Public Information Notice No. 06/71

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Tonga

June 28, 2006

On June 2, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga.¹

Background

According to preliminary information, the economy is expected to expand at a slower pace in 2005/06 than the estimated 2½ percent gain in 2004/05 (fiscal year July-June), reflecting a poor squash season and slower growth in construction. Inflation declined to 9½ percent in 2004/05 compared to about 11½ percent in the previous year, and has since eased further to 5¼ percent during the year to February 2006, reflecting lower domestic food and import price increases. A fiscal surplus of about 2½ of GDP was achieved in 2004/05, in marked contrast to the deficit of 2¼ percent of GDP envisaged in the budget, owing to lower-than-budgeted wages and capital spending, and stronger tax collection. Net domestic credit grew by 21 percent in 2004/05, mainly driven by a rapid rise in housing and personal loans. To rein in this rapid credit expansion, the National Reserve Bank of Tonga (NRBT) reintroduced credit ceilings in January 2006. However, with liquidity conditions tightening in the banking system, pressure on the central bank to ease its monetary stance mounted, and reserve requirements were reduced in March.

In 2005/06, the original budget targeted a deficit of 1.8 percent of GDP, mostly covered by external concessional financing. However, available information for the first eight months of 2005/06 indicates that revenue performance was weaker than expected, mainly because of lower nontax and excise collection. Moreover, following a lengthy strike, civil servants were granted in September 2005 average wage increases of about 70 percent. The salary increase will be paid over two years: 60 percent in 2005/06 and 40 percent in 2006/07. The unanticipated cost of the first phase of the wage increase is estimated to be about 3 percent of GDP. Savings have been carried out (mostly capital expenditure cuts and a hiring freeze) that are expected to more than offset this cost as well as the likely revenue shortfall. The authorities are also working on downsizing the civil service by a quarter by the end of the fiscal year, to be achieved by targeted and voluntary redundancies, and the related severance payments could amount to about 5 percent of GDP.

The trade balance deteriorated in 2004/05, as imports expanded on the back of strong domestic demand, more than offsetting a rebound in exports. Despite a continued increase in remittances, the current account shifted into a deficit. The capital account surplus declined from its record high in 2003/04, as private capital inflows returned to a more normal level. Gross international reserves fell to 3¾ months of current year's imports of goods and services. The pa'anga has remained stable relative to its basket since 2004. Given the high inflation in Tonga relative to its main trading partners, this development translated into a real appreciation of the Tongan currency of about 11 percent (January 2004-February 2006).

Short-term economic prospects are highly uncertain and depend critically on the authorities achieving the proposed substantial downsizing of the civil service. The swing in the fiscal position from surplus to deficit is expected to contribute to a widening of the current account deficit in 2005/06. Only if an expected government asset sale to foreign investors is completed, will there be sufficient financing to maintain the reserve position, keep the exchange rate broadly stable, and prevent major inflationary pressures from emerging. In 2006/07, economic activity would be adversely affected by the proposed civil service downsizing. The payment of the severance package would cushion this effect somewhat, although it could also put pressure on reserves and the exchange rate.

Executive Board Assessment

Executive Directors expressed concern about the deterioration in the economic outlook since the last Article IV consultation. They regretted that the large civil service wage increase in September 2005 marked a departure from the prudent fiscal policy that had been followed over the past years, and underscored that the increase could have significant negative consequences for macroeconomic and external stability.

Against this background, Directors considered that Tonga's economic prospects were highly uncertain and depended on the authorities' ability to manage the impact of the wage settlement. They urged the authorities to follow through on their stated intentions to contain the costs of the wage settlement, and push ahead with key reforms to safeguard macroeconomic stability, improve governance, and enhance the role of the private sector.

Directors welcomed the authorities' commitment to fiscal adjustment, and stressed that more sustainable fiscal measures were required. In this regard, they noted the ambitious plan formulated by the authorities to bring the civil service down to a more appropriate size, based on targeted and voluntary redundancies. Directors also noted, however, that the scale of the envisaged downsizing was unprecedented, and cautioned that alternative measures may need to be considered, should the proposed plan not materialize as expected.

Directors called on the authorities to push ahead with other fiscal reforms. They stressed that strengthening the legal framework and capacity for tax enforcement would be critical to offset the revenue decline in trade taxes expected from Tonga's accession to the WTO. Directors added that a fully operationalized accounting system, including its rollout to all ministries, would be critical to improve public expenditure management. The introduction of a medium-term budget framework signaling the authorities' commitment to a sustainable fiscal policy would help foster donor support. In addition, Directors emphasized that the pace of public enterprise reform should be accelerated and, in particular, that the government should not renationalize the power sector.

Directors welcomed the authorities' resolve to further tighten monetary policy in response to the wage settlement, and utilize the full flexibility of the exchange rate system, if needed. In this regard, the introduction of open-market type instruments was seen as a useful step to improve the central bank's control over monetary developments. Directors noted, however, that these new instruments remained untested, and that the central bank might also need to rely on its more rudimentary credit ceilings in the near term.

Directors noted that indicators of banking soundness had improved, although the recent rapid expansion of credit was of some concern. In this regard, Directors encouraged the authorities to continue to monitor closely credit developments to avoid a deterioration in asset quality. They also called for an early enactment of the Amendments to the NRBT Act to strengthen central bank independence. The authorities were encouraged to build on the progress made in the area of Anti-Money Laundering/Combating Financing of Terrorism (AML/CFT) to address the remaining issues.

Directors agreed on the need to create a more dynamic private sector in order to foster higher growth. In this context, they supported the authorities' decision to establish a public-private sector task force to identify and reduce critical impediments to private sector development. In particular, Directors called on the authorities to improve the business and investment climate by repealing distortionary tax incentives, reducing restrictions on business licensing and foreign direct investment, and strengthening the legal framework for securing property rights.

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.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.