IMF Executive Board Concludes 2009 Article IV Consultation with TongaPublic Information Notice (PIN) No. 09/122
September 22, 2009
Public Information Notices (PINs) form part of the IMF's efforts to promote transparency of the IMF's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. The staff report (use the free Adobe Acrobat Reader to view this pdf file) for the 2009 Article IV Consultation with Tonga is also available.
On September, 4, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga.1
Tonga’s recovery from the economic contraction and domestic political disturbance of 2006/072 has been halted by the global economic slowdown. Following a contraction of 1¾ percent in 2006/07, the economy rebounded by 2½ percent the following year, leading up to the coronation of a new king in August 2008. However, high international food and fuel prices followed by the global slowdown and tightening domestic financial conditions slowed growth and put pressure on international reserves.
Growth is estimated to have been less than ½ percent in 2008/09. Solid growth in the service and construction sectors was largely offset continued poor performance in manufacturing and agriculture sectors. Inflation, which reached 12 percent in mid-2008 as the economy struggled with high international prices, has moderated to around 2 percent.
Remittances fell by around 15 percent in 2008/09, reflecting the recessions in the two main source economies—the United States and New Zealand. The associated decline in import demand and declines in import prices reduced external pressures while unusually strong investment and capital flows in the latter half of 2008, both private and official, allowed reserves to increase slightly to over 4 months of import cover.
Fiscal revenue fell considerably below budget targets in 2008/09 as a result of reductions in tax rates, slowing growth and declines in imports. Tight expenditure control and significant increases in grants, however, enabled the government to deliver a fiscal surplus that will be used to establish a disaster and natural emergency fund. The 2009/10 budget aims to again achieve a surplus, excluding reconstruction borrowing, by improving revenue performance while raising public sector pay and increasing expenditure on infrastructure and social services. Loan-financed reconstruction of the central business district will, however, lead to an overall deficit of around 3 percent of GDP.
External debt declined to around 29 percent of GDP in 2007/08 as a result of fiscal consolidation and reduced donor disbursements. Initial drawdowns of a large reconstruction loan saw debt increase to around 31 percent of GDP at the end of 2008/09. Further loan utilization will see debt levels rise further in coming years.
2008/09 was a turbulent year for the financial sector. Following a period of rapid lending growth and tight liquidity, broad money began contracting in 2009 as deposits were withdrawn in response to worsening economic conditions. Credit growth halted as the Reserve Bank tightened monetary policy and commercial banks increased their lending requirements in response to an increase in bad loans. Interest rates have declined from their mid-2008 highs, but remain high. The exchange rate, which is a trade-weighted peg, appreciated around 6 percent in real effective terms during 2008.
Executive Board Assessment
Executive Directors observed that Tonga’s recovery from the 2006 disturbances has been hampered by global and domestic economic conditions. Remittances are declining in the wake of the global downturn and domestic banks are curtailing credit in response to a build-up of bad loans. Downward risks arise from the probability of a sharper-than-projected decline in remittances.
Directors noted that the authorities’ ability to respond to the downturn is limited. Fiscal policy is constrained by high public debt, while the scope for monetary expansion is circumscribed by relatively low international reserves. Against this background, Directors endorsed the authorities’ strategy of pursuing reconstruction while aiming for a small surplus in the non-reconstruction budget, and relaxing reserve requirements to ease pressures on domestic borrowers. Continued donor support will be important to help the authorities address the difficult challenges ahead.
Directors cautioned that revenue shortfalls may compromise the planned stimulus spending. They encouraged the authorities to devote greater attention to improving revenue enforcement, especially customs collections. The government should also prioritize expenditures carefully, and consider a more gradual implementation of the planned public wage increases. Directors welcomed the authorities’ contingency plan, in the event that revenues are lower than budgeted.
Directors noted that the large reconstruction loan will place a heavy debt burden on the country, which could be shouldered only if the loan-financed expenditure proves productive; GDP continues to grow over the medium term; and the budget remains balanced. Directors urged the authorities to vet proposed reconstruction projects carefully, approving only economically viable ventures. Financing for future infrastructure investments should rely as much as possible on domestic revenues and grants.
With reserves likely to remain in the lower part of the Reserve Bank’s comfort zone, Directors encouraged the authorities to maintain a cautious monetary policy stance and to stand ready to tighten should credit growth re-accelerate and the outlook for reserves and inflation deteriorate. Directors noted the staff’s assessment that the exchange rate remains consistent with external stability and that projected external current account deficits are sustainable. They welcomed the authorities’ intention to use the adjustment band within the current exchange rate peg if needed to safeguard reserve coverage.
Directors encouraged the authorities to make further efforts to enhance banking supervision to prevent a further deterioration in banks’ balance sheets. Regulation will need to remain vigilant to prevent further surges in high-risk lending.
Directors underscored the importance of structural reform for improving growth and raising living standards, guided by the authorities’ Strategic Planning Framework. They congratulated the authorities on the recent steps to rationalize public enterprises, and encouraged them to make further progress in this area and to sustain efforts to improve the business climate.
Directors recommended strengthening the statistical framework, noting that the recent advances in compilation need to be matched by improvements in the underlying data.