The financial year, 2005/06, provided many challenges to conducting monetary policy. Unsustainable growth in credit to the private sector in the first half of the year, a significant increase in salaries awarded to civil servants and a deterioration in the government’s fiscal position posed major risks to macroeconomic stability.

The rapid growth in credit and the increase in the salaries of civil servants contributed to strong growth in imports and placed downward pressure on the level of foreign exchange reserves. The associated strong growth in domestic demand also risked the prospect of higher inflation. It was against this background that the Reserve Bank Board, with the approval of the Privy Council, decided to tighten monetary conditions. Credit ceilings were introduced in January 2006 aimed at slowing the growth of credit and promoting external and internal price stability. Exchange control policies were also tightened.

By the end of June 2006, the policy initiatives appeared to have contributed to stabilising the macroeconomic situation. The pace of credit growth slowed markedly, foreign exchange reserves remained above the Reserve Bank’s target of 3-4 months of imports, the currency remained stable, and inflation trended downwards.

Nevertheless, the economic effects of the increase in the salaries of civil servants and the payment of redundancies are yet to be fully realised. Imports are expected to grow firmly in 2006/07 and exports are expected to remain stagnant with adverse implications for foreign exchange reserves and external price stability. Inflation is also forecast to rise from present levels. Given this outlook, the Reserve Bank in consultation with the banks decided in June 2006 to extend the credit ceilings for another six months. The ceilings for December allow for an expansion of credit that is consistent with promoting external and internal price stability. Special consideration for exemptions to the ceiling would continue to be given for loans to foreign exchange-earning sectors and for loans fostering balanced economic growth. Furthermore, the repayment of a large amount of private individual loans from the government redundancy and salary arrears payments would provide extra scope for the banks to extend credit.

In November 2005, the Board approved the reintroduction of Reserve Bank Notes to improve the management of liquidity in the banking system. Market conditions did not warrant the issue of Reserve Bank Notes until March 2006 when the Required Reserves Ratio was reduced to 12.5 percent from 15 percent. The use of open market operations has always been the preferred instrument for managing liquidity in the system but the high cost prompted the Bank to discontinue the issue of Reserve Bank Notes in 2001. The Reserve Bank’s capital position has improved over the past 5 years and has enabled it to re-commence the issue of Reserve Bank Notes.

The year was also eventful on the banking supervision front. The Financial Institutions Act 2004 became effective, bringing the licensing and supervision of financial institutions into conformity with the Basel Core Principles for Effective Banking Supervision. The new Act assigns the authority for licensing financial institutions to the Reserve Bank. As such, existing financial institutions were issued with a banking license under the new Act. This new Act strengthens the supervisory role of the Reserve Bank by tightening requirements on statistical reporting, as well as providing legal backing for the establishment of prudential standards. Indicators of banking system soundness were strong, with capital ratios above minimum required levels and a fall in non-performing loans to the lowest level in nearly a decade.

Progress was also made in the area of combating money laundering and terrorist financing. In July 2005, Tonga was formally welcomed as a member of the Asia Pacific Group on Money Laundering, reflecting Tonga’s commitment to support global movements towards combating money laundering and terrorist financing. The Reserve Bank continued to carry out other functions that contribute to monetary and financial sector stability. These functions included the management of the supply of the Tongan currency, provision of daily settlement for inter-bank transactions, undertaking foreign exchange operations with the government and the banks, foreign exchange control administration, and registrar of government bonds.

The Reserve Bank commissioned Pricewaterhouse Coopers, Fiji to undertake a generic review of the Bank’s salary structure against 5 major organisations including the government’s post-wage settlement salary structure. This ensured that the Bank’s salary structure remained within the salary range of these large organisations. The Bank continued to enhance the skills base of the staff through training. Staff participated in courses across the range of central banking functions, attending workshops relating to financial programming, bank supervision, anti-money laundering and information technology.

The annual set of accounts of the Reserve Bank for this year adopted and complied with the requirements of the International Financial Reporting Standards (IFRS) with the exception of the treatment of foreign currency gains and losses, where it will continue to comply with the provisions of the National Reserve Bank of Tonga Act.

I thank the staff of the Reserve Bank for their dedication and hard work in what has been an eventful year. I also thank the members of the Board for their continued support during the year. The assistance from the International Monetary Fund, the Reserve Bank of Australia, the Reserve Bank of New Zealand, Reserve Bank of Fiji, other regional central banks, Bank of England, Pacific Technical Assistance Centre, AusAID, NZAid, AUSTRAC, and AMLAT is also gratefully acknowledged.

Governor Siosi Mafi