Public Information Notice No. 04/76

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Tonga

July 29, 2004

On June 23 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga.¹

Background

Over the past few years, economic activity has been lackluster, while inflation has been on a steady rise. Real GDP expanded by 1.9 percent in 2002/03 (fiscal year July-June), down from 2¾ percent in 2001/02 (Table 1).² Growth has been supported by improving conditions in agriculture, construction, and a recovery in tourism, particularly since early 2002. But other sectors in the economy, such as fishing, wholesale and retail trade, transportation and communications, and some manufacturing, have continued to experience weak conditions. Inflation has risen from about 7 percent in 2000/01 to 11 percent in 2002/03, and remained around an average annual rate of 12 percent during the first four months of 2004. In recent years, imported inflation, along with the limited response of the supply side of the economy to rising budget deficits, increased recourse to domestic financing, and increases in electricity and tariff rates for tobacco and alcohol imports have also contributed to the higher inflation rate.

Budgetary performance has also deteriorated markedly. The budget deficit has risen from ⅓ percent of GDP in 1999/00 to about 3 percent of GDP in 2002/03. A weak economy, the knock-on effects from adverse external shocks, a sharp adjustment in public wages in 2000/01, and rising difficulties with tax administration and compliance have played an important role in the deterioration of public finances. But at the same time, public sector enterprises have reduced dividends to the government, and forced significant gross transfers and lending, particularly in 2002/03. As a result, capital spending has been compressed, and recourse to domestic financing risen. Total government debt reached 60 percent of GDP in 2002/03, although roughly 75 percent is external at concessional terms.

In June 2004, the government submitted its 2004/05 Budget to the Legislative Assembly for approval. In the budget, the deficit outturn for 2003/04 was estimated at ½ percent of GDP, compared to 1½ percent in the 2003/04 Budget. In addition, the new budget projects a deficit equivalent to 2½ percent of GDP in 2004/05. Revenue and grants are expected to increase by about 1 percent of GDP relative to the estimated outcome for 2003/04, mainly due to increases in nontax revenue and in grants, partly offset by lower income tax revenue. Expenditure and net lending is projected to rise by about 2½ percent of GDP. Most of this rise represents higher capital spending, reflecting anticipated increases in grants and external financing. The remainder of the spending rise is accounted for by wages and salaries and other current spending.

While remittances have provided a vital buffer to the economy, the current account deteriorated, posting a 3 percent of GDP deficit in 2002/03. External loans, together with high seasonal inflows, have contributed to raise official reserves from about 2 months of total imports in 2002/03 to 3½ months by April 2004. The increase in official reserves has also been assisted by credit demand conditions, as the ratio of bank loans to deposits declined steadily from close to a six-year high in early 2003. Nevertheless, credit still expanded at a rapid pace, as some banks resorted to offshore borrowing to support their loans and operations. Interest rates have become increasingly negative in real terms, and banks more reticent to hold government bonds, as these yield only 6½ percent and have long maturity.

In recent years, the National Reserve Bank of Tonga (NRBT) effectively used its discretion to adjust the pa'anga relative to the basket peg in order to preserve official reserves, with the pa'anga depreciating by about 8½ percent in real effective terms between July 2000 and June 2003. However, in the second half of 2003, the pa'anga appreciated by 9 percent in real effective terms against the basket of currencies, unwinding most of the depreciation in real terms since mid-2000.

The economic outlook is subject to considerable risks, particularly from a poor squash harvest in 2003, stagnant conditions in the fishing industry, the high indebtedness in some sectors and rising nonperforming loans in the banking system. The global recovery underway would lift remittances and tourism, but this sector would be affected by capacity constraints, particularly following the cancellation of Royal Tongan Airlines's operations. Construction projects, along with favorable

conditions for vanilla and kava, may help dampen the unfavorable outlook in other sectors. Inflationary pressure would persist on the back of higher commodity and oil prices, and deteriorating public finances, including higher public wages.

