The Tongan economy suffered a double blow from the catastrophic impact of the Hunga Tonga Hunga Ha’apai (HTHH) volcanic eruption and tsunami in January 2022, and the local COVID-19 outbreak since February 2022, amid the prolonged adverse effects of global inflation due to the COVID-19 related disruptions on global supplies and shipping services, rising food and energy prices and of course the effects of the war in Ukraine. These developments have further derailed economic recovery from previous cyclones such as TC Gita and TC Harold.

Primary goals of the Government are to reinstate and reconstruct the economy, improve economic growth and reduce poverty. As stimulus packages boost government expenditure and increase aggregate demand, these also add to imported inflation.

Fighting inflation or supporting economic growth is the main challenge facing the National Reserve Bank of Tonga. Monetary policy has to be conducted carefully to maintain internal and external stability and preserve financial stability while facilitative to the efforts of the Government to improve economic growth with equity.

These are the main economic challenges that the country faces:

  1. High inflation. Tonga’s annual headline inflation peaked at 9.3% in December 2021 but slowed down to 7.8% in March 2022, which are well above the Reserve Bank’s 5% reference rate. The cascading global impact of the ongoing pandemic and geopolitical tensions contribute to the surges in imported prices of goods and services. Inflation has increased for the same reasons in other Pacific Island countries. The higher imported commodity prices as well as the expectation of higher imported prices and supply side bottlenecks have been passed through to domestic producer prices, combined with the ongoing disruptions to domestic supply from natural disasters. The bulk of the inflationary pressures are therefore supply-driven and are beyond the Reserve Bank’s control. Domestic inflation is transitory and will moderate once the agricultural sector recovers and secures the domestic food supply.
  2. Excess liquidity, (about $330 million) remains in the banking system as a result of the high inflows of budget supports, project grants, and relief funds from development partners to assist the Government’s recovery programme and also the significant inflows of private remittances. These have increased the foreign reserves and money supply way beyond the country’s demand for money. The delay in the implementation of Government projects, partly due to the international border closure, contributes to the high liquidity levels holding up, while credit growth has turned negative since mid-2020. Mopping this huge excess supply of liquidity from the banking system through open market operations is a costly exercise and beyond the Reserve Bank’s current financial capacity.
  3. The slowdown in credit growth reflects loan-run offs amid limited local lending opportunities as the ongoing pandemic-related uncertainties weighed on business confidence and investments.
  4. Weak economic growth. The Reserve Bank estimates GDP growth to contract again by 2.0% in FY 2021-22, following an estimated -2.5% growth in FY 2020-21.

Given those competing challenges, the Reserve Bank has carefully examined various channels of monetary policy that could appropriately address them.

Using monetary policy to fight inflation includes measures that would slow down economic growth and aggregate demand, as reflected below. Examining the underlying sources of inflation is also key to the consideration of the appropriate tool that would effectively contribute to curbing inflation.

  1. Increase interest rates, (current actions taken by the central banks in New Zealand, Australia and USA to fight inflation).

If the Reserve Bank opts to increase interest rates to curb inflation, this would undermine the request from the Minister of Finance to reduce interest rates as a way of encouraging credit growth in order to facilitate economic growth.

While decreasing interest rates as requested by the Ministry of Finance would ease borrowers’ debt service burden, it would not necessarily increase credit growth, given the ongoing COVID-19 related uncertainties. What can be done to encourage lending in the domestic market are enabling infrastructures, such as:

    • bankruptcy laws,
    • enhancing the land administration system, and
    • completing the establishment of the domestic credit registry.

The rising corporate and household indebtedness also limit borrowers’ capacity to borrow which further hinders any additional lending by the banks.

The effectiveness of direct controls to reduce interest rates, would be hard to monitor due to the differences in types and sizes of loans, but it may pose risks to financial stability, through impacts on banks’ profitability and capital position.

  1. Slow down bank lending to reduce aggregate demand and economic growth.

Slowing down bank lending will undermine the efforts of the Government to increase economic growth and rollout concessional loans through the Tonga Development Bank. Credit growth is also already negative therefore this tool would be redundant at this point.

  1. Re-value the Pa’anga to make it stronger. The scope of the exchange rate to counter inflation is restricted by the exchange rate regime being pegged to a basket of the major trading partners’ currencies.

