Mission Concluding Statement 

Tonga: Staff Concluding Statement of the 2022 Article IV Mission

May 13, 2022

Washington, DC: Tonga’s economic activity is slowly normalizing following the Hunga Tonga Hunga Haʻapai (HTHH) volcanic eruption and the local outbreak of COVID-19 in early 2022. The authorities’ strong policy response, together with swift humanitarian assistance by the international community, helped keep the economy afloat and protect the vulnerable. Tonga now faces a daunting challenge of reconstructing its economy while coping with high inflation due to surging global energy and food prices. Fiscal policy should be expansionary in the short term with focus on social protection and reconstruction, accompanied by reforms to strengthen the public finances in the medium term. Monetary policy should stand ready to tighten if inflation is expected to stay elevated for longer. Ongoing efforts to strengthen financial supervision and access to credit should continue. To achieve Tonga’s long-term development goals, bold structural reforms are needed to develop the private sector, including building climate-resilient infrastructure, improving internet connectivity, and lowering barriers for foreign direct investment.

Recent Economic Development

1. Tonga’s nascent economic recovery has been severely disrupted by a double blow from the HTHH volcanic eruption and the first local outbreak of COVID-19 at the start of 2022. After sustaining an earlier double shock from Tropical Cyclone Harold (April 2020) and the pandemic overseas, Tonga’s economy had been slowly regaining momentum since the second half of 2021, underpinned by strong remittances and policy support. But the recovery was derailed by the volcanic eruption and the COVID-19 outbreak, which put virtually all activities to a halt in the first quarter of 2022. Tourism facilities were particularly hit hard due to extensive damages caused by the tsunami, and agriculture suffered from volcanic ashfalls. The economy has gradually reopened since April, as mobility restrictions eased in line with declining COVID-19 cases. Reconstruction of homes and ash clean-up activities are well underway, with support from the international community through provisions of humanitarian aid and financial assistance.

2. Inflation rose markedly since July 2021, largely reflecting higher import prices. Headline inflation averaged 7.8 percent (y/y) from July 2021 to March 2022, above the National Reserve Bank of Tonga’s (NRBT’s) reference rate of 5 percent. The rise in inflation was mostly driven by higher import prices and, after the volcanic eruption in January 2022, also by disruptions in domestic supply conditions. A measure of core inflation (excluding food and energy) estimated by IMF staff at end-March 2022 stood at a moderate 3.4 percent after peaking at 4.2 percent in June 2021.

3. The fiscal balance switched to a deficit in FY2021 due to COVID-related current expenditures. The government achieved a much-needed fiscal consolidation during FY2016‒FY2020 through improvements in revenue collection, generally effective controls on current spending, and donor support. In response to the pandemic, the government implemented a fiscal package worth 5.3 percent of GDP on health care and social protection, complemented by tax relief. As a result, the fiscal balance turned from a surplus of 5.3 percent of GDP in FY2020 to a deficit of 0.9 percent in FY2021.

4. The external position in FY2021 is preliminarily assessed as broadly in line with medium-term fundamentals and desirable policies. The current account balance (CAB) is estimated to have pivoted from -3.9 percent of GDP in FY2020 to 2.6 percent in FY2021, mainly reflecting an increase in remittance inflows of 36 percent in FY2021, as the Tongan diaspora supported their families, and grants from development partners, which together more than offset a sharp drop in tourism receipts and higher imports of COVID-19-related health care supplies. The strong remittances, combined with foreign aid and the IMF’s financial assistance under the Rapid Credit Facility (US$9.7 million or 50 percent of quota), boosted foreign exchange (FX) reserves to US$318 million in FY2021 and then to US$360 million as of end-December 2021, partly reflecting the IMF’s 2021 SDR allocation (US$18.7 million) in August 2021.

