Mission Concluding Statement 

March 28, 2011

The mission expresses its gratitude to all the government agencies and staff of the National Reserve Bank for generously providing their time and input to the meetings, and for their gracious hospitality.

Economic Developments

1. Tonga’s economy is recovering from the effects of the global financial crisis, the domestic credit crunch, and adverse weather-related shocks. The recovery is being supported by increased construction activity and improvements in the external environment.

• Growth. Growth is estimated to rebound to 1¼ percent in FY2010/11 on the back of stronger tourism activity and an expansionary fiscal policy financed by donor aid and previously contracted loans. Remittance inflows have stabilized in recent months and should provide additional impetus to growth during the remainder of the fiscal year. However, this growth momentum will likely be limited by continued tight domestic financial conditions as banks maintain tight lending standards following the large rise in nonperforming loans of the past two years.

• Inflation. CPI inflation rose to 6½ percent y/y in February 2011 reflecting mainly increases in global food and oil prices and one-off effects from higher excises on tobacco and alcohol. Inflation is likely to average around 6 percent in FY2010/11.

• External position. The trade deficit is expected to widen to 37½ percent of GDP in 2010/11 as the recovery in import demand outpaces that of exports. Consequently, the current account deficit is projected to rise to around 11 percent of GDP despite a turnaround in remittance inflows. International reserves should remain at comfortable levels with the disbursement of donor grants.

2. Macroeconomic policies remain accommodative.

• Fiscal Policy. In FY2010/11, generous grant inflows from donors helped narrow the fiscal deficit to an estimated 2 percent of GDP (from about 5¼ percent of GDP in FY2009/10). Despite this temporary improvement in the fiscal position, Tonga’s indebtedness has increased markedly over the past two years owing to two loans from EXIM bank of China with a face value totaling around 30 percent of GDP. The roll out of these loans and increased grants has helped finance stepped-up capital expenditure in FY2010/11, providing an offset to weaknesses in private demand.

• Monetary Policy. The National Reserve Bank of Tonga (NRBT) began remunerating at 1 percent banks’ exchange settlement account balances above TOP1 million, encouraging banks to reduce lending rates. However, credit to the private sector continued to fall, albeit at a slower pace, with banks maintaining tight lending standards to restore the health of their balance sheets.

Economic Outlook

3. Activity is expected to strengthen further in FY2011/12. Growth should reach around 1¾ percent, supported by strong construction and tourism activity, as well as increased remittance inflows. Banks’ profitability should improve and, with many losses realized, lending is likely to resume.

4. Inflation will likely continue to rise, but remain below the peak of 2007/08. While the uptick in inflation in FY2009/10 was mainly due to one-off effects, inflationary pressures are likely to continue through FY2010/11-12 reflecting higher global fuel, food, and other commodity prices as well as the expected recovery in domestic demand. The staff forecasts inflation to reach around 6 percent on average in FY2010/11-12 with most of this increase stemming from the imported component of inflation and limited pass-through to domestic inflation.

5. A key challenge for Tonga remains to lift medium-term growth prospects. Prospects have been held back by Tonga’s geographic isolation, its narrow export base, and unfavorable business environment. Staff expects medium-term growth to remain at around 1¾ percent. This medium-term outlook assumes stepped up capital spending, structural reform, improved fiscal management to support fiscal consolidation, and unchanged demographic trends, which have historically included a high emigration rate.

6. Risks to the outlook remain on the downside. A protracted rise in world commodity and food prices would hit Tonga’s economy hard, feeding through to inflation, growth, and the current account deficit. At the same time, if global growth falters, remittances, tourism, and exports could be hit, weakening economic activity and threatening reserves. In addition, Tonga’s high public debt leaves the country’s finances highly vulnerable to shocks, including natural disasters, limits the fiscal space for future spending on social and developmental priorities, and poses a risk to economic prospects. Mitigating the risks will necessitate further progress on structural reforms to raise the growth potential, continued grant provision from donors, as well as fiscal consolidation and prudent debt management.

Focus of Macroeconomic Policies in the Near and Medium Term

Macroeconomic policies in the years ahead need to focus on restoring the room for countercyclical policies, reducing the risks to Tonga’s external and fiscal sustainability, and laying the foundations for higher potential growth.

