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Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia
Tonga Economic growth in 2003 picked up slightly, though inflation remained high and foreign reserves were under pressure. The outlook is for faster expansion and improving public finances, provided that the economic and public sector reform program is implemented effectively. Economic Assessment Economic growth in FY2003 (ended 30 June 2003) climbed a little to 1.9% from 1.6% in FY2002. Agriculture, forestry, and fisheries grew slowly at 1.4%, with expansion of squash, vanilla, and root crop production offsetting a decline in fishing caused by poor regional weather conditions. Construction expanded by 4.0%, as reconstruction work following the late 2001 cyclone was completed. The services sector grew by 2.4%, with growth reportedly strong in finance; modest in commerce, hotels, and restaurants; and stagnant in government services. Tourist arrivals in FY2003 were up by 7.0% from the FY2002 level. In the transport and communications subsector, Royal Tongan Airlines expanded its international services by leasing an aircraft. Continued slow economic growth exacerbated the problem of inadequate employment opportunities, especially for young school leavers, and prevented a reduction in the 23% of households living below the basic needs poverty line. The overall budget deficit for FY2003 was T$10.5 million (3.1% of GDP), slightly above the original target deficit of T$8.7 million. There were shortfalls in external grants and nontax revenues that were partly offset by tax revenues coming in above budget estimates. Total revenues and grants amounted to 28.9% of GDP. Total expenditures and net lending were below budget at 32.1% of GDP, primarily because of lower capital expenditures. Wages and salaries rose by 10% on the FY2002 level but fell slightly to 48.8% of total current expenditures. In contrast, net lending to nonfinancial public enterprises (NFPEs) was almost 10 times the budget estimate because the Privy Council (King and Cabinet) authorized assistance to Royal Tongan Airlines outside the budget appropriation process. The overall budget deficit was financed 28% externally and 72% domestically through borrowing and drawdowns of government cash balances. The public domestic debt outstanding at end-FY2003 was T$37.4 million (about 11% of GDP), and included government debt and government-guaranteed debt of public corporations. Public external debt was T$164.4 million, equivalent to just under half of GDP. Inflation continued at double-digit rates, reaching an average of 11.1% in FY2003 as a result of higher oil prices and further weakening of the local currency (Figure 2.35). According to central bank data, the US dollar value of merchandise exports fell slightly in FY2003 while imports rose by 21%, largely because of higher imports of consumer goods, construction materials, fuel, and capital equipment. The consequent widening of the trade deficit, together with increased deficits on the services and investment income accounts, more than offset the increased surplus on the transfers account. The current account deficit reached 3.1% of GDP. The capital account surplus rose as increased net official inflows outweighed a decline in net private capital flows, but the overall balance of payments moved from surplus into deficit. Foreign reserves reached 3.5 months of import cover by December 2003. Policy Developments In 2003, the Government focused on implementing the Economic Public Sector Reform Program (EPSRP), which has the primary aims of maintaining a stable macroeconomic environment and achieving sustainable economic growth led by private sector development. In pursuit of these aims, the legislative framework for public sector management underwent substantial change, with four acts coming into force during 2003. The Public Finance Management Act strengthens the power of the Minister of Finance to ensure fiscal discipline. The Revenue Administration Act provides a legal foundation for improving tax and customs administration. The Public Enterprise Act gives the Minister of Finance the power to appoint public enterprise directors, requires public enterprises to submit timely annual reports, and provides a framework for corporatization and privatization. Finally, the Public Service Act provides for a modernization of the civil service. The budget for FY2004 projects a reduction in the overall deficit to T$6.6 million or about 1.8% of GDP. Revenues and grants are forecast to rise by 29% on the FY2003 level and total expenditures and net lending by 22.5%. Half of the rise in revenues and grants comes from an expected increase in external grants to an historically high level. The other half of the rise is expected to come from economic growth and improved tax compliance, especially in collection of import duties, and administrative fees and charges. Taxes on income and profits are budgeted to fall. The revenue estimates assume speedy and effective implementation of tax administration reform. Current expenditures are projected to increase by 14.6% from the FY2003 level, largely because of greater purchases of goods and services. Capital expenditures are projected to rise eightfold because of the construction of a new hospital in the capital city through external funds. Net lending is projected to be negative in the expectation that assistance to NFPEs will be confined to direct subsidies of T$3.2 million. The actual budget outcome in FY2004 will depend heavily on the extent to which the Government can control demands from public enterprises. About 89% of the budget deficit projected for FY2004 is to be funded by external