To use the flexibility in the exchange rate to strengthen the Tongan pa’anga to counter inflation would disadvantage recipients of foreign exchange, particularly remittances, an important income subsidy and social safety. The pass through of a stronger exchange rate to import prices and to overall consumer prices, however, is minimal (less than 0.5 percentage points).

Revaluation losses and undue pressure on the foreign reserves may also result.

The costs of an exchange rate policy to strengthen the Tongan pa’anga therefore far outweighs the benefits, while it reduces the much-needed liquidity in the banking system for banks to lend and to support economic activity.

Many of Tonga’s major trading partner countries such as the United States, Australia, and New Zealand have already taken action in tightening monetary policy to curb inflation. The effects of these actions will also pass through to Tonga’s inflation through imports as reflected in the annual headline inflation trending down to 9.1% in February 2022 and 7.8% in March 2022 without any interventions from the Reserve Bank.

  1. Mop the excess liquidity by increasing the Statutory Reserve Deposit ratio and/or issuing Reserve Bank notes. These two options will signal that the Reserve Bank is conducting contractionary monetary policy, which will undermine the Minister of Finance’s 2023 Budget policies. The buildup of excess liquidity is beyond the Reserve Bank’s control therefore issuing Reserve Bank notes would be a very expensive exercise while having limited impact on fighting inflation.

Given the above, with the understanding that impacts of our trading partners fighting inflation will be imported to Tonga through our exchange rate basket, the Reserve Bank will therefore take a wait-and-see approach to inflation over the next 6 months.

The Reserve Bank will however continue to maintain its current accommodative monetary policy stance and work in tandem with the Government towards supporting economic growth and macroeconomic stability, while remaining alert to inflation and maintaining financial stability.

To facilitate the Government’s efforts in the 2022/23 Budget Strategies, the Reserve Bank will continue to maintain the current policy efforts:-

  1. Maintain the monetary policy rate at 0% (zero interest rate policy);
  2. Maintain the current weights in the Exchange rate basket, which supports the country’s economic fundamentals;
  3. Reduce the minimum loans/deposit ratio from 80% to 70% and push the banks to meet this target within the next 6 months;
  4. Maintain the Statutory Reserve Deposit (SRD) at 10% and stand ready to increase to 15% if high inflation persists;
  5. Maintain the inflation reference rate at 5%.
  6. Continue to facilitate an enabling financial infrastructure to support prudent credit growth by establishing a domestic credit registry;
  7. Liaise with the Government on:
    • developing bankruptcy laws to reduce the default risks component of the interest rate structure;
    • enhancing the efficiency of the land administration system;
    • establishing a Loan guarantee scheme to assist the micro, small and medium enterprises (MSMEs); and
    • establishing an interest rate subsidy available to all banks in order to promote low cost lending to targeted sectors such as micro small and medium enterprises.
  1. Continue to enhance financial sector supervision to better monitor the corporate and household indebtedness, and enhance anti money laundering supervision, while protecting financial consumers’ interests, through:
    • robust risk assessments and stress-testing; and
    • up to date prudential guidelines for risk management at banks and non-bank financial institutions.
  1. Maintain clear channels of effective communications with the financial institutions to ensure delivery of essential financial services to the public, especially during pandemic-related lockdown periods;
  2. Continue to improve the efficiency of the payments system, through the rollout of the Domestic Electronic Payment System (DEPS) which will automate the settlement and clearing system;
  3. Continue to combat de-risking by global and local banks in order to retain banks’ correspondent bank relationships and foreign exchange dealers’ bank accounts such as:
    • addressing the recommendations from Tonga’s Mutual Evaluation Report to strengthen the Anti- money laundering and Combating the financing of Terrorism supervision of financial institutions and cash dealers;
    • encouraging the development of technological solutions (FinTech) including exploring the feasibility of issuing central bank digital currency (CBDC);
    • completing the setup of the Reserve Bank’s Know Your Customer (KYC) system with the plan to set up a National KYC framework linking it to the e-Government project.

Having said the above, the Reserve Bank will continue to watch the trend of inflation and will liaise with the Government on the best way forward, as some of the monetary interventions will offset the Government’s growth strategies.