Mission Concluding Statement 

Tonga: Staff Concluding Statement of the 2024 Article IV Mission

August 25, 2024

Tonga’s economic activity has strengthened driven by construction, strong remittances, and a recovery in tourism with real GDP projected to accelerate to 2.4 percent in FY2025, supported also by a recovery in agricultural output. However, the elevated frequency of natural disasters, supply-side constraints, and geographical remoteness collectively temper the medium-term outlook. Inflation has moderated from its highs, driven by a moderation in core prices, and it is projected to decline further as the effects of El Nino on local food prices dissipate. Monetary policy tightening will be needed including by raising the policy rate if demand-driven domestic inflation pressures resurface. The current expansionary fiscal stance is deemed appropriate in the short term, with the primary balance ex-grants expected to mildly deteriorate in FY2025. Over the medium-term, however, a gradual and credible fiscal consolidation and additional grant financing commitments are warranted to put debt on a firm downward path. Financial sector policies should aim at promoting financial deepening while safeguarding financial stability by expanding their macroprudential toolkit, conducting regular bank stress tests, and strengthening prudential standards. Finally, structural reforms with a focus on bolstering disaster resilience, advancing digital transformation, and strengthening governance frameworks to foster a conducive business environment are essential for Tonga to meet her developments goals.

MACROECONOMIC DEVELOPMENTS AND OUTLOOK

Recent Developments

1. Economic activity has strengthened and become more broad-based driven by construction and strong remittances, although some bottlenecks remain. Growth in FY2023 (July 2022-June 2023) broadened with real GDP growth estimated at 2.0 percent, driven by public sector investment, household consumption, and a recovery in tourist arrivals. Growth continued in FY2024 with GDP estimated to have expanded at 1.8 percent despite a ½ percentage point drag from agricultural production. The potential for a stronger recovery has, however, been hindered by supply-side constraints. These include labor shortages, as evidenced by rising job vacancy posting.

2. After peaking at 14.1 percent in September 2022, headline inflation has since been normalizing, now hovering around the 5 percent reference rate of the National Reserve Bank of Tonga (NRBT), driven by a steady decline in core prices. After bottoming at 3.2 percent year-over-year in March 2024—driven by the moderation of global goods and commodity prices and some easing of local supply-side constraints—headline inflation has picked up reaching 5.4 percent in June 2024, driven by a 24 percent surge in local food prices, attributed to reduced agricultural output from crop failures, partly due to El Niño, and strong food demand from festivities. Core inflation, as calculated by the IMF, however, has continued to fall, reaching 1.2 percent in June 2024. This decrease has been supported by a slow increase in import prices, with the imported component of inflation rising by 0.8 percent.

3. Credit continues to expand in line with the recovery. Total lending grew by 4.1 percent (y/y) at the end of June 2024 driven by lending to both households (6.0 percent) and businesses (2.2 percent) sectors. Demand for credit mostly stemmed from professional services, distribution, and construction, consistent with the rebound in activity in these sectors. Due to the ample liquidity in the system, credit supply proved to be elastic—thus, interest rates have remained flat.

Outlook and Risks

4. The near-term outlook remains favorable. GDP is projected to accelerate to 2.4 percent in FY2025, mostly led by continued strength in domestic demand including large public investment projects (such as the Funga’uta Lagoon Bridge and the Nuku’alofa port upgrade) and a rebound in agricultural output as the effects of El Nino dissipate. Inflation is expected to moderate below the 5 percent reference rate in FY2025 and onward, supported by a retrenchment in local food prices from their recent highs and low import prices inflation.

5. Medium-term growth prospects are weak. Tonga’s long-term growth is projected at 1.2 percent, reflecting its exposure to increasingly frequent natural disasters and limited economies of scale due to geographical barriers.

6. Risks are tilted to the downside. Frequent natural disasters could place additional demands on scarce public resources and reduce agricultural output.  A decrease in asset quality of the banking sector, together with a further loss of correspondent banking relationships (CBRs) in the region due to AML/CFT-related weaknesses, could disrupt transfers and remittance flows. The risk of a faster-than-expected outflows of Tongan workers could contribute to lower GDP growth and higher domestic inflation. A global slowdown would reduce tourism receipts and remittances. Rising vulnerabilities in the banking sector pose a downside tail risk. On the upside, tourism could recover faster due to a stronger-than-expected pent-up demand, agricultural exports could surprise on the upside, and grants and construction activity could come stronger than expected.

