The Tongan economy showed considerable resilience over 2006/07 in the face of substantial economic shocks. Significant increases in public service salaries paid in two tranches over the past two years, as well as large scale redundancies, placed considerable strains on inflation and the government's fiscal balance. Furthermore, the civil unrest in November 2006 threatened the macroeconomic stability of the country with the destruction of around 20 percent of Tonga's GDP. The Ministry of Finance forecasts economic growth to have contracted in 2006/07 by 3 to 4 percent. Ongoing record prices of imported commodities, particularly oil, added to the internal shocks, while appreciations in the New Zealand and Australian dollars placed further upward pressure on imported inflation. The culmination of these events presented major challenges to the conduct of monetary policy.

I am pleased to report that despite these many challenges, the external balance of the country continued to improve, stability and confidence in the financial sector was maintained and inflation eased. The level of official foreign exchange reserves remained above 4 months of import cover throughout 2006/07 and average inflation fell to 5.1 percent, the lowest level in 7 years. Beyond 2006/07, a moderate pick-up in activity is expected, underpinned by increased construction spending. It is pleasing to note that growth in lending for business investment is already gathering momentum.

The financial year began with growth in household credit continuing at an unsustainable pace, albeit well below the growth in 2005/06. Credit ceilings, introduced in January 2006, were extended to December 2006, allowing for an expansion of credit that was consistent with the protection of foreign exchange reserves and macroeconomic stability. However, the civil unrest of 16 November 2006 dramatically changed the economic outlook, therefore the Reserve Bank refocussed its policy measures to maintain monetary and financial sector stability. Amid the crisis, the Reserve Bank liaised on a daily basis with the banks to ensure that the public's requirements for currency were effectively andsecurely satisfied. Foreign exchange guidelines were tightened and the quality of banks' loan portfolios was closely monitored. In February 2007, the credit ceilings were suspended, allowing affected businesses to have greater access to funds for reconstruction. Liquidity in the banking system nevertheless remained constrained and in April, the Reserve Bank reduced the required reserves ratio of commercial banks from 12.5 percent to 10 percent, resulting in an injection of T$6.2 million into the banking system. Monetary policy has since remained accommodative, with the Reserve Bank choosing to leave excess liquidity in the banking system by refraining from issuing Reserve Bank notes in order to facilitate reconstruction.

In an important milestone in the development of Tonga's financial system, The National Reserve Bank Amendment Bill 2007 was passed by the Legislative Assembly in August 2007 after being deferred in 2005. This Act will strengthen the institutional capacity of the Reserve Bank and ensure greater autonomy in the conduct of monetary policy. The Act also strengthens the accountability and transparency of the Reserve Bank in exercising its powers. The Reserve Bank will be required to publish every six months a Monetary Policy Statement; the first Statement was published in September 2007. The release of regular Statements on Monetary Policy mean that commentary relating to the conduct of monetary policy will no longer be included in the Annual Report as in previous years.

Separate to the Act and to further enhance accountability and transparency, the Reserve Bank reviewed its policies and procedures relating to liquidity management and in October 2006 commenced publishing daily liquidity data on its website. In December 2006, the terms and conditions of the Reserve Bank's Repurchase Agreement facility were revised and the repurchase agreement rate was set at 2 percent above the inter-bank market rate.

Substantial progress was also made in enhancing accountability and transparency within the wider financial system. The release of Prudential Statement No. 3, relating to administrative penalties, which became effective in September 2006, is designed to ensure the timely and accurate provision of data by banks, a vital prerequisite for sound economic and financial decision making. Furthermore, the release of Prudential Statement 4, Disclosure of Interest rates and Fees and Charges, requires banks to fully disclose the cost of their services and products and became effective in August 2007. This Prudential Statement was prepared after consultations with the newly-formed Association of Banks in Tonga (ABT), an initiative that was welcomed by the Reserve Bank. The establishment of the ABT in April 2007 is expected to provide an important forum for the discussion of issues that can only enhance the effectiveness and efficiency of the financial system.

Despite the unexpected crisis of November 2006, which interrupted the implementation of the 2006/07 workplan, the Reserve Bank successfully completed its target to update the documentation of the Bank's policies and procedures together with staff job descriptions. The Reserve Bank continued to carry out its regular functions that contribute to monetary and financial sector stability. These functions include the supply of Tongan currency, provision of daily settlement for inter-bank transactions, foreign exchange operations with the government and the banks, foreign exchange control administration and registrar of government bonds.

The Reserve Bank continued to develop the skills base of its staff, through local and overseas training. Staff participated in courses across the range of central banking functions, including bank supervision, reserves management, remittances, anti-money laundering, balance of payments reporting and information technology.

The annual accounts of the National Reserve Bank of Tonga comply with the requirements of the International Financial Reporting Standards, with the exception of the treatment of foreign currency gains and losses, which meets the provisions of the National Reserve bank of Tonga Act, 1988. The Reserve Bank's balance sheet expanded to T$133.4 million, a 6.4 percent increase from the previous year attributed mainly to the increase in the level of official foreign reserves over the year. Consequently, the Reserve Bank's operating profit, reached T$3.6 million, an increase of 14.5 percent over the previous year.

I thank the staff of the Reserve Bank for their efforts during a very challenging period for the Reserve Bank and the Tongan economy. I also thank the government and members of the financial sector for their part in ensuring that confidence and stability in the system was maintained. Appreciation is also extended to the members of the Bank's Board for their continued support during the year. The assistance from the International Monetary Fund, Pacific Technical Assistance Centre, the Reserve Banks of Australia, New Zealand and Fiji, other regional central banks, the Bank of England Centre for Central Banking Studies, AusAID, NZAid, AUSTRAC, AMLAT and the Pacific Antimoney Laundering Project is also gratefully acknowledged.

Governor Siosi Mafi