On July 19, 2013, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga¹ on a lapse of time basis².

Economic growth slowed to 0.8 percent in fiscal year 2011/12 (July-June), from an average of about 3 percent during the previous three years. Reflecting the completion of public investment projects, Tonga’s growth is likely to remain low in 2012/13, at about ½ percent. Starting in 2013/14, recovery of remittances and tourism—along with improved infrastructure—will lead economic growth to recover to a slightly lower growth rate than the historical trend.

Headline inflation has fallen significantly. After peaking at 9.7 percent in May 2011 (above the official reference range of 6–8 percent), inflation decelerated to 0.5 percent in April 2013, led mainly by imported food and oil prices. Going forward, inflation is expected to recover to about 5.5 percent.

There are no imminent risks to the external balance. Despite the continued contraction of remittances since 2008, increases in foreign grants and, more recently, a decline in imports led gross official foreign reserves to rise to about 8½ months of imports as of March 2013.

The overall budget deficit decreased to 2.7 percent of GDP in 2011/12 from 7.6 percent in the previous year. The 2012/13 budget aims to eliminate the fiscal deficit. While a mid-year assessment of the 2012/13 budget suggests that revenue collections could be less than budgeted, this is projected to be matched by spending restraint. Following an upgrade by the World Bank of its Country Policy and Institutional Assessment rating for Tonga’s macroeconomic policies and institutions, the risk of external debt distress for the country has been reclassified from high to moderate. Monetary policy continues to be accommodative, and recent data show some signs of stabilization in credit growth. Progress in improving the regulatory and institutional infrastructure has continued, including inauguration of a credit bureau.

Executive Board Assessment

On July 19, 2013, the Executive Board of the IMF concluded the Article IV consultation with Tonga and considered and endorsed the staff appraisal without a meeting.

The Tongan economy is expected to remain weak in FY 2012/13, following the completion of key public work projects. Beyond FY 2012/13, staff projects the economy to recover gradually, but to a slightly lower growth rate than the historical trend before the global financial crisis. Risks to the near-term outlook are tilted to the downside, reflecting external risks and weak business confidence.

The current macroeconomic policy mix, which combines fiscal consolidation and monetary accommodation, is appropriate. The overall fiscal deficit fell from 7.6 percent to 2.7 percent of GDP in FY 2011/12; and the FY 2012/13 budget aims to eliminate the remaining deficit. Monetary conditions have remained accommodative for the past three years.

In view of Tonga’s level of external debt—an important vulnerability despite the Debt Sustainability Assessment rating upgrade—and the expected increase in debt repayments, fiscal consolidation should be sustained. The FY 2013/14 budget could aim to maintain a similar level of primary balance surplus as in FY 2012/13, to preserve cash buffers with the expected repayments on the external loans and limited borrowing options. A credible fiscal consolidation strategy should not factor in debt relief until it becomes certain, and the space that could result from debt relief should be prudently used.

The authorities need to start considering an unwinding of the accommodative monetary policy stance. In particular, the National Reserve Bank of Tonga should stand ready to mop up excess liquidity with the bottoming out of the credit cycle. At the same time, other efforts to overcome obstacles to renewed credit growth should continue. In this context the government’s plan to further commercialize Tonga Development Bank has merits, but a thorough due diligence assessment is essential.

Staff strongly supports the creation of a presumptive tax regime for small and medium-sized companies and the natural resource tax regime. Revenue reform efforts should include streamlining and enhancing the transparency of tax exemptions. Formalization of the Public Financial Management (PFM) reform roadmap is important to demonstrate the authorities’ commitment to reform and to inform technical assistance from donors.

Tonga’s structural challenges to growth call for reforms to strengthen investor confidence. Reforms should focus on policy coordination and judicious deregulation. The current framework for coordination could be further strengthened, for example by establishing a high-level coordinator. A tailored support mechanism for foreign investors should also be put in place. The business licensing reform has achieved an important milestone, and could now focus on easing ancillary licenses.