Mission Concluding Statement 

Kingdom of Tonga: Concluding Statement of the 2013 Article IV Consultation

March 25, 2013

This statement contains the preliminary findings and policy recommendations of the IMF mission, following discussions with the Tongan authorities and a range of private sector companies. The IMF team values the candid and comprehensive discussions with our official counterparts. We have benefited from the close and continuous interaction with the Tonga authorities and would like to express our sincere gratitude to them for their close cooperation.

Summary

The growth of the Tongan economy is expected to remain weak in fiscal year (FY) 2012/13, following the completion of selected public work projects. Beyond 2013, staff projects the economy to recover gradually, but growth rates to remain slightly below the historical trend before the global financial crisis. Risks to the near-term outlook are tilted to the downside, reflecting external risks and weak business confidence. In view of Tonga’s high level of external debt and the expected increase in debt repayment, fiscal consolidation should be sustained. The focus of monetary policy should increasingly shift to financial stability from active monetary policy, with the National Reserve Bank of Tonga (NRBT) standing ready to mop up excess liquidity with the bottoming out of the credit cycle. Efforts to overcome obstacles to credit growth should continue in order to support economic recovery. In this context, the government’s proposal to fully commercialize the Tonga Development Bank (TDB) has merits, but a due diligence process is needed to guard against fiscal and governance risks. Boosting Tonga’s long-term growth prospects requires strengthening investor confidence (including foreign investors). Against this backdrop, structural reforms to nurture the business environment are well placed and should continue.

The Economic Context

1. After achieving about 3 percent annual growth during the previous three years, real GDP growth slowed down to 0.8 percent in FY 2011/12. In the previous three years, public investment projects, particularly those funded by China’s EXIM bank, had offset the spillovers from the global financial crisis. However, those projects are now completed and a sharp slowdown in construction activity is exerting a drag on growth—along with weaknesses in remittances, other investment spending, and tourist arrivals. Staff expects these weaknesses to continue to limit growth to about ½ percent in 2012/13. Starting in 2013/14, a gradual recovery of remittances and tourism—along with improved infrastructure—is expected to raise growth to about 1¾ percent in the medium term.

2. Headline inflation has fallen significantly. After rising to 9.7 percent in May 2011 (above the official reference range of 6–8 percent), inflation plummeted to 1.2 percent in February 2013. The deceleration was driven mainly by declines in imported food prices and moderation in global oil prices. Going forward, inflation is expected to recover to a level consistent with the historical trend (about 5.5 percent), given the stable commodity price outlook. However, in the near term, there is an upside risk to inflation from the needed realignment of electricity prices to fuel costs.

3. Despite the continued contraction of remittances since 2008, increases in foreign grants and, more recently, a decline in imports, led gross official foreign reserves to rise by about 40 percent since December 2010, while the pa’anga appreciated by 2½ percent in real effective terms. In the medium term, however, the overall balance of payment is expected to return to a deficit, with the recovery of remittances more than offset by increased imports and external debt repayment. Gross international reserves are projected to fall, but remain above 4 months of imports (the NRBT’s target).

4. Risks to the near-term outlook are tilted to the downside given continued fragilities in the global economy as well as domestic vulnerabilities. The most imminent external risk relates to lingering concerns over fiscal policy in the United States (Tonga’s major source of remittances) and its potential impact on the nascent recovery. A re-intensification of euro area stress is also a major risk. On the domestic side, slippages in critical reforms, particularly those agreed with development partners could, by disrupting donor budget support, adversely affect Tonga’s macroeconomic stability. Failure to maintain fiscal prudence or to pursue Public Financial Management (PFM) reforms would also undermine investor confidence.

Near-Term Challenge: Rebuilding Policy Buffers and Improving Business Confidence

5. The current macroeconomic policy mix combines fiscal consolidation and monetary accommodation. The overall fiscal deficit fell from 7.4 percent to 2.7 percent of GDP in FY 2011/12; and the FY 2012/13 budget aims to eliminate the remaining deficit, mainly through a reduction in capital expenditure in line with the completion of the China-funded investment projects. Monetary conditions have remained accommodative for the last three years: lower reserve requirements, increases in international reserves, and limited central bank sterilization have led to the sharply higher excess reserves of banks.

