Public Information Notice No. 98/83

Public Information Notice: IMF Concludes Article IV Consultation with Tonga

November 9, 1998

On October 23, 1998, the Executive Board concluded the Article IV consultation with Tonga¹.

Background

Tonga is a small island economy in the central Pacific with a population of about 100,000 and a per capita income of $1,700. Emigration has kept the annual growth of the resident population to 0.3 percent in recent years.

Over the last decade, real GDP growth has been low at 1 percent on average, with contraction in the last three years. A small number of primary products (squash, vanilla and fish) dominate commercial production and exports, leaving Tonga vulnerable to changes in export market and supply conditions. In addition, the private sector has been crowded out by a large public sector—the government spends more than 40 percent of GDP and state enterprises are involved in key commercial activities. Implementation of reforms to encourage private and foreign investment and to diversify the production base has been slow; tourism remains stagnant and manufacturing output, already limited, has been shrinking.

Tonga is highly dependent on foreign aid and private transfers from Tongans abroad. It will be hard to sustain this pattern of development over the medium term as donors are no longer increasing nominal amounts of aid, and opportunities for further emigration to Australia, New Zealand and the United States are limited.

Recent macroeconomic policies have been expansionary. The fiscal balance worsened from a small surplus in 1995/96 [ Fiscal year is July 1 –June 30.] to deficits in the following two years, mainly because of large wage increases. Private sector credit, increased strongly by 20 percent in the year to June 1998 because of lending for personal and housing purposes, and financing of a private power project. The domestic component of the price index rose by 8 percent in 1997/98, reflecting the macroeconomic stance and the impact of drought. Import prices, however, declined and overall inflation was kept at 3 percent.

Higher demand largely spilled over to imports. The external current account deficit widened to 11 percent of GDP in 1997/98, well above the average for recent years, because of falling exports and rapid import growth. Gross official reserves declined to 2.3 months of imports. The pa’anga, pegged to a basket consisting of the Australian dollar, New Zealand dollar and the United States dollar, has appreciated in real effective terms by 12 percent since mid-1995.

Executive Board Assessment

Directors expressed concern that expansionary macroeconomic policies had resulted in the erosion of foreign reserves, and that structural weaknesses had constrained economic growth. This underscored the need to tighten monetary and fiscal policies, and undertake structural reforms without delay to set the foundation for sustainable growth.

While Directors welcomed the recent move by the authorities to raise the reserve requirements and the minimum lending rate, both by 2 percentage points, they stressed that monetary policy needed to be tightened further and through market based means. Given that the weak income position of the National Reserve Bank of Tonga had prevented it from conducting effective market operations, Directors suggested that treasury bills should be issued and transferred to the central bank to strengthen its income position.

Directors stressed that fiscal policy also needed to be tightened. Noting that high growth of the wage bill was a main factor behind the fiscal deterioration, they urged the authorities to adopt a prudent wage policy, and aim to turn the current and overall fiscal balances from deficit to surplus within a few years. They also emphasized the need to protect outlays for social, and operation and maintenance purposes.

Directors urged the authorities to remain alert to any sign of distress in the banking system and strengthen on-site supervision of banks. In this context, Directors expressed concern that the high level of nonperforming loans in some banks might rise further when the monetary policy is tightened.

Directors welcomed the authorities’ recent move to increase flexibility in exchange rate management that allowed the rate to be adjusted by up to 2 percent a month. They emphasized that exchange rate management needed to be flexible to maintain Tonga’s external competitiveness and help reduce the large external current account deficit of recent year.

Directors regretted that structural weaknesses continued to constrain economic growth. They urged the authorities to establish and implement a firm plan to reduce the size and the role of the public sector through privatization and rationalization of the government structure. Directors observed that diversified private sector development should be a priority, through establishing a neutral and transparent business environment and broad based tax and tariff regimes, noting that the existing incentives, provided on a discretionary basis, had done little to encourage private investment.

Directors noted that shortcomings in the accuracy, timeliness and coverage of data needed to be addressed to provide a basis for effective monitoring of the economy and formation of policies. In particular, the national accounts, government finance, and balance of payments data have important weaknesses with long lags.