Outlook and Risks

5. The short-term growth outlook is subject to large uncertainties. Following a contraction of 2.7 percent in FY2021 mainly due to the border closure, Tonga’s real GDP in FY2022 is projected to decline by another 1.9 percent (Table 1), reflecting substantial disruptions to economic activity due to the damaged capital and COVID-19 containment measures, as well as losses in agricultural production from the tsunami and volcanic ash. Annual GDP growth is projected to rebound to 3.2 percent in FY2023, led by reconstruction. The short-term outlook is predicated on the following assumptions:

• While the authorities plan to gradually reopen international borders over FY2023, a meaningful recovery in tourism is expected be delayed to FY2024 given the time required for repairs and reconstruction of severely damaged tourism facilities.
• The reconstruction of flagship infrastructure projects is expected to accelerate in FY2023 after the border reopens in July, which would allow entries of foreign engineers.
• Crop production is expected to gradually recover over FY2023-FY2024 as the soil contamination caused by the tsunami and volcanic ash dissipates.

Average inflation is projected at 8.2 percent (y/y) in FY2022, up from 1.4 percent in FY2021, reflecting the impacts of ongoing geopolitical tensions on international commodity prices and supply-side disruptions caused by the volcanic eruption on domestic prices. In FY2023, inflation is expected to decline to an average of 4.4 percent (y/y), below the NRBT’s reference rate of 5 percent, as international commodity prices stabilize in line with the IMF’s April 2022 World Economic Outlook forecasts.

6. The catastrophic impacts of the volcanic eruption and the COVID-19 outbreak have led to a BOP need. The CAB is projected to switch back to a deficit (-6.1 percent of GDP) in FY2022 and deteriorate further in FY2023 (-22.4 percent). The substantial worsening of the CAB would be driven by increased imports of food―reflecting reduced domestic crop production, imports of reconstruction-related materials, subdued tourism and agricultural exports, and a decline in remittances from the exceptional levels during FY2021-FY2022. Notwithstanding the post-disaster increase in donors’ aids, the deterioration in the CAB has generated a sizable external financing gap under the current grant commitments.

7. The balance of risks is tilted to the downside. In addition to frequent natural disasters, a faster-than-expected rise in international food and energy prices due to geopolitical tensions, including the war in Ukraine, could significantly weaken private consumption by reducing households’ real purchasing power and deteriorate the CAB. A faster-than-manageable local community transmission of COVID-19 is another important risk in the short term, especially given a high incidence of noncommunicable diseases and weak health care capacity. In the medium term, loss of correspondent banking relationships (CBRs) is an important downside risk, given Tonga’s heavy reliance on remittances.

8. The medium-term outlook is weak. Tonga’s growth potential is low due to its exposure to natural disasters, remoteness, and a limited production base. Without bold structural reforms to boost climate resilience and private sector development, growth is expected to converge to its long-term potential rate of 1½–2 percent. Over the medium term, the CAB is expected to gradually deteriorate relative to its pre-pandemic levels, reflecting heavy import dependence, weak competitiveness, and large infrastructure needs. International reserve coverage is expected to trend down to around 3½ months of prospective imports in the medium term.

9. Tonga is assessed as being at high risk of debt distress. Without additional grant commitments to staff’s baseline projection, the present value of public debt-to-GDP ratio is projected to rise above the 70 percent debt-distress benchmark in FY2032. This mainly reflects significant spending needs over the long term to cover infrastructure gaps and achieve Tonga’s climate resilience goals and SDGs. Debt obligations are largely external and over half of total public debt is to China Exim Bank. Debt repayments are expected to pick up in FY2024, mainly to the Exim Bank, and stay elevated at over 3 percent of GDP until FY2027.

Policies to Recover and Rebuild Stronger

10. The series of natural disasters underscore the urgency to implement reforms to enhance climate resilience and nurture the private sector. Tonga is among the most vulnerable to natural disasters globally. While battered by two major tropical cyclones in early 2018 and 2020, Tonga nonetheless managed to build macroeconomic policy buffers, including by mobilizing additional tax revenue and limiting public wage bill increases. These buffers helped Tonga to counter the adverse spillover effects from the global pandemic in FY2021 through a bold policy support package focused on health care and social protection. Looking forward, implementing reforms to enhance climate resilience and promote private sector development, accompanied by efforts to strengthen the public finances, will be essential to meet the long-term development goals outlined in Tonga’s Strategic Development Framework 2015–2025.

