During the past six months, global economic conditions continued to be dominated by the impact of the global economic and financial crises. However, in recent months, forecasts for global growth were being revised upward assisted by unprecedented macroeconomic and financial policy support. Large fiscal stimulus packages and accommodative monetary policy measures introduced in many countries began to bolster economic activity. According to the International Monetary Fund (IMF), the global economy is beginning to pull out of recession but stabilization is uneven and the recovery is expected to be sluggish. In major advanced economies including the United States, gradual recovery in growth is anticipated in 2010. In the June quarter, the New Zealand economy emerged from its worst recession in three decades and slow growth is expected toward the end of this year. In Australia, economic conditions have been stronger than expected, underpinned by increases in consumer spending, exports and business investment, therefore, overall growth through 2010 is expected to be close to trend. The Reserve Bank of Australia in early October increased its cash rate by 25 basis points, the first country to start lessening the stimulus provided by monetary policy.

The Monetary Policy objectives of the National Reserve Bank of Tonga (NRBT) are to maintain an adequate level of foreign reserves, and to promote monetary and price stability. Prior to June 2009, due to threats to the Bank’s objectives, the Reserve Bank adopted a tight monetary policy stance while ensuring that adequate liquidity is available to the banking system. The impact of the global crisis which has led to falling remittances, declining tourist receipts and continuing declining exports threatened the outlook for foreign reserves and the external stability of the country. However, the lower inflows from remittances and tourism also led to a sharp decline in imports of goods and lower overseas payments.

Against this background the external position of the country continued to improve. The level of foreign reserves continued to rise and remained above 4 months of import cover in the past six months, credit growth continued to decline and inflation eased. The threat to monetary policy objectives has abated and therefore, the stance of monetary policy changed to easing to enable further reduction on domestic banks’ interest rates in order to support credit growth and stimulate sustainable economic activity. The Reserve Bank ceased the issue of NRBT notes in June 2009 and reduced the Statutory Reserve Deposit (SRD) from 10 percent to 5 percent in August 2009. The Reserve Bank also reduced the interest rate on its repurchase facility for domestic banks from 10 percent in March to 4.5 percent in May 2009.

Foreign reserves continued to remain at healthy levels, underpinned by large capital inflows and lower import payments which offset falling remittances. At the end of September 2009, the official foreign reserves reached a record high of $163.3 million, equivalent to 6.7 months of imports. This was mainly due to the receipt of the Special Drawing Rights (SDR) allocations made by the IMF to its member countries in August and September. These SDR allocations are to assist IMF member countries to address the fallout in global crisis and accelerate recovery.

Private sector credit growth has slowed considerably contracting by 9.7 percent year on year to August 2009. Both lending to the household and business sectors declined over this period. The marked slow down in credit growth is largely due to the tightening of credit criteria by commercial banks in response to the rapid increase in non-performing loans since the middle of 2008. However, when the China reconstruction loan is accounted for, the overall private sector credit grew by 1.4 percent during the year ended August 2009. The large provisioning for bad and doubtful debts by the commercial banks resulted in a deterioration in banks’ profitability and large capital injections were required and made to the commercial banks late last year and early this year. The banking system remains well capitalized and sound.

Annual inflation has eased in the past six months to 0.5 percent at the end of August 2009. The lower international oil prices and the weakening of the New Zealand dollar against the Tongan pa’anga up to the first quarter of 2009 have contributed to the fall in imported inflation, which passed through to domestic inflation. Fuel and food imports dominate the CPI basket and price fluctuations in these items have been reflected in the large fall in headline inflation over the past year.

Outlook

The outlook for Tonga is still uncertain. While the global economy is getting out of the recession, recovery will be slow and protracted with unemployment continuing to rise. This means that the negative impact on remittances and tourism in Tonga will continue in the next six months. Economic activity and credit growth will continue to be slow, therefore foreign reserves are expected to remain at comfortable levels, and inflation will remain low. Against this background, the current stance of monetary policy will remain unchanged for the next six months.

Foreign reserves are anticipated to decline but will remain at adequate levels, above 4 months of import cover by the end of June 2010. Exports are forecast to remain low in the coming months while imports are projected to rise, consistent with the rebound in oil prices and the reconstruction of the central business district. The outlook for remittances is of major concern. The increase in unemployment rate in the United States and New Zealand and the high unemployment rate in Australia will further reduce the amount sent from families in these countries to Tonga.

Private sector credit in the banking system is expected to remain slow as bank lending conditions are expected to remain tight for a while. Large construction and infrastructure projects are being financed mainly by the AusAID and NZAID Private Sector Reconstruction Facility, the China reconstruction loan and foreign aid. Against this background, liquidity in the banking system will continue to remain high in the next six months.

The outlook for inflation will remain low in single digit on the view that international oil prices will remain below the levels a year earlier. Given the current development in international oil prices which are passed on to domestic prices with a lag of two months, the recent increase in electricity prices, and the strengthening of the New Zealand dollar, the headline inflation is projected to rise but will remain below 8 percent by end of June 2010.

The primary focus of monetary policy in the next six months will continue to be on safeguarding the country’s foreign reserves position. Nevertheless, given the uncertainty in the current environment, there are downside risks to the outlook on foreign reserves which may affect the current monetary policy stance. The declining remittances in line with the predicted slow recovery in the global economy, the rising oil prices, increasing imports and exchange rate movements will all exert downward pressure on foreign reserves.

However, the Reserve Bank will continue to 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.