IMF Concludes 2022 Article IV Consultation with Tonga

Washington, DC : The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation 1 with Tonga.

Tonga’s economy was severely hit by the double blow from the Hunga Tonga-Hunga Haʻapai volcanic eruption and the local outbreak of COVID-19 in early 2022. The natural disaster derailed the nascent recovery from Tropical Cyclone Harold and border closures in early 2020 and caused substantial damages to properties and public infrastructures. Moreover, strict mobility restrictions involving two national lockdowns to contain the local spreads of COVID-19 brought virtually all activities to a halt in the first quarter of 2022. Although economic activity has been gradually normalizing since April in line with the easing of mobility restrictions and supported by strong policy measures, real GDP is nonetheless expected to decline by 1.9 percent in FY2022, following a significant contraction of 2.7 percent in FY2021.

The outlook is fragile and subject to significant downside risks. Annual GDP growth is projected at 3.2 percent in FY2023, led by reconstruction and policy support. Tourism is also expected to contribute to the growth rebound following the planned gradual reopening of international borders during FY2023, although a meaningful pickup will likely materialize in FY2024 after a further progress in repairs and reconstruction. Downside risks mainly stem from natural disasters, a faster-than-expected rise in international food and energy prices, a new highly contagious and lethal COVID-19 variant or a new virus, and the loss of correspondent banking relationships.

The macroeconomic policy response since the global pandemic has focused on protecting the vulnerable and maintaining stability. The conservation of fiscal space in the run up to the pandemic, including by limiting the increase in the public wage bill and raising additional tax revenues, together with financial support from the international community, allowed the government to deploy significant fiscal support measures to mitigate the socioeconomic impacts of the pandemic and natural disasters, especially in hard-hit sectors such as tourism and agriculture. Meanwhile, foreign exchange reserves have been maintained at comfortable levels (over nine months of import cover) since FY2020.

Executive Board Assessment 2

Executive Directors agreed with the thrust of the staff appraisal. They commended the authorities for taking swift actions to protect the vulnerable following the volcanic eruption and the local outbreak of COVID-19 in early 2022. Directors noted that the outlook remains fragile and subject to downside risks related to the lingering pandemic, rising international food and energy prices, loss of correspondent banking relationships, and vulnerability to natural disasters. They emphasized the need to continue supporting the recovery in the short term and to implement structural reforms aimed at enhancing Tonga’s climate resilience and raising its long-term growth potential. Given Tonga’s high risk of debt distress and sizable financing needs, Directors underscored the importance of continued financial support from the international community, including through grants and debt relief, as well as capacity development from the Fund.

Directors agreed that fiscal policy should focus on supporting the economic recovery and reconstruction efforts in the short term, while providing targeted financial assistance to low-income households and hard-hit sectors. Once the recovery becomes entrenched, a fiscal adjustment will be necessary to bolster public finances. Directors recommended a combination of revenue and expenditure measures, including to rationalize tax exemptions, strengthen tax administration, improve spending efficiency and contain the public wage bill. They also emphasized the importance of preserving debt sustainability and welcomed the authorities’ commitment to avoid non-concessional financing. Directors encouraged the authorities to enhance transparency and accountability of government operations and to follow through on prior emergency financing governance commitments.

Directors concurred that, while the current monetary policy settings are appropriate, the authorities should stand ready to tighten the monetary stance if needed. While banks remain well-capitalized, Directors noted that financial sector risks have risen. They encouraged the authorities to closely monitor credit risks, ensure adequate provisioning for loan losses, and remain vigilant of non-bank financial institutions. Directors supported developing a macroprudential policy framework and welcomed the establishment of the Financial Stability Unit in this regard.

Directors agreed that structural reforms are essential to enhance Tonga’s climate resilience and promote private sector development. In this regard, they encouraged the authorities to improve the regulatory framework for foreign direct investment, expand and upgrade public infrastructure, increase social spending, and enhance land leasehold market 2 operations. Directors welcomed the authorities’ commitment to continue strengthening the AML/CFT framework, which will help reduce risks to correspondent banking relationships.

It is expected that the next Article IV consultation with Tonga will be held on the standard 12-month cycle.