Fiscal Policy

11. The government responded swiftly to address the economic impacts of the volcanic eruption, with help from the international community. Since the disaster, donors have collectively pledged additional budget support worth 6.7 percent of GDP for FY2022 and 3.6 percent of GDP for FY2023 in grants. The support allowed the authorities to finance fiscal measures targeted to affected businesses and households, including tax reliefs, loan subsidies, and cash transfers. Reconstruction activity is also well underway under a comprehensive reconstruction plan, with 8 out of 20 high-priority projects already completed. Notwithstanding the additional budget support, staff expect the fiscal deficit to widen from 0.4 percent of GDP in FY2021 to 1.4 percent in FY2022 due to lower tax revenues and additional spending needs after the volcanic eruption.

12. The envisaged expansionary fiscal stance in FY2023 is appropriate considering the urgent spending needs for reconstruction and recovery. The authorities are targeting a larger budget envelope in FY2023, which is expected to lead to an increase in the fiscal deficit from FY2022 despite higher domestic revenues expected in FY2023. Staff support an expansionary fiscal policy stance, considering the continued need for social spending, as well as the significant capital investment needed to rebuild damaged public infrastructure. The capacity for capital investment, especially for flagship infrastructure projects, is expected to improve as borders reopen in FY2023, which would allow foreign engineers to enter. The authorities’ fiscal strategy also aims to bolster the economic recovery over the medium term, including by improving public services in health and education, promoting private investment, and strengthening climate resilience through facilitating relocation of properties from high-risk coastal areas and construction of stronger buildings.

13. In the medium term, a combination of domestic fiscal measures and additional donor support is needed to meet large development spending needs while reducing the risk of debt distress. The fiscal adjustments could take place post-reconstruction and include a gradual increase of tax revenues and containing current expenditures at prudent levels. New grant commitments in line with the historical trends are also essential to fund capital investment projects for SDGs and climate resilience. In this context, staff support the government’s current strategy to pursue additional grants from development partners and avoid any new non-concessional borrowing from external creditors.

14. The authorities remain committed to reforms aimed at broadening the tax base and improving spending efficiency. Tax and customs administration has improved across several areas, including enhanced management of tax arrears, the deployment of the Automated System for Customs Data (ASYCUDA World), and the ongoing implementation of the Electronic Sales Register System (ESRS). The new bill on public financial management, which improves transparency and the medium-term budget processes, is expected to be submitted to the cabinet for approval by end-FY2022. Further reforms, with capacity development (CD) support from the IMF including on tax policy and administration and through training of staff in the Ministry of Finance, will help facilitate the medium-long-term fiscal adjustments outlined above. Specifically, the reform efforts could focus on the following:

• Revenues . The authorities could increase revenues by about 3 percent of GDP by reducing tax exemptions and strengthening tax administration. A recent IMF TA report estimates that additional revenue of 2½ percent of GDP could be collected by removing major tax exemptions, notably those related to the provision and consumption of electricity. Introduction of new exemptions or tax incentives should be minimized and based on a transparent process involving public disclosure of the criteria, time frame, recipients, and amounts of such exemptions. Revenue administration reforms could also increase tax revenues by ½-1 percent of GDP through better tax compliance and lower tax arrears.

• Expenditures . Since FY2021, compensation of employees has exceeded the fiscal anchor of 53 percent of domestic revenue, partly reflecting revenue losses and pandemic-related spending needs. In addition, goods and services spending in Tonga is above the median level of PICs (12 percent of GDP in Tonga compared with a median level of 11 percent in other PICs). Lowering spending on wages and goods and services to levels in line with peers could help improve fiscal balance by about 1½ percent of GDP.

15. Enhanced transparency and accountability of government operations could strengthen the case for more donor support and debt relief. The government should continue current efforts to strengthen information systems for cash and financial management and to improve internal audit processes, in line with the recommendations from the 2020 IMF Public Expenditure and Financial Accountability Assessment Report. Pandemic-related spending and economic relief packages should be closely monitored, audited, and reported in a timely manner. The IMF stands ready to provide CD support to assist the authorities with the implementation of their commitments related to the emergency financial assistance under the Rapid Credit Facility (approved in January 2021), including publishing audited spending and public procurement documents related to COVID-19 spending.

