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Tonga: Staff Concluding Statement IMF 2020 Article IV Consultation Mission

February 25, 2020

A mild recovery is underway after the devastation of Cyclone Gita, due to stronger consumption supported by remittances. Donor-funded reconstruction has boosted imports with limited impact on domestic demand. Policies have delivered strong macro financial outcomes: low inflation, a fourth consecutive budget surplus; and financial sector stability. However, the medium-term outlook is modest and fragile due to slower growth in remitting/partner countries, and a high vulnerability to natural disasters. Tonga is also in high debt distress with repayments set to spike from 2024 onward. The main challenge is to improve climate resilience and meet development goals without worsening debt dynamics. This will require stronger budget surpluses, high-quality revenue and spending policies that help: broaden the tax base, improve official capacity while containing the wage bill, and expedite investment. Large additional donor funding, in the form of grants, will also be needed. A more durable solution to addressing Tonga’s fiscal, development and growth challenges is to grow the private sector. Without strong measures in this area, Tonga is likely to remain in a low-growth remittance-dependent equilibrium, growing well below regional averages. The reforms needed to unlock private sector potential are manifold but improving the operation of the land market is a crucial step.

A Slow Recovery from Tropical Cyclone Gita

1. The economy is gradually recovering after stagnating in FY2018 due to the effects of Cyclone Gita. Growth is estimated at 3 percent in FY2019, driven by stronger consumption due to remittance inflows, supportive monetary policy and credit growth. Nonetheless, the recovery is slower than expected due to a loss in market share for agricultural exports (following cyclone-related damage) and slower growth in partner/remitting countries. Inflation was low due to weaker global commodity prices and the dissipation of the post-Gita surge in local prices.

2. The recovery is translating into larger current account deficits. A real exchange rate depreciation is helping to buoy export competitiveness. But reconstruction and remittance-led consumption is boosting imports. International reserves, which increased substantially in FY2018 due to delays in implementing donor‑funded reconstruction, declined somewhat to US$214 million at end-2019 (equal to some 6½ months of import cover).

Commendable Policy Management

3. Economic policies have been prudently managed. The government demonstrated strong commitment to fiscal consolidation by achieving a fourth consecutive year of budget surplus in FY2019. This surplus was based on continued strength in revenue collection and generally effective controls on current spending in line with its fiscal anchors. Budget surpluses appear to have continued through the first half of FY2020. Given low inflation, monetary policy has been appropriately accommodative to support the recovery. Financial supervision and inclusion have been improving steadily and there are no imminent concerns regarding financial stability—banks are profitable, well-capitalized and relatively liquid, with low non‑performing loans due to loan write-offs and settlements. A raft of regulatory and institutional improvements are either underway, under consideration, or ready for enactment. Reduced political tensions and a widespread perception that the government’s commitment to economic reform is strong, has lifted optimism.

But the Growth Outlook is Modest…

4. Tonga’s growth potential is well below what it could be . The economy has been growing well below the regional average for the past two decades. Growth is partly constrained by its remoteness, narrow production base, and a lack of economies of scale. High vulnerability to natural disasters does not help matters. But these constraints have been aggravated by a reluctance to take necessary steps to grow the private sector and, thereby, limit the exodus of labor by creating economic opportunities at home. While a growing emphasis on enhancing climate-resilience has increased Tonga’s capital stock, its labor force has remained virtually stagnant despite high birth rates. Moreover, social and economic limitations on the ability of women (the more skilled section of the labor force) to contribute effectively to the economy, even as the country loses its skilled male workers to emigration or seasonal worker programs, hurts growth prospects.

5. A growth model that relies heavily on the export of labor is unsustainable. Remittances are a mixed blessing. They help reduce poverty in the informal sector, support the economy, buttress the economic effects of natural disasters and help finance Tonga’s heavy import dependence. However, remittances are helping keep the economy caught in a low-growth equilibrium. The loss of skilled and unskilled workers is affecting reconstruction and agricultural production, limiting public sector capacity and business formation, and helping to keep the production base narrow, agrarian, and informal. Remittance inflows are also highly cyclical and dependent on the economic strength of remitting countries. And they can also be disrupted unless AML (anti-money laundering) legislation, regulations, and enforcement are substantially strengthened (see forthcoming 2020 APG (Asia Pacific Group on Money Laundering) assessment).

