The Reserve Bank’s monetary policy remained accommodative over the past six months. The Bank’s outlook was for inflation to remain below 6 per cent and for foreign reserves to remain above three months of imports.

Gross Official Foreign Reserves reached a record high of $253 million in August, or 8.2 months of imports. Receipt of aid from Tonga’s development partners underpinned this increase. Tongan consumer prices fell by 0.6 per cent over the year ended August 2012, a softer outcome than that recorded in the last Monetary Policy Statement. As such, the Reserve Bank’s primary objectives of maintaining an adequate level of foreign reserves and promoting low and stable inflation were achieved.

Global economic growth slowed during the second quarter of 2012, after rebounding in the first quarter. The slowdown was broadly based because spillovers from financial stress in the Euro Area periphery were widespread and domestic factors caused a slowdown in Asia. As such, the IMF has softened its global growth forecasts since March, now projecting real GDP to grow by 3.3 per cent and 3.6 per cent over the 2012 and 2013 calendar years.

Tonga’s real GDP is estimated to have contracted by 0.2 per cent over 2011/12, which is weaker than the outcomes of the past couple of years. The growth compares poorly with GDP growth globally, and throughout the South Pacific, for the same period.

Partly driving the weaker outcome was an accelerated decline in the value of remittances. A more disciplined Government budget also contributed, with the Government implementing a smaller budget deficit than in 2010/11. Activity in the construction sector fell significantly, with several large donor-funded projects coming to completion. The primary sector suffered from a depletion of sea cucumber and sandalwood stocks.

While the Reserve Bank has allowed a buildup of exceptional levels of liquidity to support domestic lending, this measure has been outweighed by other forces that have been reducing banks’ appetite to lend. Notably, the continuing decline in remittances has contributed to the high frequency of borrower defaults over recent years, to which the banks have responded by tightening lending standards. The weak economic conditions and bleak outlook also affects demand for credit and potential investments.

The Reserve Bank has recently announced the removal of interest payments on banks’ Exchange Settlement Accounts (ESAs). The idea is to strengthen banks’ individual incentives to use these account balances for prudent private sector lending.

Outlook

The Ministry of Finance has forecast Tongan real GDP growth of 0.4 per cent for the 2013 financial year. The outcome is better than for 2012 but below the average of the past decade. The Reserve Bank anticipates a similar outcome, with the outlook for remittances still bleak and a more disciplined government budget providing less short-term support to growth. The recent downward revision of global economic growth prospects will have spillover effects on Tonga through remittances, tourism, currency movements, oil and food prices.

Construction activity is expected to contract the most, following the completion of large donor-funded works. The outlook for tourism is also modest. Any significant growth will depend on either a reversal of recent declines in visitor numbers, or a rise in real spending per visitor, which is already high by historical standards. The primary sector has mixed prospects. The depletion of Tonga’s sea cucumber and sandalwood stocks point to slower long-term growth but may be offset by rising demand for other agricultural goods, like watermelon and squash.

Credit outcomes are likely to remain soft in the next six months, albeit perhaps not so soft as over the past year. A high level of liquidity and the Reserve Bank’s recent removal of interest payments on the ESA balances are both designed to support lending growth.

The level of foreign exchange reserves is expected to increase in the next six months, due to the expected receipt of official aid funds. Foreign reserves are then expected to start declining towards the end of 2013, with the commencement of China loan repayments in September 2013. Nevertheless, foreign exchange reserves are expected to remain comfortably above three months of import cover.

Inflation is expected to remain below the Reserve Bank’s benchmark of 6 to 8 per cent in the next six months. Despite generally falling over the six months to August, world oil prices have picked up over the past few months, mainly due to supply disruptions amidst growing unrest in the Middle East. The Pa’anga has been relatively steady against the US dollar in that time so most of the recent oil price increases will be reflected in higher imported fuel prices. However, with modest prospects for Tonga’s domestic economic activity, and the second round effects of lower imported inflation still to play out, the outlook for domestic inflation is to remain low over the next six months.

Against this background, the current accommodative monetary policy stance will be maintained in the next six months. The Reserve Bank will continue to target maintaining the country’s foreign reserves position at an adequate level, and promoting low inflation, mindful of the risks to the global economic outlook. The Reserve Bank will continue to monitor closely the country’s economic and financial conditions in order to promote a sound and efficient financial system.