7. The external position for FY2024 is preliminarily assessed to be broadly in line with the level implied by medium-term fundamentals and desirable policies. Remittance inflows remained strong, and tourist arrivals continued to recover in FY2024. However, higher imports due to continued economic recovery and construction activity led to a widening of the overall current account deficit from 6.6 percent of GDP in FY2023 to 7.4 percent in FY2024. Foreign exchange reserves have declined slightly in FY2024 but remained adequate covering 10.6 months of imports supported by grants inflows under the capital account. Exchange rate stability has been maintained under the current currency regime.

8. Tonga is assessed as remaining at high risk of debt distress.[1] Recent developments confirmed the previous assessment during the 2023 Article IV consultation. Without additional grant commitments to staff’s baseline projection, the present value (PV) of the external and public debt-to-GDP ratios are projected to keep rising and both cross the 55 percent threshold and the 70 percent benchmark in FY2034, largely and persistently. This reflects significant development spending needs over the long term to achieve its climate resilience goals and Sustainable Development Goals (SDGs). Debt obligations are largely external. Debt repayments surged to 3.5 percent of GDP in FY2024 and remain elevated at over 3.0 percent of GDP until FY2027. The government’s plan to refrain from new non-concessional borrowing would further help reduce Tonga’s risk of debt distress.

POLICY RECOMMENDATIONS

Fiscal Policy

9. The current expansionary fiscal stance is deemed appropriate in the short term. Excluding grants, the FY2024 fiscal impulse (about 2 percent of GDP) was significantly expansionary and expected to moderate to mildly expansionary (about 0.5 percent of GDP) in FY2025. Despite increased reconstruction-related expenditures, the overall fiscal balance is estimated to have remained in surplus in FY2024 at 3.5 percent of GDP, thanks to continued record-high grant inflows and higher-than-expected consumption tax and income tax revenues due to strong remittance and a rebound in construction-related business activities. IMF staff projects the fiscal balance to revert to a deficit of 8.0 percent of GDP in FY2025, as external grants return to their historical trend, while public reconstruction expenditures remain strong. The authorities should consider cutting spending unrelated to reconstruction, including by limiting the public sector wage bill which is expected to cross the 53 percent limit as share of domestic revenues following the 15 percent expected increase in public sector wage bill in FY2025—because of a 5 percent public sector wage increase (cost of living adjustment) and filling up vacancies.

10. Over the medium-term, a gradual and credible medium-term fiscal consolidation and additional grant financing commitments are warranted to put debt on a firm downward path. The fiscal deficit is projected to widen substantially in the long term under the baseline scenario, primarily due to sizable spending needs to achieve Tonga's SDGs and climate resilience objectives. The fiscal adjustments should have a three-prong approach: domestic revenue mobilization (including a gradual increase in tax revenues), enhancing spending efficiency, and securing additional grants. It includes removing tax-inefficient exemptions without increasing the statutory rates, improving tax administration, restraining the public wage bill, rationalizing other low-priority current expenditures, and securing additional grants from development partners. 

11. Fiscal rules have helped maintain debt sustainability in Tonga. Tonga has generally adhered to the fiscal rule's limitations despite recent shocks. Several areas offer opportunities to strengthen its effectiveness, including clearly articulating the rule’s rationale, strengthening its enforcement, improving institutional processes, promoting timely and accurate fiscal reporting, introducing an escape clause, focusing on total current expenditure (rather than just wages), and considering incorporating provisions for building fiscal buffers to manage disaster-related shocks in the medium to long term.

Monetary Policy

12. The current monetary policy stance is appropriately accommodative as consumer price inflation is expected to stabilize below the 5 percent reference rate. The NRBT took measures last year to signal tightening. In February 2023, the NRBT increased the statutory reserve deposit (SRD) ratio from 10 percent to 15 percent, the first adjustment since July 2017, while keeping the policy rate (i.e., the rate on excess bank reserves) unchanged at zero percent. The impact on aggregate demand and bank lending, however, has been limited due to the banking system's abundant excess liquidity. If demand-driven domestic inflation pressures resurface (possibly driven by the expanding construction activity), coupled with signs of accelerating bank lending and an increase in the credit-to-GDP gap, a monetary policy tightening will be warranted, including by raising the policy rate (i.e., the floor interest rate paid on excess reserves). This adjustment in the policy rate would also create room to lower the rate in case important downside risks materialize (e.g., a major natural disaster).