6. The economic outlook is, therefore, modest. The post-Gita recovery is expected to speed up in 2020-21 to 3½ percent GDP growth, as exports and investment continue to recover. However, slower global growth is likely to moderate remittance inflows, limiting consumption, the mainstay of the economy. Growth is expected to gradually decline to an estimated potential rate of 1.8 percent in the medium-term as Tonga is likely to stay stuck in a low-growth remittance-dependent equilibrium unless there is a concerted effort to remove bottlenecks hampering private sector operations. Inflation is likely to remain well below the reference rate of 5 percent, due to lower global food and fuel prices. External balances are expected to deteriorate. Weak export competitiveness, large debt repayments, and high import bills due to large infrastructure needs will keep current account deficits high and rising for the foreseeable future. Reserve coverage is expected to trend down to about 4 months of imports, well below desirable coverage levels of 6¾ months.

… And Growth Remains Fragile

7. Tonga’s risk of external debt distress remains high because of the impending spike in debt repayments starting in 2024, particularly to the Exim Bank of China. Without new grant financing commitments and additional fiscal adjustment to service Tonga’s debt obligations, international reserves will need to be run down, and additional debt incurred. Moreover, Tonga is one of the world’s most exposed countries to climate change and natural disasters, and another major cyclone could derail the recovery while placing additional demands on scarce public resources. Despite efforts to strengthen institutions, the ability to prepare for and proactively manage these risks is hampered by limited public sector capacity and resources.

8. Global factors also pose challenges. Rising protectionism and weaker global growth, including from knock-on effects of the coronavirus, may temper exports of goods, tourism receipts, aid and remittances on which the economy is heavily reliant. The balance of economic risks therefore remains tilted to the downside.

How Can Tonga Build Resilience and Escape a Low-Growth Trap?

9. The government’s broad strategic goals are on the right track. The policy agenda rightly focuses on building an inclusive, sustainable and knowledge-based economy, emphasizing development, gender equality, good‑governance, climate resilience, sustainable provision and maintenance of infrastructure and technology, effective land administration and environmental management.

10. The challenge is effective prioritization with a longer-term perspective in mind, and consistent implementation . This requires greater stability in the government’s policy priorities, better sequencing, and improvements in cross-governmental coordination, given scarce domestic resources to support reforms and the need to maximize benefits from donor funds. Longer-term and whole-of-economy planning should help the government lead, instead of reacting to, donor priorities.

11. Donors should also to do their part. The international community provides considerable support to Tonga to achieve its development goals. But the support could be better aligned with the government’s policy priorities, better coordinated to avoid further stretching thin implementation capacity, more inclusive in developing specific policy solutions, and use (while strengthening) Tonga’s own public financial management and information systems to allocate funding. The seasonal worker programs could focus on developing skills more relevant to Tonga’s circumstances, and be complemented with mechanisms (funding and training) to facilitate the return and reintegration of workers into higher value-added economic activities.

Priority # 1. Achieving climate resilience and development goals while ensuring debt sustainability

12. The financing needs to achieve climate resilience and development goals are daunting, given the small tax base and risk of high debt distress. The IMF’s Climate Change Policy Assessment (CCPA) estimates that climate-resilience projects will cost some 140 percent of 2018 GDP, of which donor funding has been committed for about half. Meeting Tonga’s development goals by 2030 will require an additional annual spending of 5 percent of 2018 GDP by 2030. There is also a need to increase the national Emergency Fund to around 1 percent of GDP and set aside sufficient funds for infrastructure maintenance.

13. The budget will need to deliver higher surpluses for the foreseeable future to ensure debt sustainability. Public debt needs to be at 35 percent of GDP to ensure stable debt dynamics over the long‑term. To achieve this debt-to-GDP goal without new grant commitments, annual fiscal surpluses of some 4 percent of GDP are needed, on average, over the period 2021­−24, well above the draft budget target for FY2021 (a surplus of 0.8 percent of GDP). Fiscal surpluses of this magnitude would allow a sufficient buildup of fiscal buffers for debt repayment and emergency funds for climate-related shocks, even if new grant financing were not forthcoming.