7. Fiscal policy in the near term. Tonga remains at a “high risk of debt distress” according to this year’s World Bank-IMF debt sustainability analysis. Therefore, the near-term fiscal stance should give priority to mitigating the risks to Tonga’s fiscal sustainability and create room to respond to future shocks. Reducing Tonga’s vulnerabilities will require avoiding new borrowing, reducing current spending, a careful prioritization of spending, improving tax administration, and transparency.

• Reducing current spending. We welcome the government plan to maintain the partial new hiring freeze in FY2011/12 at the level of the general government. There is also a need to maintain the wage bill at its 2010/11 level as the rapid rise in the wage bill since the redundancy program is hampering the provision of core public services and crowding out the government’s limited resources devoted to productive programs and the provision of social services. In addition, it is important for the government to ensure that the salary structure of civil servants adequately reflects performance and contributes to increasing efficiency in service delivery.

• Careful prioritization of spending. In rationalizing expenditure, there will be a need to align spending plans with the development priorities laid out in the National Strategy Planning Framework (NSPF) (see below) and ensure that all line ministries adhere to the annual management plans and budget targets.

• Improving revenue administration and collection. This will provide fiscal space for the delivery of core public services and promote fiscal consolidation.

• Improving revenue administration will require ensuring the proper classification and valuation of goods at customs, increasing compliance through the use of the unique tax identification number recently assigned to corporate tax payers, and increased training of customs officers. In addition, with the introduction of self-assessment, completing the automation of customs processing will provide resources to strengthen auditing and tax collection.

• Improving revenue collection will also require expanding the tax base by streamlining tax exemptions. For better transparency and fiscal control, exemptions could be replaced by transfers and explicitly brought into the budget.

• Improving transparency. We welcome the government steps toward increased transparency in fiscal accounts in the context of the Tonga Energy Road Map program and encourage the government to apply such a level of transparency to other fiscal activities. Improving transparency in the government fiscal accounts will help secure donor financial support and alleviate the burden of adjustment that lies on the government’s accounts. Greater details on the composition and distribution across line ministries of expenditure and revenue could be included in the budget papers for the upcoming fiscal year. Notwithstanding these measures, the staff projects the overall deficit (including grants) to widen to around 4¼ percent of GDP in FY2011/12 as many capital spending projects—financed through loans contracted during previous years—are rolled out and grants return to lower levels. The primary deficit is expected to reach 3½ percent of GDP.

8. Medium-term fiscal policy. Over the medium term, a primary surplus of 1 percent of GDP would be needed to put the fiscal position on a more sustainable path, bringing down public debt to around 30 percent of GDP by the early 2020s. This could be achieved through continued expenditure restraint as well as improved expenditure prioritization and revenue administration. There is a need to integrate within a single institutional medium-term budgeting framework this fiscal path, the annual budget, and the medium-term development objectives laid out in the NSPF. The staff believes that given Tonga’s vulnerability to shocks, implementation of such a comprehensive medium-term budget framework (MTBF) should start in the FY2011/12 budget. Early implementation of the MTBF will help guide medium-term policy efforts, anchor expectations, build policy space to address shocks, and signal to the donor community Tonga’s commitment to restoring fiscal sustainability. A successful implementation of such a strategy will require better reporting by line ministries, as well as improved capacity, fiscal control, and communication between different agencies involved in the budget process. In this regard, the staff welcomes the government decision to modify the budget process and to allocate funds at more aggregated levels consistent with priorities set in the NSPF. However, to avoid loss of control, this new program could be implemented on a pilot basis by limiting it initially to better performing ministries.

9. Debt management. A comprehensive debt management strategy is needed to limit the large credit and currency risks in the government balance sheet. The Fund stands ready to assist in developing such a strategy and expects to provide technical assistance organized by the Pacific Financial Technical Assistance Center (PFTAC) during the current fiscal year. Nevertheless, the mission encourages the authorities to proceed with the selection of eligible private sector construction projects (financed through the China EXIM loans) on a commercial basis to limit the credit risk to the government balance sheet and also risk of excess capacity in some sectors of the economy. Limiting the credit risk and reducing the risk of excess capacity will free resources for development priorities set out in the NSPF.

10. Public sector enterprises. The staff welcomes the recent government decision to publish the audited accounts of all public enterprises, change the composition of the boards, and make board members more accountable. These changes should improve corporate governance. For increasing efficiency and reducing risks to the budget, it is important public enterprises are run on a commercial basis. We encourage the government to move ahead with corporatization and privatization plans, while providing amendments to the regulatory structure to promote competition in goods and service markets and foster medium-term growth.