13. With the forthcoming amendments to the NRBT Act, there is an opportunity to strengthen the monetary policy framework in several key areas. The reserve bank could redefine its preferred inflation measure by focusing on a core measure, that excludes volatile energy and food prices which are largely beyond monetary policy's control. A more proactive use of the policy rate would aid in stabilizing domestic prices. This approach should be supported by enhancing the NRBT’s communication strategy, such as publishing regular board meeting dates to improve transparency and market expectations. Furthermore, to ensure that increases in sterilization costs resulting from a policy rate hike do not lead to concerns about the NRBT’s operational independence, the NRBT and the government could consider further clarifying the operational guidelines for transfer of profits, coverage of losses, and recapitalization, consistent with the 2021 IMF safeguards assessment and Technical Assistance (TA) recommendations on Tonga’s monetary policy framework. Finally, the potential amendments to the NRBT Act should not impair the financial autonomy of the NRBT.

Financial Sector Policies

14. The overall banking sector maintains strong capitalization and ample liquidity, but risks have increased. As of June 2024, the banking sector's capital adequacy remained strong at 32.1 percent, above the 15 percent regulatory requirement, supported by banking sectors’ solid profitability. The banking system’s liquidity position continued to remain high. However, the banking system NPL ratio increased from 7.4 percent in 2023Q1 to 11.2 percent at the end of June 2024, mostly driven by business loans. Overall, systemic risk remains largely contained as the major banks operating in Tonga are well capitalized and represent the subsidiaries of relatively sizeable foreign financial institutions.

15. Reforms aimed at promoting financial deepening and stability should The NRBT should also continue to conduct regular stress tests to ensure that banks maintain sufficient capital to absorb any potential losses. Strengthening prudential standards and regulations (e.g., for credit unions and those related to provisioning), avoiding frequent staff turnover, and expanding the scope and increasing the frequency of relevant data collection will help enhance Tonga’s capacity to conduct risk-based supervision and further mitigate asset quality risks in the financial sector. The NRBT’s regulatory and supervisory remit should be broadened to cover non-bank financial institutions (NBFIs) including the retirement funds. Issuing domestic government bonds to promote domestic interbank markets and, thus, financial deepening should continue.

Structural Reforms

16. Enhancing resilience to natural disasters and climate change is a top reform priority. The Disaster Risk Management bill enacted in 2023 marks an important step forward in this regard. It aims to pivot the focus of Tonga’s disaster management frameworks from ex-post responses to proactive ex-ante risk mitigation and preparedness (IMF-World Bank 2021 Climate Change Policy Assessment Report). Expanding the classification of climate change-related spending and strengthening the social protection system are other priorities.

17. Addressing key macro-critical governance vulnerabilities is essential for Tonga’s economic development Enhancing fiscal governance (revenue institutions, procurement, fiscal transparency, and public financial management controls) will support a credible medium-term fiscal consolidation strategy (paragraph 10).  Strengthening the AML/CFT frameworks (preventive measures, entity transparency, and criminal justice) also bodes well with reforms to promote financial stability (paragraph 15). In this respect, the recent appointment of the first anti-corruption commissioner in July 2024 is also a welcome development.

18. Developing the private sector is critical to boosting Tonga’s growth potential. Notably, digitalization can be an effective way to overcome geographical limitations and widen economic opportunities. The authorities’ ongoing efforts to launch a national digital ID system are a significant measure in this regard and could create synergies with other reforms, like facilitating timely delivery of social assistance and enhancing access to credit by facilitating banks’ customer due diligence process, leveraging Tonga’s active use of mobile money. Other measures include: (1) better allocate the now increased government spending on education and training, (2) improve women’s access to credit, (3) tackle regulatory restrictions to attract FDI, and (4)  modernize and clarify the land lease process by improving transparency in the land‑lease market and clarity regarding ownership rights, which could help with access to credit and, thus, boost private sector investment.

Capacity Development

19. Tonga is a major recipient of IMF technical assistance (TA) in the region. The authorities have shown strong ownership and the capacity to absorb IMF TA. Recent IMF TA focused on monetary policy operations, PFM, tax policy, government finance statistics, revenue administration, macroeconomic frameworks and nowcasting, and AML/CFT and financial stability frameworks. Strengthening data adequacy for surveillance purposes is a high priority in Tonga, especially for external, fiscal, and national accounts statistics, and IMF TA has played a critical role in mitigating the authorities’ capacity constraints in these areas.

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 their warm hospitality and constructive discussions. The team looks forward to maintaining this constructive engagement and policy dialogue.

[1] The Debt Sustainability Analysis (DSA) for Tonga will be published as part of the forthcoming 2024 IMF Article IV staff report. The latest published DSA can be found in IMF Country Report, No. 2023/361.