14. Consolidation should be based on higher-quality measures.

Revenue. Plans to review and close major consumption tax exemptions; update excise tax rates, fees and charges, especially on property; and improve revenue administration through training and better risk management, are all steps in the right direction. Tax breaks for the electricity company should ideally be removed and the full cost of diesel used for generation passed through to consumers to help achieve Tonga’s emission targets. Any resulting rise in electricity tariffs could be phased in while protecting vulnerable households. Over time, investments in renewable energy sources and transmitting capacity could help reduce tariffs. Given the urgent need to build buffers to pay down debt, keep up infrastructure maintenance and save for emergencies, vital tax policy changes may need to be introduced in a supplementary budget in 2020 to allow sufficient time to develop concrete proposals in consultation with stakeholders. Additional measures that could be considered include: broadening the personal income tax base; closing corporate income tax loopholes for multi-national companies; collecting tax arrears and reducing tax avoidance; and, improving the collection of land-related fees. The management of resources set aside to meet debt repayments should be institutionalized via legislation to ensure adequate governance structures (including withdrawal conditions).

Spending. Current spending policies should be geared toward improving capacity and value-for-money. The wage bill remains a key risk, despite ongoing reform to the public-sector remuneration system. Non-salary wage bill components have risen rapidly, potentially crowding out crucial service delivery spending. Strengthening expenditure controls on allowances (such as overtime) and non-permanent staff costs is recommended. A systemic review to determine the appropriate and fiscally sustainable size and structure of the public service to deliver the desired coverage and quality of public goods and services is necessary. Efforts to centralize and strengthen hiring and staffing decisions are welcome. While the fiscal anchors on the wage bill remain appropriate, policies should focus on rationalizing civil service functions and clarifying job descriptions; identifying and staffing critical positions; increasing automation as a step toward a phased elimination of redundant positions; prioritizing service delivery; gradually aligning compensation with market pay levels while eliminating overtime to improve work incentives and reduce turnover. The planned health insurance system and voluntary retirement scheme should be properly designed to avoid unintended consequences (such as cost overruns and large staff turnover). For faster execution of investments, the pipeline of projects should be better prioritized and published to allow private markets time to prepare in advance. Improving awareness of procurement measures across line ministries, and strengthening procurement measures to bundle contracts, can attract international firms to complement local capacity.

15. Debt management should be improved. The current policy of borrowing only on concessional terms and limiting external debt-to-GDP ratio to below 50 percent remains appropriate, although for debt sustainability considerations financing should ideally be restricted to grants if possible. Adopting a medium‑term debt strategy, with proper documentation of policies and procedures that guide borrowing and the guaranteeing of loans, and help determine the optimal composition of debt, can help better align debt‑related decisions with broader fiscal objectives. There may be scope to expand domestic borrowing to limit foreign currency risk and reliance on external financing and also help improve monetary transmission.

16. However, larger surpluses alone will not be sufficient to achieve climate resilience goals . Donor financing will be essential to fill the gap. Such financing should be in the form of grants to avoid worsening debt dynamics. Even with additional grant financing, it will be difficult to ramp up spending significantly without improving capacity constraints. A more durable solution to overcoming financing and capacity constraints would be to grow the private sector to expand the tax base over time, facilitate implementation, and support government efforts to achieve resilience.

Priority # 2. Unlocking private sector potential

17. Tonga’s private sector continues to be small. Although Tonga performs well relative to its Pacific Island peers across many aspects of the business environment, it lags in terms of registering property, the legal framework and processes for resolving insolvency. There is scope to improve governance, particularly regulatory quality, enforcement and government effectiveness. The main reform priorities are: (i) improving access to skilled labor, land, infrastructure, credit, and technology; (ii) easing entry barriers by strengthening official capacity and female labor force participation; and (iii) reducing investment uncertainty by improving climate resilience, insolvency regimes and bringing the 2018 Foreign Exchange Control (FEC) Act in line with international norms.