Monetary and Exchange Rate Policies

16. The current monetary policy stance is appropriate, but the NRBT should stand ready to tighten given significant risks to inflation. The NRBT has stayed on hold, maintaining the policy rate at zero percent, the statutory reserve deposit (SRD) ratio at 10 percent, and the inflation reference rate at five percent. Monetary conditions remain loose, with abundant banking system liquidity due to large inflows of grants and remittances in FY2021. Under the baseline outlook, staff project inflation to gradually decline to below the reference rate in FY2023 as the base effects from higher commodity prices materialize and the impacts of the volcanic eruption on domestic prices dissipate. In staff’s view, the current monetary policy settings are consistent with this baseline outlook. The NRBT should nonetheless stand ready to tighten if inflation is expected to stay above the reference rate for longer, possibly signaled by rapid credit growth or persistently high inflation expectations in major trading partners. Monetary policy tightening could be achieved by increasing the SRD ratio or, if a more decisive policy action is needed, by raising the policy rate.

17. The current exchange rate regime has served Tonga well. Tonga’s nominal exchange rate is pegged to a basket of currencies. The real effective exchange rate has appreciated by 4.7 percent since January 2021, reflecting rising inflation relative to trading partners. Exchange rate stability has been maintained with the currency basket weights set in 2018.

Financial Sector Policies

18. Bank balance sheets were strong before the volcanic eruption. Banks were profitable and well-capitalized, with declining NPLs due to loan write-offs and COVID-related loan relief measures. The high profitability reflected robust non-interest income (e.g., FX transaction fees associated with remittances) and a decline in provision-related expenses due to lower NPLs. After several years of double-digit increases, bank credit has gradually declined since mid-2020, reflecting both the weak demand for credit and banks’ increased risk aversion amidst heightened economic uncertainty. Delays and cancellation of projects due to border closures and subsequent shocks have reduced credit demand.

19. The NRBT should encourage banks to actively provision for potential loan losses and monitor credit risks closely. While banks are well capitalized, economic disruptions caused by the volcanic eruption would worsen bank balance sheets. NPLs could pick up significantly and impair banks’ ability to supply credit. Bank profitability could also deteriorate due to the natural disaster, COVID-related mobility restrictions, and rising commodity prices. In this context, some banks have provided additional loan moratorium to affected borrowers, following the expiration of a system-wide loan relief program launched in 2020 to help borrowers hit by TC Harold (2020) and the border closure due to the pandemic. To avoid a sudden increase in NPLs, banks should be required to actively provision for potential loan losses and, together with the NRBT, continue to monitor credit risks closely, especially in hard-hit sectors (e.g., tourism, wholesale and retail, transport, and agriculture). In case capital buffers become inadequate, the NRBT should consider restricting dividend payouts by banks and requesting capital injections from parent banks.

20. Ongoing reforms to improve financial supervision and develop a macroprudential policy framework should continue. There are four priorities: (i) conducting risk-based offsite supervision to assess the banking sector’s health after the natural disaster; (ii) expanding the NRBT’s regulatory and supervisory remit to cover nonbank financial institutions (NBFIs), such as insurance and pension funds; (iii) establishing a solvency stress testing framework that covers NBFI lending, with CD support from the IMF; and (iv) developing macroprudential instruments to operationalize the NRBT's financial stability mandate. While the amendments to the NRBT Act in 2014 contain a broad mandate for financial stability, the NRBT lacks a systematic approach to evaluate macrofinancial risks and implement macroprudential policies. As a first step to strengthen its policy capacity, the NRBT plans to establish a Financial Stability Unit.

