Public Information Notice No. 05/119

Public Information Notice: IMF Concludes 2005 Article IV Consultation with Tonga

August 31, 2005

On July 15, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga.¹

Background

Real GDP growth slowed to 1½ percent in 2003/04 (fiscal year July-June) from about 3 percent in 2002/03, mainly reflecting bad squash and fishing seasons and poor performance in the transport sector. Inflation remained at over 11 percent, mainly driven by high oil prices, the impact on import prices of a weakening pa'anga, and increased taxes on tobacco and alcohol. The fiscal position seems to have strengthened, administrative capacity is improving, and the reform program seems to have gained momentum. However, the fiscal position is facing increasing pressure for higher wages, and ongoing tax reforms imply high uncertainty for revenue projections. Credit to the private sector is strong and may add inflationary pressure. A more favorable investment climate needs to be fostered to reduce the country's external vulnerability and achieve a higher sustainable level of growth.

In 2003/04, total expenditure seems to have declined by about 4 percentage points of GDP, while total revenue remained stable compared to 2002/03, resulting in an overall surplus of 1.3 percent of GDP, in marked contrast to the deficit of 3.1 percent of GDP in 2002/03.² The reduction in total expenditure was estimated to have stemmed mainly from a reduction in the wage bill, reflecting the enforcement of a general hiring freeze, and a significant cut in capital expenditure, partially offset by the payment of loan guarantees related to Royal Tongan Airlines (RTA), of about 1 percent of GDP.

In June 2005, the 2005/06 Budget was approved by the Legislative Assembly. In this budget, the fiscal outturn for 2004/05 was estimated to be broadly balanced, compared to the projected deficit of 2½ percent of GDP in the previous budget. Total expenditure turned out lower than projected by about 3 percentage points of GDP on the back of continued efforts to reduce the wage bill and cut capital expenditure, while total revenue and grants are estimated to be ½ percent of GDP below their budget target on the account of lower than expected grants. The new budget projects a deficit of about 2 percent of GDP in 2005/06 that will be mostly covered by higher expected external concessional financing, and domestic financing will be limited.

The trade balance deteriorated further in 2003/04, as exports declined on the back of the low fish catch and imports rose moderately. Rising private transfers receipts and capital inflows more than offset this loss and gross international reserves reached a ten-year high of 4¾ months of current year's imports of goods and services.

In recent years, the National Reserve Bank of Tonga effectively used its discretion to adjust the pa'anga relative to the basket peg to preserve foreign reserves, with the currency depreciating by about 8½ percent in real effective terms between July 2000 and June 2003. However, in 2003/04, the pa'anga appreciated by 11 percent in real effective terms against the basket of currencies. This real appreciation continued in 2004/05, although at a slower pace.

Prospects are for a moderate economic recovery, although downside risks remain. Real GDP growth is projected to have rebounded in 2004/05 to 2½ percent on the back of a recovery in agriculture and tourism, and ongoing construction projects. These positive developments are expected to carry over to 2005/06. The outlook could be affected negatively by weaker-than-anticipated global growth, higher world commodity prices, a poor squash season, and persistent low catch rates in the fishing industry. While moderating, inflation is expected to remain high in the near term due to oil prices, adverse weather conditions, and the introduction of the consumption tax. These pressures would be exacerbated if the fiscal position were to deteriorate.

Executive Board Assessment

Executive Directors noted the positive developments since the last Article IV consultation. Growth had picked up, although inflation remained high, and the fiscal position seemed to have strengthened. The authorities' reform program also appeared to have gathered momentum. However, Directors noted that important challenges remained to reduce Tonga's external vulnerability and achieve a higher and sustainable level of economic growth.

Against this background, Directors urged the authorities to build on recent favorable developments to improve macroeconomic policy performance, strengthen the economy's resiliency, and continue structural reforms. In this regard, they noted that the country's limited administrative capacity constrained the pace of reforms and encouraged the authorities to achieve greater coordination with donors to assure a reliable flow of technical assistance. Directors added that it would be important to enhance private sector participation in the reform process.

Directors urged the authorities to persevere with fiscal consolidation and limit recourse to domestic financing to help curb inflation. In this regard, they welcomed the authorities' estimate that the fiscal position in 2004/05 was broadly balanced and stressed that they should be equally prudent in executing this year's budget. In this regard, Directors recognized the challenge implied by the implementation of further tax reforms. They encouraged the authorities to proceed with the second phase of the tax reforms to reduce Tonga's heavy reliance on trade revenue and the excessive tax burden on some sectors. At the same time, they cautioned that these reforms would imply unusually high downside revenue risks for the budget, and must be accompanied by intensified efforts to improve revenue administration and public expenditure management to preserve a sound fiscal position.

In this context, Directors welcomed recent efforts to build capacity to implement the consumption tax, but felt that these efforts needed to be sustained. They called on the authorities to take decisive measures to improve governance and administration in customs. Directors added that a fully operationalized accounting system would be critical to improve public expenditure management, including its rollout to all ministries and the provision of appropriate training. They also urged the authorities to identify areas of savings in the execution of their budget, possibly through downsizing and outsourcing of public services, to contain the actual increase in the wage bill.

Directors welcomed the progress on public enterprise reform, but considered that more needed to be done to contain contingent liabilities and improve corporate governance. In this regard, they urged the authorities to finalize the liquidation of RTA and encouraged them to step up the privatization process. They also called on the authorities to fully enforce the Public Enterprise Act and limit new public guarantees, including through the adoption of an official policy framework to reduce moral hazard and possible fiscal costs.

Directors also welcomed the authorities' resolve to continue to maintain exchange rate flexibility, and encouraged them to use their discretion to adjust the value of the currency relative to the basket to which it is pegged, as needed to protect the level of reserves. In addition, they urged the authorities to seek further information on the payment obligations on external debt of the private sector to avoid unanticipated large capital outflows. They also welcomed the authorities' intentions to set up a framework for open market-type operations.

Directors agreed that making the economy more dynamic would require greater efforts to involve the private sector and deal with governance issues. In this context, they called on the authorities to improve the business and investment climate, clarifying the boundaries between the private and public sectors so as to level the playing field, and strengthening the legal framework for securing property rights.

Directors noted that indicators of banking soundness had improved, although concerns were voiced about the recent rapid expansion of credit to the housing sector. Directors encouraged the authorities to monitor closely the developments in this sector to avoid any deterioration in credit standards.

Directors encouraged the authorities to improve the reliability, coverage, and timeliness of statistics to strengthen economic analysis, and assist the authorities in conducting policies and implementing reforms.