Public Information Notice No. 01/112

Public Information Notice: IMF Concludes 2001 Article IV Consultation with Tonga

October 31, 2001

On September 4, 2001, the Executive Board concluded the 2001 Article IV consultation with Tonga.¹

Background

Real GDP growth, after temporarily strengthening in 1999/00 to about 6 percent, is estimated to have slowed to about 3 percent in 2000/01 (fiscal year beginning July 1). Growth in 1999/00 was supported by a strong rebound in agricultural production, especially root crops and squash, and the services sector owing to a surge in foreign visitors related to the millennium celebration in 1999. Although tourism has since held up in 2000/01 and construction and government services have accelerated, real GDP growth is estimated at about 3 percent due to the low agricultural output growth from a buoyant base year.

The external current account deficit has widened further to an estimated 8 percent of GDP in 2000/01, reflecting limited supply response to strong demand and a deteriorating services balance. Exports have remained flat while merchandise imports, which have fallen by 4½ percent in U.S. dollar terms, still remain high relative to Tonga's payment capacity. Net service receipts fell further in 2000/01 reflecting payments related to Tonga's airline operation. Accordingly, international reserves fell from US$15½ million at end 1999/00 to US$12 million at the end of 2000/01, the equivalent of 1¾ months of imports, which is less than half the level two years ago. In addition, to dampen foreign reserves losses, the National Reserve Bank of Tonga (NRBT) adjusted downward the value of the pa'anga by 21 percent against the U.S. dollar during 2000/01 (or by about 5½ percent in real effective terms) compared with a 6²/3 percent depreciation of the composite currency basket. As more than 50 percent of the CPI basket is based on imported commodities, the inflation rate increased further to 7 percent in 2000/01, from 5¼ percent in 1999/00.

Domestic demand in 2000/01 was fueled by expansionary fiscal and monetary policies. The overall fiscal deficit for 2000/01 is estimated at 2²/3 percent of GDP, reflecting the payment of cost of living adjustments for civil servants in July 2000 and January 2001 (10 percent each) and lower than budgeted revenue collections of about 2½ percent of GDP. Notwithstanding a substantial compression of nonwage current expenditure, the government had to resort to domestic bank financing of about 4 percent of GDP. Despite a rise in the reserve requirement from 12 percent to 15 percent in September 2000, excess liquidity, coupled with the low interest paid on NRBT short-term bills, facilitated strong credit expansion by banks. Accordingly, domestic credit expanded by 41½ percent, reflecting a large loan for importation of telecommunications equipment (that is likely to take place in early 2001/02) and rapid credit expansion to public enterprises.

The financial position of banks broadly improved in 2000, except for one problem bank where little progress was made. The Tonga Development Bank (TDB) succeeded in restructuring about T$5 million of its bad loans and recovered T$2.3 million from collateral. The TDB has recently shifted its loan portfolio toward a more commercial basis and micro-financing. The ratio of loan loss reserves to total impaired assets of the commercial banks increased from 64 percent in 1999 to 87 percent in 2000, due to an increase in specific provisioning of T$0.8 million by the problem bank. Nevertheless, little progress was made by the bank in addressing its nonperforming loans which, as a ratio to total loans, have remained at 40 percent in 2000.

Executive Board Assessment

Executive Directors were concerned that fiscal and monetary policies had fueled domestic demand in 2000/01, when Tonga's foreign exchange-earning capacity was weakening, leading to a widening of the external current account deficit and pressure on official foreign reserves. Furthermore, they noted that domestic supply response to the policy stimulus was limited, and real GDP growth fell. Directors stressed the importance of fiscal and monetary tightening and early implementation of corresponding measures to regain external viability.

Directors expressed concern at the large cost of living adjustments in 2000 and 2001, and urged the authorities to limit the overall deficit in 2001/02, including through a reduction in the wage bill and revenue-enhancing measures such as reduction of exemptions, an expansion in the coverage of the sales tax, and an increase in administrative fees and charges. They considered the proposed tax and tariff changes to be an important step toward shifting the burden of taxation from foreign trade to domestic transactions, while improving the fairness and equity of the tax system. However, as these changes are expected at best to be revenue-neutral, Directors urged the authorities to cut current expenditure through a reduction in government employment, in order to make room for capital expenditure. In this context, Directors recommended that the proposed tax and tariff reform be accompanied by civil service reform and welcomed the initial steps taken by the authorities.

Directors recommended a sharp curtailment in bank credit expansion. Given the absence of alternative mechanisms of credit control, Directors considered bank-by-bank credit ceilings to be necessary for the time being, but requested that they be set in a transparent and equitable manner.

Directors considered the current exchange rate regime and the level of the exchange rate to be broadly appropriate, and recommended that the NRBT continue to adjust the pa'anga as needed in order to meet its foreign reserve targets.

Directors emphasized the importance of good governance for attaining external viability, noting that a lack of transparency of certain public transactions in the past had threatened macroeconomic stability. In this context, they suggested that the Tonga Trust Fund be consolidated with the budget and that its financial statements be made public in a timely manner.

Directors considered foreign investment and private sector activity to be key drivers of Tonga's economic development over the medium term. Accordingly, they urged the authorities to establish a transparent regulatory environment that would reduce uncertainties for investors and establish a level playing field, emphasizing, in particular, the importance of extending the land lease period and eliminating the reassessment of rent every five years.

Directors encouraged an early resolution of impaired bank loans and continued restructuring of the TDB to ensure financial system stability. They considered official intervention to deal with bank insolvency to be necessary to mitigate further losses and to minimize the fiscal cost.

Directors noted that, despite recent improvements in data reporting, data weaknesses continue to hamper economic analysis. They encouraged the reactivation of the statistics advisory group to help coordinate the production of economic statistics and to prepare the ground for Tonga's eventual participation in the GDDS.