18. The operation of the land market should be improved as a matter of priority . The complexity, non‑transparency and delays in the operation of the leasehold market are a major hurdle for Tongan and foreign investors. Land-related concerns have also stalled the approval of high priority regulations, such as the insolvency law, which further deters investment. While the law allows anyone to lease property for up to 50 years subject to Cabinet approval or 99 years subject to Privy Council approval, in practice, tenures are much shorter (10−30 years) with an unregulated and ad hoc process for renewal. Selling Tongan land is illegal but there is an active market in informal land transactions that functions through the transferring or leasing of land in exchange for a "gift" of the equivalent value. Despite revisions to the Land Act, low liquidity in the property market has made it difficult for medium- and small-scale enterprises (MSMEs) to use real estate as collateral. Short land tenures and uncertainties regarding renewal and property rights make it difficult to attract major investments into Tonga, even investments from non-resident Tongans. They also constrain banks’ ability to support worthy long‑term investment projects (e.g., private solar farms) since the collateral value of property loans, and the creditor’s rights vis-à-vis the land is unclear, leaving banks’ potentially subject to significant operational risks. Modernizing and clarifying the land lease process by improving transparency and predictability in the land‑lease market and clarity regarding ownership rights could help maximize the use of vacant or underutilized land, provide greater confidence for both domestic and foreign investors regarding their rights, and improve incentives to ensure that structures built on such land are climate resilient.

19. Strengthening female labor force participation will help lift productivity . The female workforce (with more years of schooling) should be empowered to achieve their full potential. While Tongan women fare better than regional counterparts, they are constrained by limits to land ownership, a legal framework that does not adequately protect their interests (especially regarding property rights) and poor representation in Government. The government’s plan to improve female participation is under-resourced and ill-defined. A landmark Employment Relations Bill, approved by Cabinet, has the potential to improve employment conditions for women once enacted. Additional barriers to female labor force participation could be identified and addressed.

20. More could be done to increase business formation. The insolvency regime should be improved to provide banks and private companies a predictable, speedy, and transparent resolution framework to recover nonperforming loans. Facilitating speedy in and out-of-court solutions with better protection of secured creditors’ rights would help reduce credit losses due to impaired assets and help improve credit to private business. Additional measures could include: greater competition in corporate lending by further developing non-bank financial institutions; reforms in the land leasehold market to allow real estate to be used as collateral; improved functioning of the credit bureau and banks’ access to quality information; and, enhanced financial training and literacy for MSMEs (accounting, budgeting) to reduce screening and lending costs. Deregulating restricted lists of protected sectors will allow greater foreign investment.

21. Amendments to the 2018 FEC Act are necessary, and we are encouraged that they are under consideration . While repatriation requirements are common in countries with capital controls, there is still scope for improvements to the repatriation requirements in the FEC Act to ensure they can be effectively enforced. The Act should be sufficiently robust to ensure its objective of protecting the country’s international reserves, particularly in times of economic stress in Tonga, are met in a manner that still provides certainty and a conducive environment for investors and the public at large. We look forward to reviewing the amendments under discussion and to assisting with cross-country information about practices and outcomes in comparable countries.

Other Policies

22. Monetary policy should stay supportive. The current policy stance should be continued since inflation is likely to remain low. Raising the statutory reserve requirement on banks from 10 to 15 percent of deposits to allow greater scope for easing should economic conditions worsen, is fine, given excess liquidity in the banking system. The National Reserve Bank of Tonga (NRBT) should look through temporary inflation spikes emanating from domestic supply-side and global commodity price shocks, as they are beyond its control and are typically transitory. The NRBT should stand ready to raise interest rates on excess reserves should signs of overheating or credit misallocation emerge.

23. Efforts to improve financial sector supervision should continue . The priorities are: establishing a solvency stress testing framework and assessing the impact of stress events related to climate change and remittances; improving financial sector risk management practices, including by enhancing insolvency regimes and related institutional frameworks necessary to reduce credit costs for banks. Household debt should be closely monitored given signs of stretched household balance sheets and the large exposure of bank balance sheets to household mortgages.

24. The AML/CFT framework needs to be strengthened. Given the importance of remittances for the economy, Tonga remains vulnerable to the partial withdrawal of correspondent banking relationships (CBRs). This vulnerability would be reduced by strengthening Tonga’s AML/CFT framework to satisfy international standards and address any concerns raised in the 2020 APG assessment which is currently underway.

The IMF mission team would like to thank the government and the NRBT for constructive discussions and their warm hospitality and it stands ready to provide additional policy advice and technical assistance to Tonga.

Tonga: Selected Economic Indicators, FY2017–FY2023 1/

Population (2018): 101 thousand

Quota: SDR 13.8 million

Est.

