Public Information Notice No. 07/102

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with Tonga

August 13, 2007

On July 11, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga.¹

Background

Economic activity was disrupted by the November 2006 unrest, albeit temporally, following the civil service wage settlement and the voluntary redundancy program in FY05/06 (fiscal year July-June). Real GDP growth, having slowed in FY05/06, is now estimated to turn negative in FY06/07, declining by 3½ percent. The external current account deficit is also estimated to widen to 10½ percent of GDP in FY06/07 from 8¼ percent of GDP in FY05/06, as imports remain steady despite the drop in output, and transfers reportedly declined. Meanwhile, consumer price inflation slowed to about 5 percent by early 2007, from about 10 percent in FY04/05, as the public sector wage increase does not appear to have put upward pressure on private sector wages so far.

The conduct of fiscal policy after the wage settlement contributed to mitigate its negative impact. In FY05/06, the fiscal balance swung into a deficit of 3⅓ percent of GDP from a 2½ percent surplus the year before. The wage bill rose to 20 percent of GDP from 12 percent of GDP in FY04/05, reflecting payment of the first installment of the wage settlement and the voluntary redundancy program. Nonetheless, non-wage spending was kept under tight control, and revenues increased sharply, much of the gains reflecting an improvement in collection efficiency brought about by the consumption tax introduced in 2005 and higher customs revenues. Despite revenue losses stemming from the November unrest, for FY06/07, the government has maintained its deficit target in the Budget of a deficit of 2⅓ percent of GDP, with buoyant revenue collection and a decline in the wage bill ratio to GDP.

The National Reserve Bank of Tonga (NRBT) took steps during 2006 to limit private credit growth and cope with the liquidity implications of the large severance payments. Credit ceilings, introduced in January 2006, were reset in July 2006 for the 6-month period to December to counter rapid credit growth reflecting strong demand for housing loans and ample bank liquidity. In addition, to contain the expected liquidity effects of the government's redundancy payments, the NRBT also stepped up its issuance of central bank notes. In the event, growth in private sector credit decelerated sharply to an annual rate of 10½ percent by end-December 2006. In early 2007, however, the NRBT eased liquidity in response to the riots, lowering reserve requirements and reducing the outstanding stock of notes, to support private credit for reconstruction and business restocking. Nonetheless, the public sector is also expected to play a large role in reconstruction, and the government is seeking a possible large external loan to finance those projects.

However, the economy will continue to be subject to uncertainty and shocks. While economic growth should return to positive, albeit low, levels in the medium term, there are lingering risks on the policy front that could derail efforts to restore stability, in particular those that might arise from pressures to increase public sector hiring. The government's borrowing plan currently being considered also raises serious concerns for debt sustainability, as debt service requirements would place serious strain on the medium-term fiscal and external positions, placing Tonga at a high risk of debt distress. Moreover, a further drop in remittances and terms of trade shocks could present significant pressures on official reserves.

Executive Board Assessment

Executive Directors welcomed the resilience of Tonga's economy in the face of recent large shocks, with inflation declining, continued financial stability, and a contained international reserve position. These achievements reflect the authorities' cautious economic policies, including a tight credit policy and the maintenance of a basket exchange rate peg. Looking forward, Directors stressed that impediments to private sector activity will need to be eliminated in order to improve medium-term growth prospects. A constructive political transition will help to limit economic vulnerabilities on both the domestic and external fronts.

Directors commended the authorities for pursuing prudent fiscal policies in a difficult environment, and looked forward to continued efforts to set fiscal policy on a sustainable track. While the persistent fiscal strains arising from the 2005 wage settlement have been partly contained through expenditure restraint and revenue gains, further fiscal consolidation through the prioritization of nonwage spending and the rationalization of public sector wage setting practices will be needed over the medium term. Directors also noted the importance of resisting pressure for new hires in the short term, and stepping up efforts to build public support for a continued reduction in civil service staffing over the medium term. They welcomed recent gains in revenue collection efficiency, and agreed that continued improvements in revenue administration and compliance will be critical, especially in light of the planned cuts in import duties and income tax reforms.

Directors stressed that a cautious public borrowing policy is essential to ensuring sustainable public and external debt dynamics. Noting the increased risks to external debt sustainability associated with the proposed reconstruction loan, several Directors encouraged the authorities to consider scaling back their borrowing plans or to attempt to improve the concessionality of the loan. Other Directors, however, pointed out the urgent need and positive growth effects of the planned reconstruction projects. Some Directors encouraged the authorities to maximize the role of the private sector in the reconstruction efforts. Directors also noted the financial risks stemming from a possible state acquisition of the power company.

Directors observed that, while monetary easing in the aftermath of civil disturbances had been justifiable in the short term, credit policy may need to be tightened if fiscal pressures re-emerge. In this light, they welcomed the NRBT's commitment to monitor monetary and credit developments closely. Directors looked forward to the reform of the legal framework supporting the use of indirect monetary instruments and enhancing the independence of monetary policy. They supported recent initiatives to improve financial sector supervision, while calling for continued vigilance in the face of rapid growth in credit to the household sector.

Directors agreed that Tonga's basket peg exchange rate regime has provided a credible nominal anchor and contributed to low inflation. They recommended that the authorities make greater use of the flexibility of their exchange rate regime, as needed, to counter real exchange rate appreciation, and welcomed the authorities' assurance that they will monitor developments affecting Tonga's external balance closely. Directors, however, also pointed to the role of structural reforms in preserving external competitiveness.

Directors underscored the importance of sustaining reform momentum in order to achieve faster growth through an enhanced business and investment environment and strengthened public enterprise performance. To this end, they encouraged the authorities to step up the pace of implementation of their public sector reform program and the recommendations of the

public-private task force on the business climate. Directors welcomed Tonga's accession to the World Trade Organization.

Directors encouraged the authorities to strengthen statistical capacity further, and supported continued assistance from the Fund to help improve the reliability, coverage, and timeliness of statistics.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.