11. Monetary policy. NRBT’s efforts to remunerate banks’ exchange settlement account balances over TOP1 million and maintain adequate liquidity in the system are appropriately aimed at encouraging banks to step up lending. While these efforts have helped to lower lending rates, credit by commercial banks remains limited as banks have tightened lending standards and uncertainty remains about the economic outlook. With ample liquidity in the banking system, there is little need for further policy loosening, however, and the mission considers that the NRBT should maintain its current stance. However, if monetary conditions were to normalize faster than anticipated, the existing liquidity overhang could exacerbate inflation and exert downward pressure on international reserves. In such a case, monetary policy will need to be tightened through a combination of hikes in interest rates on the NRBT repo facility, the issuance of central bank paper, and reserves requirements. At the same time, a protracted run up in global commodity prices could also cause inflation to rise above and reserves to fall below levels expected in the baseline, but in such a case there would be no need for a tightening of monetary policy if core inflation remains stable as it did during the 2007–08 global food and fuel prices hike. Rather, the appropriate policy response would be to further advance fiscal consolidation, while providing targeted support to the poor.

12. Monetary management. The staff continues to believe that pressure to administer interest rates should be resisted. Bank profitability in Tonga, including interest rate spreads, does not appear to be excessive when compared to other South Pacific jurisdictions. Administering interest rates would hamper banks’ ability to price risk and reduce the availability of credit for riskier borrowers.

13. Exchange rate. The staff assesses the exchange rate as broadly in line with fundamentals. If downward pressures on reserves emerge, the NRBT will need to gradually depreciate the pa’anga against the basket within the flexibility afforded by the current exchange rate arrangement in order to safeguard external stability. However, to be effective, such depreciation would need to be accompanied by further fiscal restraint given the effects a weaker currency would have on the public debt. Also, NRBT should consider updating the weights in the currency basket to ensure that the weights are consistent with the changing structure of the economy, including trade patterns and the emergence of renminbi debt.

14. Banking system. Banks are well capitalized; profitability has improved somewhat in recent months, but remains well below levels of the past years, owing to high provisioning. In order for credit growth to normalize, further improvements will be needed in banks’ balance sheets, in Tonga’s economic growth prospects, and in the institutional framework for lending. The enactment of the Personal Property Security Act will go some way toward reducing risks to bank lending but more efforts are needed. Progress needs to be made in instituting a centralized credit bureau and modifying the legal framework to ensure timely registration and recovery of collateral, including a secured bankruptcy protection law. Implementation of such changes, together with effective supervision of banks to ensure financial stability, have the potential to reduce borrowing costs, improve access to finance, and lay the foundations for stronger economic growth. We welcome NRBT stepped up regulation and supervision and its plan to adopt a standardized examination report format. However, capacity constraints continue to limit NRBT’s ability to conduct effective supervision. Therefore, while technical assistance provided by PFTAC will continue to assist NRBT to strengthen capacity to examine the safety and soundness of banking institutions, longer-term donor-financed assistance may be required.

15. Medium-term growth. Rebuilding Tonga’s policy space and reducing the country’s vulnerability to shocks also hinge on strengthening medium-term growth prospects. This, in turn, requires promoting private sector activity—a key objective of the government NSPF. We continue to encourage the government to extend land leases to 99 years for all allotments and activities to encourage construction and investment, make further progress with public enterprise reform to level the playing field between public and private enterprises, reduce the number of business licenses, and lower barriers to foreign investment. Improving efficiency in the delivery and generation of utilities, as currently envisaged, will reduce the cost of doing business. In this regard, we welcome the government adoption of the Tonga Energy Road Map, which should reduce Tonga’s vulnerability to oil price shocks and improve the cost-effectiveness of energy.

16. Social issues. The decline in remittances following the global financial crisis and rising food prices have contributed to increasing hardship in Tonga, particularly in the outer islands and outside the main urban center of Nuku'alofa. Moreover, preliminary results of the 2009 household income and expenditure survey show that hardship has been increasing in Tonga during the past decade. Therefore, there is a need to speed up reforms to lift Tonga’s medium-term growth and advance fiscal consolidation to free up resources for social protection programs, such as establishing a contributory pension scheme and increasing coverage of health insurance and workers’ compensation, and allow the government to focus on inequality and labor market policies.