance on AML/CFT (2002–2005) and on National Reserve Bank of Tonga Act and Financial Institutions Act (2013–2014).
  - PFTAC assistance on budgetary management, tax administration, banking legislation and supervision, balance of payments and national accounts statistics.
- Resident Representative: Regional Resident Representative Office for Pacific Islands opened September 2010 in Suva, Fiji. Mr. Tubagus Feridhanusetyawan is resident representative.

*Italicized note: As of April 20, 2016.*

### PFTAC country strategy 2016–17: objectives and priority TA
- Background and objectives:
  - Support authorities to sustain fiscal consolidation and improve macroeconomic environment amid slow growth, high non-performing loans, and high public external debt.
  - Strategy guided by APD regional strategy and PFTAC funding-cycle results framework.
- PFM and fiscal management priorities:
  - Implement high priority reforms from the Roadmap, including accounting and reporting improvements (1.7) and planning to upgrade government FMIS (1.7).
  - Support development of an effective medium-term budget framework (1.6), produce more accurate macroeconomic analysis (5.1), and improve cash/debt management (1.7).
  - Possible follow-up PEFA assessment, probably in 2018 (1.1).
- Revenue administration:
  - Support design/implementation of compliance improvement strategy and new function-based organizational structure.
  - Additional TA to improve core tax functions scheduled in FY2017.
  - Legal assistance to review/benchmark Revenue Services Administration Act with enactment of proposed amendments scheduled by end-2016.
- Statistics:
  - National Accounts produced on two independent measures (4.1); range of income indicators produced (4.3).
  - BOP statistics developed according to BPM6 standards (4.9).
  - Work on using tax returns to estimate GDP by production to support future rebase and potential quarterly GDP estimation.
  - BOP and GFS support transitioned from IMF HQ to PFTAC from 2015.
- Financial sector supervision:
  - Deployment of standard prudential returns (3.1) and enhanced off-site analysis (3.3).
  - Intensive support FY2015/16 to develop on-site supervision techniques (3.4, 3.5).
  - Review of NRBT’s Prudential Statements and drafted additional guidelines; introduction of credit union oversight program (3.9).
  - March 2016: IMF Legal Department completed desk review of Financial Institutions Act.
- Macroeconomic forecasting and modeling:
  - TA in 2015 to build capacity for forecasting and linking analysis into budgets; development of TOP Model (financial programming framework) (5.2).
  - October 2015: five-day workshop on practical applications of TOP Model; development of satellite revenue forecasting tool by MFNP and MORC.
  - Participation in High Level Dialogue on Enhancing Resilience to Natural Disasters (5.4) and workshops on fiscal frameworks, medium-term expenditure planning, and forecasting tax revenues (5.2).

*Italicized note: As of April, 2016.*

### World Bank–IMF collaboration: coordination and priorities
- Areas of cooperation:
  - Article IV Consultation: World Bank provided support and analytical inputs; co-prepared Debt Sustainability Analysis appendix.
  - Economic updates: IMF analysis used as basis for budget support decisions.
  - Structural fiscal reforms: Joint TA in public expenditure management, medium-term macro-framework, and structural policy issues.
- Shared macroeconomic and structural reform priorities:
  - Sustainable fiscal management:
    - Risks from South Pacific Games (SPG) construction costs and payroll pressures.
    - Need for clear borrowing policy to ensure borrowing supports high priority investments and remains sustainable.
    - Importance of revenue administration improvements, expenditure control, prioritization, structural reforms, and continued donor grants.
  - Exchange rate flexibility: Use flexibility afforded by current arrangement to safeguard external stability.
  - Promoting private drivers of growth:
    - Focus on tourism, agriculture, fisheries, mining.
    - Need to improve efficiency/regulation of energy, water, telecommunications; strengthen lending institutions and creditor rights; improve tourism infrastructure (including commercialization of Tonga Communication Corporation); lower regulatory barriers to foreign investment.
- World Bank financial support summary:
  - Total IDA and Trust Fund commitments to Tonga over past six years nearly US$140 million (compared to US$30 million between 1985 and FY2010).
  - World Bank budget support operations FY2011–FY2016: total US$27.8 million.
  - Two further budget support operations planned for FY2017 and FY2018.
- Planned Bank and Fund activities (February 2016–January 2018):
  - Bank work program highlights include procurement IT systems TA (FY2016), social protection and disaster risk management TA (FY2017), second inclusive growth DPO (FY2017), credit registry TA (FY2017), fiscal anchor TA (FY2018), tax exemptions TA (FY2017).
  - Fund work program highlights include External Sector Statistics (follow-up) (FY2015), PFM Roadmap (follow-up) (FY2015), Financial Sector Supervision (follow-up) (FY2015), 2015 Article IV Mission (February 2015), 2015 Article IV Staff Report/Board Meeting (April/May 2015), 2016 Article IV Policy Note (February 2016), 2016 Article IV Mission (March 2016), 2016 Article IV Staff Report/Board Meeting (June 2016).

