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

The world economy has continued to recover although there are signs that global growth is now moderating to a more sustainable pace. The extent of the recovery varies significantly across regions and has been strongest in Asia. In contrast, growth in some of the major advanced economies has been more subdued. The International Monetary Fund (IMF) has estimated that the world economy will grow by around 4½ percent in 2010. While the recovery in the global economy is proceeding broadly as projected, the recovery in the United States (US) is at a very modest rate and the pace of recovery in Europe is particularly uncertain given plans for bringing forward fiscal consolidation. In contrast, economic activity in China has been very strong, although there are signs that growth is now slowing to a more sustainable rate. In Australia, the economy has weathered the global downturn better than many other countries and it has continued to expand at a solid pace, due to the strong contribution from public investment and high commodity prices. The positive outlook for investment is underpinned by Australia’s high terms of trade and the expected strong growth in Asia’s demand for energy and resources. The New Zealand economy continues to recover, though continued household caution has seen consumer spending remain subdued and many firms have become less optimistic about their prospects.

The National Reserve Bank of Tonga (NRBT) continues to focus on its monetary policy twin objectives of 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 supported by large inflows, credit constraints on domestic demand and a modest pick up in remittances. Consequently, liquidity in the banking system continued to increase and remained at a high level. Despite the availability of excess liquidity in the banking system, banks’ credit growth to the private sector continued to contract mainly reflecting weak domestic demand from low remittances. Headline inflation increased over the past six months reflecting mainly the imposition of government excise tax on imported tobacco and alcohol, and the increase in world oil prices. 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 were muted by the banks’ continuing to consolidate their balance sheets and focusing on recovering of non performing loans thus credit growth continued to contract.

Foreign reserves continued to increase and remained at comfortable levels, underpinned by the receipts of government aid funds from Tonga’s development partners, capital injection and deferred import payments. At the end of September 2010, official foreign reserves amounted to $172.7 million, equivalent to 7.3 months of imports. The high level of foreign reserves also reflects the weak domestic demand, slow economic activity and tight credit condition.

Private sector credit growth contracted by 13.1 percent over the year to August 2010 compared to the 12.9 percent contraction in the year ended February 2010. The contraction in credit growth reflected the impact of the slow recovery in the global economy, the banks’ balance sheet consolidation process, and the write off of bad debts. However, when the reconstruction loan from the People’s Republic of China is accounted for, the overall credit to the private sector grew by 6.8 percent during the year ended August 2010.

Inflation has increased in the past six months, reaching 5.0 percent in the year ended July 2010 before it eased to 2.9 percent in the year ended September 2010. The rebound in world oil prices, the imposition of government excise tax on imported tobacco and alcohol in July 2010 and the depreciation in the Tongan pa’anga against the exchange rates of import source countries, mainly New Zealand and Australia, contributed to the pick up in imported inflation. Fuel and food imports dominate the CPI basket and price fluctuations in these items, particularly fuel, have eventually passed through to domestic inflation. This is reflected in the increase in the electricity price by 4 seniti in March 2010 and 2 seniti in June 2010 before falling by 4 seniti in September 2010.

Outlook

While the domestic economy shows sign of recovery, the outlook remains weak. The world economy is recovering, but not enough to reduce unemployment significantly, particularly in the United States. The dampening effects on remittances and tourism for Tonga will continue to be felt in the coming months. While credit growth will continue to be subdued, economic activity is expected to pick up with increased construction and infrastructure activities supported by foreign aid. Inflation is expected to rise as a result of the rebound in oil prices but will remain in single digits. Against this background, the 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 will slowly pick up but will 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 prices and as deferred import payments are made. Combined with capital outflows especially debt repayments, these will exert downward pressure on foreign reserves.

There are signs that banks are starting to lend to the private sector though banks’ credit growth will continue to remain modest in the next six months. 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 there will be more than adequate liquidity in the banking system.

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 appreciation in the currencies of the main import source countries against the Tongan pa’anga and the expected recovery in domestic demand will also contribute to inflationary pressures.

The Reserve Bank will continue to maintain the country’s foreign reserves position at an adequate level, and promote low inflation, mindful of the downward risks to the outlook. The slow rebound in remittances, the slow global economic recovery and the high unemployment rates in the major remittance source countries especially in the United States, the rising oil 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.