Projections

FY2017

FY2018

FY2019

FY2020

FY2021

FY2022

FY2023

Output and prices

(Annual percent change)

Real GDP

5.4

0.2

3.0

3.5

3.5

2.6

2.3

Consumer prices (period average) 2/

7.2

7.0

4.1

1.3

2.2

1.3

1.2

Consumer prices (end of period) 2/

9.8

6.7

1.6

1.7

3.5

-0.4

3.2

GDP deflator

6.4

5.5

3.5

2.3

2.1

2.1

2.1

Central government finance

(In percent of GDP)

Revenue and Grants

43.6

42.9

44.2

40.5

39.5

39.1

35.3

Revenue (excluding grants)

24.2

25.0

28.2

23.8

23.8

24.0

24.2

Grants

19.5

17.9

16.0

16.7

15.7

15.1

11.1

Expenditure

40.0

40.0

41.5

40.5

39.2

38.8

38.2

Expense

29.6

31.6

32.5

31.1

30.9

30.6

30.6

Transactions in nonfinancial assets (net)

10.4

8.4

9.0

9.4

8.3

8.2

7.6

Overall balance

3.6

2.9

2.7

0.0

0.2

0.3

-2.9

Net acquisition of financial assets

4.9

3.4

1.5

0.5

0.3

0.4

1.4

External financing (net)

1.0

0.6

-1.2

-1.5

-1.4

-1.4

4.1

Domestic financing (net)

0.3

-0.1

0.0

2.0

1.5

1.4

0.2

Debt

Public debt (external and domestic)

46.0

45.6

41.6

39.7

37.7

36.0

38.7

External debt

39.1

37.7

34.1

30.7

27.6

25.0

28.0

Debt service ratio

1.3

1.1

2.1

2.0

1.9

1.8

1.7

Money and credit

(Annual percent change)

Total liquidity (M3)

13.7

7.6

4.3

5.6

5.7

3.6

4.2

Of which: Broad money (M2)

13.0

9.4

3.5

5.7

5.8

3.7

4.3

Domestic credit

4.8

-6.5

6.0

28.1

18.0

15.6

10.6

Of which: Private sector credit

18.0

6.7

7.6

8.1

8.5

8.1

8.1

Interest rates (end of period)

Average deposit rate

2.3

2.3

2.3

...

...

...

...

Average lending rate

8.6

8.5

8.2

...

...

...

...

Balance of payments

(In percent of GDP)

Exports, f.o.b.

4.6

2.9

3.4

4.6

4.8

4.9

5.0

Imports, f.o.b.

-45.2

-44.9

-49.9

-52.5

-52.9

-53.6

-54.1

Services (net)

-3.4

-3.1

-5.5

-5.9

-6.1

-7.0

-6.8

Investment income (net)

4.0

6.1

7.4

7.1

7.3

7.3

7.4

Current transfers (net)

33.6

33.0

37.7

35.0

34.4

33.3

30.4

Of which: Remittances

27.4

29.4

30.0

28.5

29.5

28.1

27.8

Of which: Official grants

8.2

6.0

8.4

7.4

7.3

7.8

5.2

Current account balance

-6.5

-5.9

-6.8

-11.8

-12.6

-15.2

-18.1

Overall balance

5.7

4.7

-0.4

-0.1

-1.3

-4.4

-3.4

Terms of trade (annual percent change)

2.9

-2.5

0.2

0.1

-0.5

0.6

0.4

Gross official foreign reserves

In millions of U.S. dollars

192.2

214.9

212.8

212.3

205.2

179.5

158.3

(In months of imports)

7.2

6.9

6.2

5.8

5.2

4.3

3.7

Exchange rates

US dollars per Tongan pa'ang (Period Av.)

0.5

0.5

0.4

...

...

...

...

Real effective exchange rate (2005=100)

99.3

101.8

102.4

...

...

...

...

Memorandum items:

Nominal GDP (millions of US$)

455.9

481.9

503.8

529.4

560.4

588.6

619.6

Sources: Tongan authorities; and IMF staff estimates and projections.

1/ Fiscal year beginning July.

2/ CPI basket and methodology changed in September 2018.

IMF Communications Department
MEDIA RELATIONS

PRESS OFFICER: Brian Walker

Phone: +1 202 623-7100Email: MEDIA@IMF.org

@IMFSpokesperson

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