*Italicized note: As of March 2016 where indicated.*

### Relations with the Asian Development Bank (AsDB)
- Alignment with national strategy:
  - AsDB Pacific Approach 2010–14 (extended until 2016) aligns with Tonga Strategic Development Framework (TSDF) II (2015–25).
  - AsDB Country Operations Business Plan 2016-18 supports Pacific Approach and TSDF II.
- Focus areas: mitigate environmental impact/strengthen climate resilience via renewable energy; enhance connectivity via multimodal networks and new technologies; support urban development.
- AsDB financing and TA since 1972:
  - 15 loans and 14 grants totaling US$146.08 million from ADF and other sources.
  - 69 technical assistance projects with value of US$22.42 million.
- Active projects include five grant-financed projects supporting connectivity (Tonga-Fiji Submarine Cable), Nuku'alofa Urban Sector Development (co-financed), Outer Island Renewable Energy (co-financed), Climate Resilience Sector project, and Cyclone Ian Recovery project (co-financing from New Zealand).
- No active country-specific TA projects; Tonga benefits from regional TA projects in private sector development, economic management, energy efficiency, ICT, and public financial management.
- AsDB active in joint policy reform discourse linked to budget support disbursements through policy-based lending modality.

*Italicized note: As of March 2016.*

### Statistical issues: coverage, quality, and priority improvements
- General:
  - Economic statistics broadly adequate for surveillance but data deficiencies complicate monitoring and policy formulation.
  - SD and MOFNP have received regular TA on national accounts, government finance, and BOP from STA and PFTAC; data provision to Fund continues with long delays.
- National accounts:
  - Coverage widened due to enhanced TA; partially incorporated 2009-10 HIES results.
  - Customs data supplemented with quarantine office data for merchandise exports and in-kind donor-funded capital projects and loan-financed projects.
  - Labor market statistics weak: employment statistics not compiled since 2003; average earnings statistics not available.
- Price statistics:
  - CPI based on basket from 2009-10 HIES.
  - TA in 2008 on import price index, but trade data quality insufficient.
- Government finance statistics (GFS):
  - FY2003 budget introduced presentation per 1986 GFSM; migrated to GFSM 2001 with FY2015 budget.
  - Timeliness and efficiency of reporting remain issues; source data often lagged; in-year reporting requires manual intervention.
  - Financial accounting system not upgraded; many government transactions recorded manually; debt management outside financial accounts; aid revenue not included in financial accounts.
  - Consolidated general government financial statistics not published; no data reported in GFS Yearbook to date.
  - Tonga participating in three-year GFS-IMF project for Asia-Pacific funded by Japan and committed to commence reporting for GFSY.
- Financial sector surveillance:
  - Tonga compiles FSIs but has not reported them to the Fund yet.
- Monetary and financial statistics:
  - NRBT reports central bank, other depository corporations, and monetary aggregates using SRFs; data first published in March 2008 IFS and IFS Supplement.
  - January 2012: NRBT updated data collection forms for other depository corporations largely aligned with Monetary and Financial Statistics Manual recommendations.
- External sector statistics:
  - SD compiles BOP and IIP quarterly in BPM6 format; reported annually to Fund.
  - Monthly trade figures from customs available with three-month lag.
  - NRBT compiles monthly foreign exchange transactions via OET with six-week lag; OET classification shortcomings noted.
  - Large net errors and omissions due to under-reporting of current and capital transfers and direct investment.
  - NRBT implemented new OET codes consistent with BPM6 since May 2014; SD carried out International Investment Survey (IIS) since 2014.
  - Challenges and priorities for improvement:
    - Improve coverage of financial account items by enhancing IIS response rate and gathering more accurate bank transaction data.
    - Obtain data on compensation of employees, remittances, and acquisition of goods/services by overseas workers.
    - Capture capital transfers accompanying major construction projects for BOP inclusion.
    - Maintain adequate staff resources for compiling and disseminating BOP and IIP to international standards.
    - Provide sufficient resources to undertake IIS regularly.
- Data standards and availability:
  - Participating in GDDS since May 30, 2006.
  - No data ROSC available.
- Table of Common Indicators Required for Surveillance (as of April 20, 2016) — sample entries:
  - Exchange Rates: Date of latest observation Mar-16; Date received Apr-16; Frequency MMM
  - International Reserve Assets and Reserve Liabilities: Mar-16 / Apr-16 / MMM
  - Reserve/Base Money: Feb-16 / Mar-16 / M M M
  - Broad Money: Feb-16 / Mar-16 / MMM
  - External Current Account Balance: Q2/2015 / Mar-16 / Q
  - Exports and Imports of Goods and Services: Nov-2015 / Jan-16 / M