Executive Board Assessment

Executive Directors expressed concern about Tonga's continued weak economic performance. Adverse external shocks, poor fiscal management, and slow implementation of structural reforms have hurt economic growth and development and threaten macroeconomic stability and external viability. In addition, poor governance and lack of transparency in the public sector, combined with the loss of foreign assets in the Tonga Trust Fund, have adversely affected external confidence, reduced bilateral assistance, and further impaired the economy's ability to buffer adverse shocks.

Against this background, Directors urged the authorities to redouble efforts in the areas of fiscal and monetary policies and structural reforms. They welcomed the authorities' declared commitment to pursue the necessary measures to bolster policy performance, restore macroeconomic stability, and accelerate structural reforms. Resisting pressures from vested interests and mobilizing public support will also be critical for the success of the authorities' policies aimed at boosting private-sector led growth, reducing unemployment, and improving living standards. Directors also called on the authorities to act vigorously to strengthen fiscal management and restore the viability of public finances. They noted in this context that the costs associated with the collapse of Royal Tongan Airlines pose a major new risk to the budget, which should be averted by prompt implementation of corrective policy measures.

Directors considered that concerted efforts to limit the wage bill--which remains high by regional standards--and to contain transfers to public enterprises and the rest of the economy will be key elements in consolidating the fiscal deficit. In this regard, Directors expressed concern about the direction of the public service reforms underway, which could undermine much needed wage restraint and impede a genuine restructuring of the civil service. They reiterated the importance of public enterprise reform to improve the efficiency of these enterprises and significantly reduce any transfers to them.

Directors also underscored the importance of strengthening revenue performance through improvements in tax administration and reform of the tax system. They encouraged the authorities to proceed decisively and promptly with tax modernization and the implementation of the Revenue Service Administration Act to strengthen tax administration and compliance, notably with regard to large taxpayers and customs. Directors concurred with the view that the reform of the tax system should aim at simplifying its structure, broadening tax bases (especially by eliminating exemptions), and shifting the burden of taxation away from trade.

Directors saw a need to give more authority to the NRBT to allow it to conduct monetary policy more effectively. To this end, they encouraged the authorities to promptly enact proposed legislation that would recapitalize the Bank, limit the scope for it to finance the public sector, and strengthen its independence in setting reserve requirements and interest rates. Directors welcomed the authorities' intention to continue to maintain exchange

rate flexibility, and encouraged the authorities to use their discretion to adjust the value of the currency relative to the basket to which it is pegged, as needed to preserve competitiveness and protect official reserves.

Directors agreed that improvements in the country's medium-term growth prospects will require the authorities to expedite the implementation of structural reforms in the public sector and take steps to promote private sector development. They welcomed the initial steps that have been taken with respect to public financial management, public enterprise reform, and trade liberalization in the context of the Economic Public Sector Reform Program. While acknowledging the challenges facing small island economies such as Tonga, Directors considered that greater private sector participation will be helpful in expanding opportunities and boosting productivity and job creation, particularly in sectors where Tonga has a comparative advantage. They therefore encouraged the authorities to implement measures to improve investors' perceptions of Tonga as an attractive investment destination. Key steps should include improvements in governance, transparency, and accountability throughout the public sector.

Directors observed that the banking system remains well capitalized and profitable, although concerns were voiced about the recent increase in nonperforming loans. With low economic growth and an uncertain outlook, Directors encouraged the authorities to intensify the monitoring of risks at banks, particularly those with rising foreign liabilities and large exposure to sectors that could be adversely affected by higher oil prices and exchange rate changes. They encouraged the authorities to update legislation on Anti-Money Laundering/Combating the Financing of Terrorism.

Directors commended the authorities for the substantial progress made toward WTO accession, and encouraged them to finalize preparations for WTO accession soon.

Directors called for improvements in the reliability of national statistics to strengthen economic analysis and policymaking, and encouraged the authorities to make more effective use of technical assistance in these areas. They urged the authorities to audit fiscal accounts and improve the reliability of national accounts and external debt data.