loans at concessional rates. The concessional nature of external debt means that the net present value of public external debt is considerably below the book value, standing at 25.8% of GDP in June 2003. Debt service costs are manageable at less than 10% of exports of goods and services. Tightening of monetary policy is hampered by the weakness of the central bank's balance sheet. The Public Finance Management Act permits the Government to allow the central bank to use government-issued bonds for liquidity management purposes. Ultimately, recapitalization of the central bank and higher income from foreign reserves are needed. In the meantime, reliance will be placed on credit ceilings, which need to be made binding, and on minimum reserve requirements. With regard to private sector development, the budget strategy for FY2004 and beyond is to contain the tax burden on the private sector. A new tax policy under discussion, and scheduled for implementation in FY2005, intends to change the corporate tax rate from over 37% for nonresident companies and 15-30% for resident companies to a flat rate of 20%; raise the income tax threshold; introduce a single 10% duty on most imports; and shift the tax mix from import duties to a broad-based consumption tax. Simultaneously, the Government will repeal the Industrial Development Incentives Act of 1978. The Government has already passed a new Foreign Investment Act and a Business Licenses Act, which, respectively, simplify conditions for foreign investment and streamline business registration procedures. The length of land leases and relatively frequent revisions of land rents are fundamental issues subject to ongoing government review. The Government is also seeking to attract investment through implementation of its public enterprise reform program including privatization. However, some mixed signals have been sent to foreign investors. In July 2003, the Government passed legislation restricting foreign ownership of media organizations in the country, and followed this up with selective issuing of newspaper licenses. Outlook for 2004-2005 Assuming that the effective implementation of the EPSRP, no adverse external shocks, and private remittance flows of about T$80 million-90 million a year, the outlook is for growth to accelerate into the 2.0-3.0% range during 2004-2005. Agriculture and fisheries are forecast to register a modest strengthening as fishing expands and the supplies of squash, vanilla, root crops, and kava respond to better opportunities in regional and global markets. Construction is expected to expand relatively strongly as a result of externally funded projects and a greater government capacity to fund capital expenditure. Minimal growth in the dominant government services subsector will constrain overall tertiary sector growth, but commerce, restaurants and hotels, entertainment, and private services are projected to edge up as remittance flows continue and tourism expands. The Government plans to market the country as a unique and safe tourist destination but it will need to secure adequate air services. The strengthening of public financial management, tax policy reform, and civil service and public enterprise reform should result in better budgetary outcomes, an improved strategic allocation of public resources, and more effective public service delivery. On the expenditure side, wages and salaries are budgeted to increase by 9.2% from the FY2003 level, to allow for some pay increases in the context of a continued recruitment freeze. Priority in spending is to be given to law and order, education, health, and basic infrastructure. The major risks in this scenario are a push for civil service wage increases and greater demands on the budget from an unreformed public enterprise sector. The inflation rate is projected to moderate to around 4-5% on the assumption of continued exchange rate stability. The estimate current account is expected to improve as export growth accelerates and remittances maintain their current level, but no major improvement in the overall balance of payments is likely, unless foreign investment grows significantly. Foreign reserves are projected to stay in the vicinity of 3 months of import cover. Economic growth in the forecast range would create some employment opportunities for young entrants to the labor force, but the high level of youth unemployment and an associated rise in crime will probably continue to be major social issues. Rationalization of the civil service is also likely to directly contribute to unemployment.
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In January-December 2003, the Tongan dollar appreciated by almost 9% against the US dollar, but depreciated slightly against the yen and substantially against the currencies of Australia (23%) and New Zealand (15%), which together supply about two thirds of the country's imports. Broad money increased by 13.4% in FY2003, with domestic credit rising by 18.2%. Net foreign assets declined in FY2003, but rose by 18.8% by end-September 2003 from a relatively small base in September 2002. Domestic credit growth in FY2003 involved a 28% increase in lending to NFPEs and an almost 11% expansion in lending to the private sector for business and personal purposes. Given the high inflation rate, real deposit rates were substantially negative and some real lending rates were marginally negative. The ability of the central bank to conduct open market operations remained constrained by its limited capital base and low income from foreign reserves. Reliance was placed on quarterly credit ceilings on each of the commercial banks.
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