### Debt Sustainability Analysis (DSA): external and public debt risks and scenarios
- Overall assessment:
  - Risk of external debt distress: Moderate.
  - This is the second joint IMF–World Bank DSA update since 2014.
  - Highest risks to debt sustainability arise from combined shocks to GDP, exports, the U.S. dollar deflator, and grants; public debt risks stem from strong wage growth.
- Key changes versus 2015 DSA:
  - GDP and exports deflators revised downward under new global price outlook, lowering nominal GDP and exports during projection period.
  - Fiscal balance deteriorates versus previous DSA reflecting higher wage spending and lower grants, and assuming more financing in the form of loans.
  - Current account deficit worsens, assuming larger non-debt creating inflows (capital grants cash and in-kind) in run-up to SPG.
- External DSA baseline:
  - Under baseline, all external debt distress indicators remain below country-specific policy-based indicative thresholds.
  - Rise in debt service ratios from 2019 to 2029 reflects repayments of two external loans from China EXIM Bank.
  - Bound tests: combined shock to GDP, exports, U.S. dollar GDP deflator and non-debt creating inflows breaches three debt ratios (PV of debt-to-GDP+remittances, PV of debt-to-exports+remittances, and debt service-to-revenue), with two breaching significantly and on sustained basis → supports moderate risk rating.
- Alternative scenario illustrating SPG borrowing and disaster shocks:
  - Assumes about T$100 million borrowed to finance SPG capital costs during FY2016–19 on China EXIM Bank terms: 2 percent interest, 20-year maturity, 5-year grace period.
  - Assumes natural disasters once every 4 years, leading to GDP decline by about 2 percentage points and additional recovery spending of about 1 percent of GDP in following years.
  - Compared to baseline, debt ratios increase and narrow distance to thresholds but do not breach them → moderate risk rating remains.
  - Note: "The most recent projections of the costs of the SPG range from T$80 million to T$100 million."
- Public sector DSA:
  - Baseline: present value of public debt projected to remain below benchmark and steadily decrease to below 20 percent of nominal GDP.
  - Vulnerability scenarios:
    - If primary balance remains at 2016 level throughout projection period, public debt becomes unsustainable.
    - If public wage bill grows at average rate of past three years (7 percent) during projection period, public debt becomes unsustainable.
- Key macroeconomic assumption table (selected entries; three DSAs compared):
  - Real GDP:
    - 2014 DSA 2014-19 avg 2.26
    - 2015 DSA 2015-20 avg 2.44
    - 2016 DSA 2016-21 avg 2.40
  - GDP deflator (percent change):
    - 2014 DSA 2.66
    - 2015 DSA 2.06
    - 2016 DSA 0.84
  - Overall fiscal balance (percent of GDP):
    - 2014 DSA -0.15
    - 2015 DSA -0.90
    - 2016 DSA -1.11
  - Primary balance (percent of GDP):
    - 2014 DSA 0.77
    - 2015 DSA 0.06
    - 2016 DSA -0.30
  - Growth of exports of G&S (U.S. dollar terms):
    - 2014 DSA 5.58
    - 2015 DSA 7.90
    - 2016 DSA 4.62
  - Growth of imports of G&S (U.S. dollar terms):
    - 2014 DSA 5.86
    - 2015 DSA 6.03
    - 2016 DSA 4.76
  - Current account (percent of GDP):
    - 2014 DSA -3.63
    - 2015 DSA -5.16
    - 2016 DSA -7.28
- Conclusion: Moderate risk of external debt distress under baseline and alternative SPG/disaster scenarios; public debt vulnerable to sustained weak primary balances or continued rapid public wage growth.

