Directors noted that Tonga's medium-term growth prospects are constrained by the country's geographic isolation, its narrow export base, the high cost of labor, an inability to retain skilled labor, and impediments to private sector activity. They considered that the increase in both Tonga's external and public debt over the past year has left the economy more vulnerable to shocks. Directors emphasized the need for government policies in the coming years to focus on mitigating these limitations and debt vulnerabilities through continued progress on structural improvements to raise growth potential, continued support from donors, fiscal consolidation, and careful management of liabilities, reserves, and Tonga's external position.

Directors highlighted the limited room for fiscal support in FY2010/11 and urged the authorities to maintain a sustained effort in the coming years to put the public debt firmly on a downward path. Directors encouraged the authorities to step up revenue administration and expenditure control, prioritize expenditure, limit loan drawdown to finance projects that are productive, and establish a comprehensive debt management strategy that aims at limiting the large credit and currency risks in the government balance sheet. Directors encouraged donors to continue providing grants to support the government's fiscal efforts. Nevertheless, should grants be lower than expected, further fiscal restraint and possibly redirecting part of the government spending toward higher priority projects would be required.

Directors encouraged the authorities to maintain a neutral monetary policy stance in the months ahead given the risk that the ample liquidity in the banking system could feed through to higher inflation and downward pressure on international reserves. They emphasized the need to tighten the monetary policy stance by using the wide range of tools at NRBT's disposal if risks of higher inflation or downward pressures on reserves were to materialize. Directors recommended limiting the use of direct credit controls so as to minimize the associated distortions.

Directors noted the staff assessment that the currency is moderately overvalued and underscored the critical role of the flexibility afforded by the current exchange rate arrangement in safeguarding external stability. They encouraged the authorities to stand ready to gradually depreciate against the basket in order to safeguard external stability. However, to be effective, this will need to be accompanied with further fiscal restraint given the effect a weaker currency would have on the public debt burden. Directors welcomed NRBT's decision to review the current weights in the basket.

Directors welcomed NRBT's steady strengthening of bank supervision, as well as its recent decision requiring banks to improve the disclosure to their customers about the full costs of new loans. They encouraged the authorities to further step up supervision to promote financial stability and improve intermediation.

Directors underscored the importance of improving the legal framework for collateralized borrowing to lower financial intermediation costs and restart bank lending and promote private drivers of growth. They encouraged the authorities to streamline the business licensing process and lower barriers to foreign investment and saw significant scope to improve the institutional framework for lending in order to increase access to finance and lower the cost of borrowing. In this regard, Directors urged the authorities to resist pressure to begin administering the level of interest rates to avoid a possible significant credit rationing as well as hampering banks' ability to properly price risk.

Background

Tonga has been hit hard by the global crisis with declines in tourism, remittances and exports. At the same time, in large part due to worsening credit quality, bank balance sheets have weakened. This, in turn, has restrained the availability of credit despite the central bank's efforts to stimulate demand. Compounding these downward pressures, part of the Tongan archipelago was hit by a tsunami on September 29, 2009, causing loss of life and significant material damage.

Activity is estimated to fall in FY2009/10 (July-June) by ½ percent given delays in the implementation of capital projects and the low domestic value added content of spending linked to the China reconstruction loan, while the global crisis lowered both tourism activity and remittances inflows, banks contracted lending.

Consumer price inflation fell to 1½ percent year-on-year (y/y) in January 2010, reflecting a combination of lower global fuel and commodity prices. For 2009/10, inflation is expected to average 2¼ percent, reflecting stronger domestic demand and a recent increase in electricity prices.

The current account deficit has widened somewhat due to lower remittances and exports. Reserves have risen this year as a result of the recent SDR allocation and the disbursement of donor grants and loans to reconstruct the Central Business District.

The government has responded to the global crisis by loosening fiscal policy. In FY2009/10, the deficit is expected to rise to around 4 percent of GDP (from 3¼ percent of GDP in the previous fiscal year). This, together with the government contracting a new renminbi loan from China's EXIM bank, has increased Tonga's indebtedness and put the country into the range of “high risk of debt distress” according to the joint World Bank-IMF sustainability framework. Tonga's high debt leaves the economy more vulnerable to shocks and limits the fiscal space for future spending on social and developmental priorities as interest costs are borne in the budget.

Monetary policy also has been loosened since the onset of the global crisis. The National Reserve Bank of Tonga (NRBT) has lowered reserve requirements, reduced the interest rate on its repo facility and suspended the issuance of central bank bills. Despite this, a worsening credit quality has reduced banks' willingness to lend defusing the effect of the looser monetary policy on the real economy.

Following the marked deterioration in banks balance sheets in 2008, provisioning has increased. Banks are actively improving their risk management practices, with greater staff training on credit risk analysis, better communication with bank management, and more frequent audits. Most of the credit-related losses have been front-loaded and banks are expected to return to profitability by the second half of this year.