6. The government should continue to focus on consolidating the fiscal position to restore fiscal space. High external indebtedness remains an important vulnerability, and grace periods on the external loans will expire in 2013/14. The mid-year assessment of the 2012/13 budget suggests that the actual revenue collection could be less than anticipated, mainly reflecting shortages in grants. However, the shortages will likely to be offset by corresponding cuts in grant-related expenditures and the wage freeze¹, resulting in a primary surplus of about 1½ percent of GDP. Staff supports the government’s intention to continue with the No New Loan Policy, even with lower than expected grant disbursements this year.

7. In the staff's view, the 2013/14 budget should aim to achieve moderate additional fiscal consolidation from the projected budget outcome in 2012/13— equivalent to about ½ percent of GDP in the primary balance—in order to preserve cash buffers in the face of the expected rise in external debt repayments. Moreover, a sound fiscal consolidation strategy should not factor in a debt relief scenario unless it materializes. Debt relief, should it take place, will provide some breathing space for the medium-term fiscal framework and debt sustainability, which should be prudently used for both cash buffers and priority spending. Management of currency risks posed by the external debt would benefit from improvement in hedging strategies, which could be enhanced including by technical assistance.

8. In the medium term, the gradual recovery of economic growth is expected to lead to a 1 percent of GDP increase in the revenue-to-GDP ratio, supported by revenue reform. In this context, it is advisable that the government continue to anchor the fiscal framework on the useable cash balance (broadly at the current level; about 2 months of recurrent expenditure), and reduce the share of the wage bill to 45 percent of recurrent spending. This path will enable priority spending to rise to about 1½ percent of GDP in the medium term, and protect capital investment outlays of around 2½–3½ percent of GDP.

9. The authorities should increasingly shift their policy focus from active monetary policy —focusing on efforts to support private credit to re-grow—to financial stability. Over the past three years, the transmission from accommodative monetary conditions to real economic activities has been limited, due mainly to the on-going repair of balance sheets both in banks and the private sector firms. Once signs become clear that the credit cycle is bottoming out, the NRBT should stand ready to mop up excess reserves, including by raising reserve requirements as needed.

10. Staff’s exchange rate assessment suggests that there is no evidence of misalignment of the exchange rate from the medium-term fundamentals. The current basket peg of the exchange rate has served the country well as a nominal anchor.

11. The authorities’ intention to convert TDB into a full-fledged commercial bank, and their intention to eventually pair it with a risk sharing facility, has significant merits. Given Tonga’s under-developed financial sector, measures to enhance access to credit, particularly by SMEs, will help mitigate market failure. A new commercial bank—which starts with no legacy assets—might even encourage incumbent banks to expedite balance sheet repair and to resume lending. However, expanding commercial banking at TDB also could potentially increase fiscal and governance risks, which should be properly addressed with the completion of a due diligence process being conducted by the IFC.

Strengthening the Macro-Financial Framework

12. A strengthened macro-financial framework is critical to build buffers against future shocks. Tongan banks’ efforts to clean up their balance sheets are expected to lead to a more resilient banking system. Efforts should continue to expedite this process, and to build a more robust regulatory and supervisory framework. The recent drawdown of fiscal space increases the importance of PFM and revenue administration reforms, which will help rebuild fiscal room for maneuver and improve the quality of spending.

13. The financial deleveraging cycle may have turned the corner. Latest data show that provisioning expenses are rapidly receding and credit contraction is starting to stabilize. Banks are positioning themselves to harness emerging business opportunities, with some embracing more aggressive approaches to identify the opportunities. The build-up of credit risks during the last credit boom demonstrated that home supervision and headquarters control—which are associated with foreign ownership—are not sufficient as a safeguard. In this regard, staff strongly supports the authorities’ continued efforts to strengthen on-site supervision capacities. The inauguration of a credit bureau is welcome, but there is a need to further strengthen the collateral framework including by addressing legal impediments to collateralizing lease rights on allotted lands. The planned enactment of Receivership Bill in 2013 will also be an important milestone in strengthening creditor protection.

14. Revenue reform continues to be a key medium-term priority, given the need to reduce Tonga’s reliance on donor grants and to protect growth-enhancing public expenditures. Staff strongly supports the creation of a presumptive tax regime for SMEs and the natural resource tax regime. Revenue reform efforts should include streamlining and enhancing the transparency of tax exemptions. Given Tonga’s revenue challenges, and loopholes generated by it, the mission recommends a freeze on new tax incentives. The promotion of investment, particularly from international investors, is strategically important. However, Tonga’s burdensome and (at times) non-transparent business regulations are a heavier burden on doing business than taxes. Transfers for socio-economic purposes should take the form of explicit grants or subsidies in the budget. The mission supports the recent initiatives to make the fiscal costs of tax expenditure more explicit and the planned review of existing exemptions against clear and transparent criteria. Updating both the Revenue and Customs Management Systems is an important priority for strengthening tax administration, as is the rationalization of tax penalties.