*Italicized line: Prepared by the International Monetary Fund and the International Development Association; May 26, 2016.*

### CONCLUSION

### CONCLUSION

### Debt sustainability risks
- Risks to debt sustainability increased somewhat compared to the DSA update of 2015, evidenced by the results of the most extreme shock simulations.
- Additional risks stem from the inability of the government to contain wage growth.
- Risk classification: external and public debt distress continues to be classified as moderate.
- Recent debt-management actions:
  - Negotiating debt forgiveness with the Bank of China (T$8 million).
  - Refinancing debt to the Pension Fund.
  - Finalized the Debt Management Policy.

### Authorities’ views and policy stance
- The authorities broadly agreed with the staff assessment of debt sustainability risks and strive to maintain robust debt policies.
- Concern that a higher share of loan financing by development partners (World Bank and Asian Development Bank) following Tonga’s upgrade to a moderate level of risk of debt distress in 2014 could undermine debt sustainability.
- Agreement with staff that other risks emanate from pressure to raise public sector wages and to finance the SPG, and that it is important to maintain fiscal buffers for contingencies, such as natural disasters.
- Country context notes:
  - The public sector comprises the central government and there is no local government in Tonga.
  - The Country Policy and Institutional Assessment (CPIA) rating for Tonga remains at a medium level with a three-year average score of 3.47.
  - The Tonga fiscal year starts in July.

### Macroeconomic outlook and key projections
- Growth and outlook:
  - NRBT estimates economic growth of 3.3 percent for FY2016, from an estimated 3.7 percent in FY2015 and 2.1 percent in FY2014.
  - Growth is forecast to moderate to 1.9 percent in FY2017.
- Inflation and prices:
  - Inflation picked up 1.4 percent (year-on-year) in March 2016.
  - Authorities expect an annual deflation of 0.84 percent by June 2016.
  - Authorities expect inflation to gradually pick up in FY2017; inflation risks may rise if oil prices persistently upturn.
- External accounts and reserves:
  - Foreign reserves grew to a record high of TOP323 million at end-April 2016, equivalent to 9 months of imports.
  - Standard reserve requirement cited as 3-4 months of import coverage.
  - Current account: narrowing in FY2015 attributed to lower oil and import prices; trade deficit expected to widen in preparation for the 2019 Pacific Games.
- Medium-term opportunities and risks:
  - Hosting the 2019 Pacific Games expected to boost services, tourism, and construction (airport refurbishment, hotel renovation, new resorts).
  - Potential benefits from seabed mining exploration (oil and industrial metals such as gold, silver and copper) over the next five years.
  - Downside risks: weak global growth for main trading partners, upturn in global oil and food prices, natural disasters, and volatile weather conditions.

### Fiscal policy stance and measures
- Authorities committed to fiscal discipline, lowering the fiscal deficit, and building fiscal buffers.
- 2015/2016 budget theme: “Improved Government Delivery and Accountability” to support Tonga Strategic Development Framework 2015-2025 (TSDF II).
- Four fiscal strategy principles: (i) delivering good governance; (ii) building inclusive and sustainable growth; (iii) alleviating poverty; (iv) providing safe and better public infrastructure.
- Civil service and wage measures:
  - Review of productivity, efficiency and effectiveness of line ministries underway.
  - Steps taken to eliminate half of the unfilled vacancies in the first three months of 2016; remaining vacancies to be gradually abolished.
  - A Remuneration Authority established to advise on COLA; Employment Relations Bill under review.
- Revenue administration and PFM improvements:
  - Measures adopted to improve tax and arrears collection; tax administration undergoing structural review with PFTAC assistance.
- Borrowing strategy:
  - Prudent fiscal and borrowing strategy of not incurring new concessional debt; working with development partners for budget support.
  - Inaugural Medium Term Debt Strategy (MTDS) produced by MoFNP to outline alternative borrowing strategies to achieve a more balanced public debt composition.
- Pacific Games financing measures:
  - Authorities confident of meeting funding requirements; working with development partners to secure grant financing.
  - Foreign Exchange Levy (Amendment) Act 2016 passed April 28, 2016 and effective June 1, 2016 to help finance Games operational costs.
  - A fee for airport departures likely to be levied beginning July 2016 for the same purpose.

