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

The global economy has slowed since the last review and recovery has become much more uncertain. Global activity has weakened, confidence has fallen sharply and financial risks have increased. The International Monetary Fund (IMF) in its World Economic Outlook September 2011 has estimated that global economic growth will moderate to around 4 percent in 2011 from 5.1 percent in 2010. In the United States, economic growth is slowing, public debt continues to rise and unemployment remains high. The crisis in the euro area has deepened with sovereign debt concerns in Europe continues to weigh on sentiment. Concerns about banking sector problems have caused international bank funding markets to tighten further. In contrast, growth in China remains robust with the rise in domestic demand. In Japan, activity has rebounded quickly following the earthquake and tsunami in March 2011. The Australian economy continued to benefit from the strong growth in Asia with the high level of commodity prices contributing to growth in the resources sector. However, business credit has been weak and the high exchange rate is having a significant impact on the external sectors of the economy including tourism. The New Zealand economy has performed relatively well on the back of strong terms of trade while inflation has been driven by increases in the rate of GST, and the prices of food and petrol.

The National Reserve Bank of Tonga’s (NRBT) primary monetary policy objectives continue to focus on maintaining an adequate level of foreign reserves and promoting price stability. The promotion of low and stable inflation is a difficult task given the high component of imported goods in the country’s economic activity. As such, the overall inflation of the country is highly vulnerable to imported prices, which is largely out of the Reserve Bank’s control. In the past six months, the level of foreign reserves continued to remain well above 4 months of import cover largely due to foreign aid inflows. Consequently, liquidity in the banking system continued to remain at a high level. However, banks’ credit growth to the private sector continued to contract with banks maintaining tight lending conditions, weak domestic demand and slow economic recovery. The annual headline inflation increased in the past six months reflecting the increase in global oil prices, and imported and domestic food prices. Given the high level of liquidity in the banking system, monetary policy continued to be accommodative in the past six months.

The high level of foreign reserves was underpinned by the receipts of government aid funds from Tonga’s development partners. At the end of September 2011, the official foreign reserves amounted to $208.1 million, equivalent to 7.9 months of imports compared with $157.1 million (6.1 months of imports) at the end of March 2011.

Private sector credit growth contracted by 8.9 percent over the year to August 2011 compared to the 9.4 percent contraction in the year ended February 2011. The contraction in credit growth reflected the commercial banks’ balance sheet consolidation process, the settlement of a private sector loan, the slow economic recovery and the impact of competition from other small loan schemes such as the Government Retirement Fund and the South Pacific Business Development Microfinance Ltd. However, there are signs of a pick up in new loan commitments especially on housing loans largely due to the special rates offered by the two large banks during the six months to August 2011.

The annual headline inflation has increased in the past six months and peaked at 9.7 percent in the year ended May 2011 before it eased to 6.3 percent in the year ended September 2011. The increasing global oil prices and food prices contributed to the higher imported inflation. Imported food and imported fuel dominate the CPI basket (39.4 percent) and price fluctuations in these items continued to influence the overall inflation in Tonga. The volatility in the domestic food prices mainly driven by supply also contributed to high domestic inflation during the six months to September 2011.

Outlook

Domestic economic activity is expected to continue to be supported by foreign aid funded construction and infrastructure projects as well as tourism activity. The expected increase in agricultural sector activity particularly squash and watermelon exports and the expected economic activity from the completion of the new Vuna wharf should provide additional support to economic activity in the next six to twelve months. However, the uncertainty in the economic outlook remains. The recovery in the domestic economy will continue to be at a slow pace on the back of global economic and financial uncertainty and weak domestic demand. The high unemployment rate in the United States will continue to affect remittances to Tonga. The level of gross foreign reserves is expected to remain well above the adequate level of 4 months of imports and inflation is expected to fall despite the volatility in world oil and food prices. Against this background, the current monetary policy stance will be maintained in the next six months.

Foreign reserves are expected to remain at high levels in the next six months, above 7.0 months of import cover. This is mainly due to the expected receipts of official aid funds from Tonga’s development partners, which will outweigh the official debt repayments and the expected rise in import payments when aid funds are utilized and domestic demand slowly picks up. Exports are expected to improve in the agricultural sector following the establishment of the fumigation facilities in Vava’u and Tongatapu and the revitalization of the High Temperature Force Air (HTFA) at the airport.

Despite the ample liquidity in the banking system, credit growth will remain slow in the next six months as banks continue to focus on improving their balance sheets, suppressed domestic demand and the uncertainty about the economic outlook. Liquidity in the banking system is expected to remain high on the back of the anticipated receipts of aid funds from Tonga’s development partners.

Inflation is expected to fall below the Reserve Bank’s benchmark of 6 to 8 percent in the next six months on the basis of the IMF forecast that world oil prices will fall. The expected decline in oil prices will contribute to lower imported inflation. The direct pass through of the expected fall in oil prices to transport and energy, and their feed through into the prices of food and other goods are likely to dampen the pressure on domestic inflation. The movement in the exchange rates will also have an impact on imported inflation.

The Reserve Bank will continue to target maintaining the country’s foreign reserves position at an adequate level, and promote low inflation, mindful of the risks to the outlook on the global economic and financial situation and their impact on the domestic economy. 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.