The current global financial climate is very uncertain. In the economies of the United States and the United Kingdom financial institutions are under pressure with some failing and some surviving only due to massive government-funded bailouts. As such, monetary policy around the world is taking a bit of a back seat as central banks focus on the function of maintaining financial stability.

The world economy is slowing down as response to the ensuing credit crunch, bringing with it lower official interest rates, lower stock market indices and lower commodity prices. The problem for central banks is that despite many lowering interest rates in an effort to stave of the financial crisis and encourage more lending and activity, many banks are not lending to each other and wholesale rates are in many cases rising. These outcomes underline the importance of maintaining financial stability where possible. Monetary Policy is a useful tool in maintaining monetary and price stability in normal circumstances, but when the banking system becomes dysfunctional monetary policy becomes very limited in its effectiveness.

While world economy struggles, the Tongan economy is estimated to have embarked on a modest path to recovery after several years of flat and negative growth. Much of this growth is, and will continue to be, spurred by new investment, especially construction aimed at the tourism sector. Along with renewed economic growth the Tongan economy is experiencing rising imports, rising inflation, rising non performing loans and falling foreign reserves to the end of July.

The new investment has been funded by increased lending, with credit to the business sector up more than 40 in the past year. Most construction projects need to import a large proportion of their inputs, so this investment has contributed to the run up in imports, and the funds from the banking system paying for these imports along with increased payments for higher-priced fuel have contributed to the run down in foreign reserves. Furthermore, the combination of rapid credit growth and rising non-performing loans contributed to tighter liquidity in the banking system. The National Reserve Bank of Tonga (NRBT) eased its monetary policy stance in February 2007 by removing credit ceilings in order to aid the reconstruction efforts and facilitate business growth after the events of November 16, 2006. Since then, annual credit growth increased from 4.9 percent to 19.9 percent at the end of July with credit growth to the business sector rising from 16 percent to 41 percent per annum respectively.

As the banking system had been constrained by the amount of funds that were available the NRBT saw a natural ceiling being imposed on lending growth, and expected that in due course lending growth would slow again. Through the middle of the year it became obvious that banks had reduced their lending and large debt repayments were expected to be received which provided the NRBT comfort in terms of further threat to external stability and the payment system.

Despite the increase in non-performing loans and the delay in the anticipated receipt of debt repayment the banking system in Tonga remains sound and strong. It is well capitalized and in compliance with minimum prudential standards.

Inflation reached 12.6 percent in May, its highest rate since January 2004. Much of this inflation is due to the imported costs of fuel and food. Lately, these two factors have reduced in their impact on prices in Tonga and inflation appears to be gradually retreating from its peak falling to 9.3 percent in July. The movement of the value of the pa’anga within the basket has contributed to the easing of inflation pressures.

Outlook

Overall, the outlook for Tonga is sound. Foreign reserves look set to remain comfortably above 3 months of imports for the foreseeable future, there will be adequate liquidity available in the banking system and inflation is expected to be moderating. The threat to these comes from the pace of lending growth, where the Reserve Bank must weigh up the benefits of investment and economic growth against lower reserves, higher inflation and an efficient payment system.

While foreign reserves have been falling up until July, there are large expected inflows from foreign aid and debt settlements that should see the current decline arrested shortly. The NRBT is pleased to see the increase of reserves, but is mindful of the effect that extra liquidity in the banking system will have on credit growth. Lending to the private sector is already growing at fast rates and an increase in available funds could see this growth reaccelerate.

A reacceleration of credit growth will put pressure on domestic resources, potentially leading to more inflation and tighter liquidity in the system if the increase in non performing loans is not reversed. More certain is that further increases in credit, especially for construction, will increase imports. These imports will again cause foreign reserves to lower and the nations import coverage ratio to drop. On top of the increased funds within the banking system there is the prospect of the Private Sector Reconstruction Fund (PSRF) being more fully utilized. The PSRF is expected to add about $12.5 million to lending – and a significant proportion of that will be spent on imports.

The price of oil has fallen dramatically in the last two months which should slow the increase in import payments and inflation somewhat. However, large falls and rises are still common in this market and it is too early to count on lower oil prices being a permanent part of the financial landscape. The New Zealand dollar has depreciated 14 percent since February, providing some relief from rising imported food prices. Most forecasters expect the NZD to continue depreciating, but in the current global climate forecasts are especially uncertain. The NRBT expects inflation to continue to moderate over the next year, but this expectation is dependant on the events in global markets.

The NRBT will be closely monitoring the growth in lending and foreign payment commitments by the system to ensure financial stability and maintenance of adequate foreign reserves. Should lending start to grow at an unsustainable pace due to increase in funds in the banking system then the NRBT will commence the issue of NRBT Notes to mop up excess liquidity.

The Reserve Bank will continue to closely monitor developments in the banking system in order to promote internal and external monetary stability and promote a sound and efficient financial system.