### Monetary policy and financial stability
- Monetary policy stance:
  - Authorities agree the current accommodative monetary policy stance is appropriate and stand ready to act if overheating emerges.
  - Current inflation reference range cited as 6-8 percent.
  - Authorities keen to explore additional monetary policy instruments (macroprudential tools, liquidity management); welcome Fund technical assistance.
- Reserves and opportunity cost:
  - Authorities view reserves level as high given opportunity costs but acknowledge need to maintain current level given dependence on donor funds and remittances.
  - Outlook includes higher imports for the Games and principal loan payments starting in 2019.
- Banking system indicators:
  - Risk-weighted capital ratio (RWCR) at 37 percent, above the statutory minimum requirement of 15 percent.
  - Non-performing loans (NPLs) around 10 percent (down from 20 percent in FY2009).
  - Banks’ weighted lending rate stood at 7.94 percent in March 2016; deposit rates at 2.23 percent; interest spreads narrowing but still viewed as high.
  - Loans-to-deposit ratio around 76 percent, below benchmark of 80 percent, indicating potential room for prudent lending growth.
  - Authorities will monitor credit growth and excess liquidity and remain prepared to address risks to preserve financial stability.
- Regulatory and inclusion reforms:
  - NRBT advancing supervisory, regulatory and legal frameworks: laws for licensing and supervision of non-bank financial institutions (microfinance institutions, money lenders, credit unions), amendments to Foreign Exchange Control Act, and renaming Financial Institutions Act to Banking Act.
  - Initiatives to improve financial access and inclusion (Maputo Accord 2015, Alliance for Financial Inclusion), including SME finance policy, consumer protection, and financial literacy.
  - Authorities monitoring impacts of global de-risking on correspondent banking relationships for local banks and money transfer operators.

### Structural reforms
- Authorities concur with staff on need to create a conducive business environment to stimulate private enterprise and attract FDI.
- Legislative reforms under review to facilitate private sector development and improve land usability (Land Act review) to enhance access to credit.
- First National Agriculture Sector Plan endorsed by Cabinet in December (text cut off in source).

*Source: CONCLUSION, IMF Staff Report (Tonga) — content unit _cr16178 - CONCLUSION*

### 2015. This five-year plan identifies measures to boost and modernize the agriculture industry across

### _cr16178 - 2015. This five-year plan identifies measures to boost and modernize the agriculture industry across

### Agriculture modernization and investment
- Five-year plan to boost and modernize the agriculture industry across the board.
- TOP36 million of government and Public Private Partnership (PPP) funds will be invested.
- Plan will involve collaborations with the World Bank, International Fund for Agricultural Development (IFAD) and United Nations Development Programme (UNDP).

### Energy strategy and renewable energy targets
- Decline in fuel prices over the past two years have benefitted the economy, but Tonga remains vulnerable as an oil importer to volatilities in global commodity prices.
- Energy Roadmap launched in 2010 with an objective of achieving 50 percent renewable energy (RE) source by 2020.
- Vision involves the participation of seven ministries as well as the private sector.
- Steps undertaken include developing legislations to enable RE projects and PPP schemes, restructuring the petroleum sector to be more efficient, and working with development partners.
- Potential for greater use of renewable energy in Tonga including wind, ocean and solar energy, where 5.5 mW of solar energy is required to achieve the 50 percent RE target.

### Natural disaster exposure and climate resilience
- World Bank Risk Index notes Tonga is one of the world’s most exposed to natural disaster country.
- Apart from the provision for an emergency fund allocated in the annual budget, additional efforts are required to mitigate the risks of natural disasters including climate proofing of infrastructures and monitoring ocean and weather patterns.
- Cabinet recently approved a climate change policy which will look at data management, research and information, as well as capacity building in this area.
- Existing arrangements with close partners for emergency assistance are a crucial element to address these challenges.
- Authorities are working with various parties including the European Union and the World Bank on climate resilience projects.

### Data capacity and technical assistance needs
- Authorities agree with staff assessment on the need to increase capacity in its data provision, and the importance of data quality and timeliness.
- Authorities express appreciation for technical assistance received from the Fund and PFTAC.
- Authorities look forward to further technical assistance, especially on national accounts, external sectors and banking legislations.

### Final remarks and policy commitment
- Tongan authorities remain resolute in their commitment to implement broad-based structural reforms, and build buffers to meet potential headwinds with a view to achieve their long-term economic goals.
- Authorities will focus on the successful implementation of the policy recommendations, while maintaining adherence to the principle of good governance.
- Authorities acknowledge the support and assistance provided by the Fund including PFTAC, World Bank, Asian Development Bank, and other development partners, and look forward to continuing their long-standing cooperation and partnership with the Fund.

*Source: _cr16178 - 2015. This five-year plan identifies measures to boost and modernize the agriculture industry across*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2016/_cr16178.pdf_