The world economy continues to recover following the global downturn in 2009, owing to an extraordinary amount of policy stimulus. Monetary policy has been highly expansionary, with interest rates down to record lows in most advanced and some emerging economies, while fiscal policy has provided major stimulus in response to the recession. The International Monetary Fund (IMF) has estimated the world economy will grow by around 4 percent in 2010. The recovery in most advanced economies is expected to remain sluggish, whereas in many emerging and developing countries, growth is expected to be relatively strong. At the same time, risks around the global outlook have increased and uncertainties remain. In major advanced economies including the United States, high unemployment may hold back the recovery in household spending and substantial fiscal stimulus has increased public debt levels. In contrast, the recovery in the Asia-Pacific region has been more robust, particularly in China and Australia. China’s economy has expanded very strongly, and industrial production and international trade have rebounded. In Australia, economic conditions were better than expected, reflecting developments in the Asia Pacific region and significant economic stimulus, resulting in strong consumer spending and business investment. Given the positive economic outlook for Australia, the Reserve Bank of Australia raised its cash rate by 125 basis points in the October 2009 - April 2010 period to 4.25 percent, to ensure that inflation remains consistent with its target. The New Zealand economy is recovering broadly as expected and growth is predicted to pick up further through 2010.

Maintaining an adequate level of foreign reserves and promoting price stability are the main monetary policy objectives of the National Reserve Bank of Tonga (NRBT). In the past six months, the level of foreign reserves continued to remain above 4 months of import cover bolstered by extraordinary receipts while at the same time, demand for imports weakened due to falling remittances and credit constraints. Banks’ credit growth to the private sector continued to contract and inflation remained low. Reflecting the relatively weak state of the economy, monetary policy remained accommodative to help stimulate the economy. The Reserve Bank refrained from issuing NRBT notes and the Statutory Required Reserves (SRD) was maintained at 5 percent. In addition, the Reserve Bank commenced paying interest on banks’ exchange settlement account balances over T$1 million, of 1 per cent effective from 4 January 2010, to further reduce the domestic banks’ interest rates in order to assist borrowers who are facing financial difficulties and stimulate economic activity. The Reserve Bank also reduced the interest rate on the repurchase facility for domestic banks from 4.5 percent to 1.9 percent in March 2010 in line with the decline in the interbank lending interest rate.

Foreign reserves continued to remain at comfortable levels, underpinned by large inflows and lower import payments which offset falling remittances and official capital outflows, mainly foreign currency loan repayments. At the end of March 2010, official foreign reserves amounted to $155.5 million, equivalent to 6.5 months of imports. The high level of foreign reserves reflected the IMF SDR allocations in August and September 2009, and the first disbursement of the official grant from the Asian Development Bank (ADB) in March 2010. The high level of foreign reserves also reflects the weak domestic demand, lower imports and tight credit condition.

Private sector credit growth contracted further by 12.9 percent year over the year to February 2010 mainly attributed to the further decline in lending to the business sector. The significant decline in credit growth reflected the banks’ tight credit criteria in response to the rapid increase in non-performing loans, the impact of the global crisis and the settlement of the long outstanding squash council loans. However, when the reconstruction loan from the People’s Republic of China is accounted for, the overall credit to the private sector grew by 2.0 percent during the year ended February 2010.

Inflation has generally moderated over the past six months, to 1.9 percent at the end of February 2010. The rebound in world oil prices has contributed to the pick up in imported inflation, which will eventually pass through to domestic inflation. Fuel and food imports dominate the CPI basket and price fluctuations in these items, particularly fuel, explain the large fall in headline inflation in 2009 and the recent pick up at the beginning of 2010.

Outlook

Tonga’s economy is expected to recover in the next six to twelve months, albeit slowly. While the global recovery is proceeding at different speeds in various regions, unemployment continues to remain high. This means that the negative impact on remittances and tourism in Tonga will continue in the coming months. Credit growth will continue to be subdued underpinning a comfortable level of foreign reserves. Economic activity is expected to slowly pick up due to increased construction activity. Inflation will rise as a result of the rebound in oil prices but will remain in single digits. Against this background, the monetary policy stance will be maintained on a neutral stance in the next six months.

Foreign reserves are projected to fall in the next six to twelve months but will remain at adequate levels, above 4 months of import cover. Exports are forecast to remain low and remittances will continue to remain weak as the unemployment rates in the major remittance source countries especially the United States, remain high. Conversely, import payments are projected to rise consistent with the rebound in oil prices and combined with capital outflows especially debt repayments will exert downward pressure on foreign reserves.

Banks’ credit growth will continue to slow as lending conditions are expected to remain tight for the next six to twelve months. Large construction and infrastructure projects are being financed mainly by the AusAID and NZAID Private Sector Reconstruction Facility (PSRF), the reconstruction loan from the People’s Republic of China and other foreign aid. That said, liquidity in the banking system will continue to remain ample in the next six months.

Headline inflation is estimated to pick up in the next six months as world oil prices continue to rise which will pass through to domestic prices with a lag of one month. The recent increase in electricity prices and the expected recovery in domestic demand will also contribute to inflationary pressures.

The Reserve Bank will continue to target maintaining the country’s foreign reserves position at an adequate level, the main focus of monetary policy, mindful of the downward risks to the outlook which may affect the current monetary policy stance. The downward trend on remittances, the slow recovery and the high unemployment rate in the United States, the rising oil prices and increased capital outflows will all exert downward pressure on the foreign reserves.

Nevertheless, the Reserve Bank will continue to closely monitor the country’s economic and financial conditions in order to preserve an adequate level of foreign reserves, maintain price stability and promote a sound and efficient financial system.