15. Downside risks to growth and tight fiscal space highlight the importance of continued progress with PFM reform. Major gains have been made in: (i) budget transparency, including through the publication of in-year fiscal reports and the financial statements of government; (ii) the establishing of a Treasury Single Account system; and (iii) better prioritization of budget allocations towards identified priority sectors, including through reductions in allocations to the contingency fund. Priorities going forward include: (i) addressing remaining deficiencies in the basic accounting and IT systems (e.g. updating personnel/payroll systems); (ii) strengthening the procurement process; and (iii) embedding corporate planning reforms and movement towards program budgeting. Formalization of the draft PFM reform plan is important to demonstrate commitment to the PFM reform agenda and to mobilize further technical assistance on this topic.

Reversing a Weakening of Trend Growth

16. Tonga’s efforts to develop the private sector are ongoing. Combined with the dilution of tariff preferences, new international competition has eroded Tonga’s niche markets. At the same time, a catching up of income (to source countries) through remittance channels may have reached its limit. Vast marine resources, potential to grow niche tourism, and a well educated and English speaking population are opportunities that can be explored, in particular if combined with selected deepening structural reforms.

17. Reforms focusing on policy coordination and deregulation are needed to improve the business environment. Tonga is facing difficult structural challenges, including size and remoteness. Addressing them in a way that improves growth prospects will require higher investment, including private investment. Improving the business environment will clearly facilitate this process, as will strengthening investor confidence.

18. Recent efforts to enhance intra-government coordination and dialogue with the private sector are welcome. The current framework (e.g., the Growth Strategy Committee) should be further strengthened, for example by establishing a high-level control tower to coordinate and oversee inter-ministry efforts to address impediments to private sector growth. A tailored support mechanism could be put in place, focusing initially on strategically important foreign investors (for example, a one-stop investor service desk as the intermediary between strategic investors and the regulatory agencies). Strengthened coordination will help increase policy effectiveness and transparency (including by breaking silos), and also better balance competing national causes–e.g. growth and sustainability.

19. The business licensing reform has achieved an important milestone by abolishing annual renewal requirements for the headline trade license, which is now subject only to an annual notification requirement. The reform initiatives could now focus on easing ancillary licenses, required by various regulatory agencies, in particular immigration visa (by lengthening renewal cycles); and reducing costs to business arising from outdated systems (e.g. land registration). In the latter case, a low cost fix such as a ‘fast track’ can achieve significant savings and promote transparency.

20. Improving access to information needed by new investors is also important. Enhanced communication on key ongoing reforms will also help boost business confidence. The Ministry of Commerce, Tourism and Labor’s plan to upgrade the investor information website to an interactive one can be an important first step.

21. Staff supports the authorities’ intention to develop tourism as the key engine of growth. An enabling business environment and foreign capital participation would be important to achieve this objective, as well as to revive growth in fishery and agriculture.

• Tourism. The mission supports on-going efforts to rebrand Tonga and strengthen destination marketing—there is a need to achieve consensus on which client segment and theme to focus on.
• Agriculture. The key bottleneck in this sector appears to be the lack of access to markets. Foreign investors who know their home markets can significantly contribute.
• Fishery. Consistent and predictable conservation decisions are important to promote investor confidence. A strategy is needed to better harness deep water fishery resources by enabling the flow of capital and carefully managing the access by foreign vessels.

22. The authorities’ plan to prepare a mining law is welcome given the need to prepare for a comprehensive framework for the emerging deep sea extractive potential. The IMF will explore contributing to technical assistance, working closely with other partners, as needed.

23. Continued efforts are needed to restructure distressed State-Owned Enterprises (SOEs), including Tonga Communications Corporation and International Dateline hotel. Identification of private partners for these SOEs would be buttressed by strong macroeconomic policies and commitment to business enabling reforms. On a related issue, the tariff on electricity should be realigned to fuel costs, while targeted transfers could be used to protect vulnerable electricity consumers. The financial positions of the SOEs should be better monitored and integrated into the national debt management framework, utilizing technical assistance if needed.

¹ The wage freeze policy was put in place at the start of FY 2012/13, and combined with constrained net hiring is expected to result in a significant under-implementation of the wage and employee contribution budget this year.