21. Concerted efforts are needed to support credit and promote financial deepening and inclusion. In the near term, the government could provide targeted concessional credit support to micro-, small-, and medium-size enterprises in hard-hit sectors, including through the Government Development Loan (GDL) Scheme, which has been expanded from T$13 million to T$18.3 million in 2020. Moreover, the subsidized interest rate from the GDL scheme has recently been reduced to 1 percent from 3 percent for new loans. The authorities are also considering introducing a partial loan guarantee scheme to further enhance access to credit, in the context of banks’ increased risk aversion since the pandemic. Meanwhile, further reforms are needed to reduce credit costs for banks in the long term, such as improving the coverage and quality of credit information systems, and strengthening insolvency regimes and debt enforcement. The plan to set up a credit registry within the NRBT is welcome, and the system should eventually be expanded to include NBFIs to capture all loans extended to individual borrowers. Tonga also faces, as other countries in the region, high transaction costs of remittances, which tend to be regressive. While regional efforts are essential to tackle this issue (see IMF Report on the Pacific Roundtables: Actions to Address Correspondent Banking and Remittance Pressure, 2019 ), including through harmonization of relevant regulations and supervision, promoting financial solutions such as the Ave Pa’anga Pau voucher system could also help cut the associated costs.

Structural Reforms

22. Enhancing resilience to natural disasters and climate change is a top reform priority. While the Disaster Risk Management bill passed in 2021 is an important first step toward strengthening the institutional framework for disaster risk management and preparedness, effective implementation of the law and other climate-related plans will be essential. This requires enhancing coordination across relevant ministries and management of scarce resources, as highlighted by the IMF/World Bank 2021 Climate Change Policy Assessment Report. The efficiency of climate-resilience capital spending could be improved by developing a more comprehensive and regularly updated public asset register, with the IMF’s CD support on Tonga’s Asset Management Framework, and by expanding the classification of capital spending to better identify the climate component of public investment projects. Revisions to the Building Code to include climate resilience measures, such as for the type of construction materials used, design, and construction methods, as well as improving compliance with existing construction regulations through more effective enforcement are also important.

23. Developing the small private sector is critical to boost Tonga’s long-term growth potential. While the government will inevitably need to focus on crisis management and humanitarian relief operations in the near term, it should gradually augment efforts to undertake reforms aimed at promoting private sector development and overall economic productivity. The proposed amendments to the reserved and restricted list of industries under the draft Foreign Investment Regulation 2021 are essential to reap the full economic benefits from the Foreign Investment Act of 2020, which aims to streamline the regulatory framework for FDI. The government should also push ahead additional policy initiatives, including: (i) enhancing access to credit; (ii) expanding and upgrading physical and ICT infrastructure, including to enhance internet connections with remote islands; (iii) increasing government spending on health, education, and social protection; and (iv) improving land leasehold market operations.

24. The design and implementation of the anti-corruption framework could be strengthened further. Tonga acceded to the United Nations Convention Against Corruption in February 2020, which marks an important move toward strengthening its anti-corruption framework. Enhancing accountability and transparency of government operations, as well as addressing the weaknesses in revenue administration identified by the IMF’s 2021 Tax Administration Diagnostic Assessment Tool Report (e.g., tax dispute resolution and ease of paying tax), would further help mitigate governance and corruption risks. Implementing the Anti-Corruption Commissioner Act is also essential. While the law was enacted in 2017, Tonga has yet to set up the office and appoint the Commissioner.

25. Recent efforts to reinforce the AML/CFT framework are welcome and should continue. Given Tonga’s heavy reliance on remittances and its impact on consumption and growth, loss of CBRs could have macro-critical economic impacts. Staff welcome the recent progress made in this area, including the establishment of the Financial Analysis and Supervision Coordinating Unit to strengthen AML/CFT supervision and enhanced collaboration between the Financial Intelligence Unit (FIU) and regional AML/CFT supervisors and FIUs, with the aim of improving information sharing and enhancing the FIU’s analytical capacity. The NRBT is setting up a national know-your-customer system and is seeking to revise the existing AML/CFT framework to make it more risk-based and aligned with the recommendations from the Asia Pacific Group on Money Laundering (APG).

The IMF mission team would like to thank the Ministry of Finance, the National Reserve Bank of Tonga, other ministries and government agencies, and private sector interlocutors for open and constructive discussions.