IMF Executive Board Concludes 2011 Article IV Consultation with TongaPublic Information Notice (PIN) No. 11/54
May 16, 2011
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.
On May 4, 2011, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga.1
Tonga’s economy is recovering, on the back of increased construction activity and improvements in the external environment. GDP growth is estimated to rebound to 1¼ percent in fiscal year (FY) 2010/11 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.
CPI inflation rose to 6½ percent year-on-year 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.
The government’s stepped up capital expenditure in FY2010/11 helped to offset weaknesses in private demand. At the same time, generous grant inflows from donors during the same fiscal year contributed to narrowing the fiscal deficit to an estimated 4¼ percent of GDP (from about 5¾ percent of GDP in FY2009/10). Nevertheless, Tonga remains at a “high risk of debt distress” according to this year’s World Bank-IMF debt sustainability analysis.
Monetary policy was geared toward jumpstarting bank lending. In FY2010/11, the National Reserve Bank of Tonga (NRBT) remunerated banks’ exchange settlement account balances over TOP 1 million and maintained adequate liquidity in the system to encourage banks to step up lending. However, credit to the private sector continued to fall, albeit at a slower pace.
The slower decline in bank lending reflects some improvements in banks’ balance sheets. Banks are now well capitalized; and profitability has improved somewhat in recent months, but remains well below levels of the past years, owing to high provisioning. Nevertheless, banks are likely to maintain a cautious lending stance in FY2010/11 amid uncertainties on the outlook.
Executive Board Assessment
Executive Directors noted that Tonga’s economy is recovering from the recent internal and external shocks on the back of stronger tourism activity and fiscal expansion. The policy challenge now is to reduce the country’s vulnerabilities and to boost potential growth.
Directors stressed that in the near term, fiscal consolidation is necessary to ensure fiscal sustainability and expand fiscal space to respond to future shocks. They emphasized the importance of avoiding new borrowing, reducing current spending, especially by containing the wage bill, prioritizing expenditure, and strengthening tax administration.
For the medium term, Directors agreed that fiscal policy should aim at placing public debt on a downward path. This strategy should be integrated within a medium-term budget framework that is consistent with Tonga’s development objectives. Directors also encouraged the authorities to set up a comprehensive debt-management strategy to limit the credit and currency risks in the government balance sheet. They commended the authorities’ commitment to improve transparency in fiscal accounts, which will help secure continued grant financing to support the government fiscal consolidation efforts.
Directors considered the current monetary policy stance to be appropriate. However, if the liquidity overhang or higher global commodity prices exacerbate inflation and exert downward pressure on reserves, a preemptive tightening of monetary policy would be called for.
Directors welcomed recent measures to improve the institutional framework for lending and the efforts by the central bank to step up regulation and supervision. Further improving intermediation will require enhancing the legal framework for collateralized lending, increasing competition within an appropriate prudential and regulatory framework, and enhancing consumer protection and financial literacy. Directors encouraged the authorities to resist the pressure to administer the level of interest rates to avoid possible significant credit rationing and hampering banks’ ability to adequately price risks.
Directors noted the staff assessment that the exchange rate is broadly in line with fundamentals. To safeguard external stability, they encouraged the authorities to stand ready to use the flexibility within the bands of the pegged exchange rate to gradually depreciate the pa’anga. Any depreciation should be accompanied by further fiscal restraint, given the effects a weaker currency would have on the public debt.
Directors emphasized that promoting private sector activity is essential for strengthening the medium-term growth prospects. They underscored the importance of improving the land tenure system, making further progress in reforming public enterprises, reducing the number of business licenses, and lowering barriers to foreign investment.