The Reserve Bank’s neutral monetary policy stance remained unchanged in the past six months.

The recovery in the global economy continues to advance, however remains uneven. In many advanced economies, growth remains subdued and unemployment rates are still very high. In contrast, activity in many emerging economies remains buoyant, inflationary pressures are rising, and there are signs of overheating driven in part by strong capital inflows. The International Monetary Fund (IMF) has estimated that the world economy will grow by 4.4 percent in 2011, a fall from 5 percent growth in 2010. In the United States (US), the pace of recovery has picked up on the back of easing financial conditions and increased private demand. Nevertheless, improvement in the labor market remains slow. Economic activity in Europe remains below potential level and unemployment is still high. In contrast, the Chinese economy continues to grow strongly and is expected to remain robust in the next two years. In Australia, economic activity expanded at a solid pace in the second half of 2010, due to high demand for Australian commodities, supporting business investment. However, in December 2010 and early 2011, economic activity was disrupted by the floods across Australia, causing a significant decline in coal production over recent months and heavy damage to crops. Despite the adverse impact of the floods on the external sector, Australia’s employment growth continues to be strong and business conditions remain positive. The modest and weaker economic growth in New Zealand was exacerbated by the impact of the Christchurch earthquake in February 2011. Consumer and business confidence are likely to be reduced, and economic uncertainty could see households trim spending and firms delay investment plans. To lessen the economic impact of the earthquake, the Reserve Bank of New Zealand reduced the official cash rate by 50 basis points to 2.5 percent in March 2011.

The primary monetary policy objectives of the National Reserve Bank of Tonga (NRBT) continues to focus on maintaining an adequate level of foreign reserves and promoting price stability. In the past six months, the level of foreign reserves continued to remain well above 4 months of import cover mainly due to foreign aid inflows, credit constraints on domestic demand and deferred import payments. Consequently, liquidity in the banking system continued to remain at a high level. Despite the availability of excess liquidity in the banking system, banks’ credit growth to the private sector continued to contract with banks containing tight lending conditions. Headline inflation increased over the past six months reflecting the rise in world oil prices, imported and domestic food prices, and increase in the imported tobacco and alcohol tax rate. Given the high level of liquidity in the banking system, monetary policy continued to be accommodative in the past six months. However, the desired outcome of the monetary policy measures continued to be muted by the banks’ balance sheets consolidation and focusing on recovering of non performing loans. Consequently, credit growth continued to contract.

Foreign reserves remained high at comfortable levels, despite declining at the beginning of the year. The high level of foreign reserves was underpinned by the receipts of government aid funds from Tonga’s development partners as well as deferred import payments. Nevertheless, the high capital outflows contributed to the fall in foreign reserves over the past three months. At the end of March 2011, official foreign reserves amounted to $157.1 million, equivalent to 6.4 months of imports compared with $172.7 million (7.1 months of imports) at the end of September 2010.

Private sector credit growth contracted by 9.4 percent over the year to February 2011 compared to the 13.1 percent contraction in the year ended August 2010. The contraction in credit growth was mainly due to the banks’ balance sheet consolidation process and the write off of bad debts. However, if the disbursement of the reconstruction loan from the People’s Republic of China was channeled through the banking system and accounted for, the overall credit growth to the private sector would have increased by 17.9 percent during the year ended February 2011.

Inflation has increased in the past six months, reaching 6.9 percent in the year ended January 2011 before it eased to 6.5 percent in the year ended February 2011. The rising world oil prices and global food prices, and the imposition of government excise tax on imported tobacco and alcohol in July 2010, contributed to the escalation in imported inflation. Imported food and imported fuel dominate the CPI basket and price fluctuations in these items have a major influence on the overall inflation in Tonga.

Outlook

Domestic economic activity is expected to be underpinned by foreign aid funded construction and infrastructure projects. However, the uncertainty in the economic outlook remains. Despite the recovery in the global economy, unemployment remains high in the major remittance source countries particularly in the United States. The floods in Australia, the earthquake in Christchurch, and the earthquake and tsunami in Japan are likely to affect remittances and tourism in Tonga. The level of gross foreign reserves is expected to remain above 4 months of imports and inflation is expected to rise as a result of the increase in oil and food prices. Against this background, the current neutral monetary policy stance will be maintained in the next six months.

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

Despite the ample liquidity in the banking system, credit by banks will remain limited in the next six months as banks will continue to tighten the lending standards, given the focus to improve their balance sheets and the uncertainty about the economic prospects. Large construction and infrastructure projects are being financed mainly by foreign aid from Tonga’s development partners. As such, the foreign reserves will be supported by foreign aid expected to be received in the next six months therefore liquidity in the banking system is expected to be more than adequate.

Headline inflation is estimated to increase in the next six months as world oil prices and global food prices continue to rise. The appreciation in the NZ dollar against the Tongan pa’anga and the expected pick up in domestic demand from the construction activities will contribute to inflationary pressures while the appreciation of the pa’anga against the US dollar will contribute to dampen the inflationary impact of the rising world oil price.

The Reserve Bank will continue to maintain the country’s foreign reserves position at an adequate level, and promote low inflation, mindful of the downside risks to the outlook. The uncertainty in the global economy and the high unemployment rates in the major remittance source countries especially in the United States, the rising oil and food prices and increased capital outflows will all exert downward pressure on the foreign reserves.

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.