Tonga : development through agricultural exports

PIDP Pacific Islands Development Program

ECONOMIC REPORT No. 4

TONGA: DEVELOPMENT THROUGH AGRICULTURAL EXPORTS by Mark Sturton

(3Q EAST-WEST CENTER

E C O N O M I C R E P O R T SERIES

No. 1 Sturton, Mark, and Andrew McGregor, Fiji: Economic Adjustment, 1987-91. Honolulu: Pacific Islands Development Program, East-West Center. 1991. 56 pp.

No. 2 Sturton, Mark, and Andrew McGregor, Vanuatu: Toward Economic Growth. Honolulu: P a c i f i c Islands Development Program, East-West Center. 1991. 56 pp.

No. 3 Sturton, Mark, Policy Implications: of an O i l Shock in Fiji, Tonga, and Vanuatu. Honolulu: Pacific Islands Development Program, East-West Center. 1992. 48 pp.

Distributed by University of Hawaii Press

Order. Department 2840 Kolowalu Street

Honolulu, Hawaii 96822

Tonga: Development Through Agricultural Exports Economic Report No, 4

Tonga: Development Through Agricultural Exports Economic Report No. 4

by Mark Sturton

April 1992

Pacific Islands Development Program East-West Center 1777 East-West Road Honolulu, Hawaii 96848

MARK STURTON has extensive experience with macroeconomic policy in the Pacific islands region. He has worked in Fiji's Central Planning Office and the Reserve Bank of Fiji where he was Research Director. As a consultant to the United Nations, he has served as economic policy adviser in the Cook Islands, Papua New Guinea, Tonga, and Vanuatu. Sturton has a special interest in policy modeling—analytical tools for designing economic policy appropriate to the small island economies of the region. He has a Ph.D. from Sussex University and was formerly a PIDP Research Associate in charge of the macroeconomic components of PIDP's Economic Development and Private Sector Program. Currently, Sturton is Research Director of the National Reserve Bank of Tonga.

Library of Congress Cataloging-in-Publication Data

Sturton, Mark, 1947-Tonga : development through agricultural exports / by Mark Sturton

p. cm. — (Economic report: no. 4) Includes bibliographical references. ISBN 0-86638-152-X 1. Produce trade—Tonga. 2. Agriculture—Economic aspects—Tonga. 3.

Foreign trade promotion—Tonga. I. Title. EL Series. HD9018. TC62S78 1992 382\41'099612—dc20 92-17319

CIP

Copyright <D 1992 by the East-West Center All Rights Reserved Manufactured in the United States of America

*C The paper used i n this publication meets the m i n i m u m requirements of A m e r i c a n N a t i o n a l

Standard for Information Sciences—Permanence of Paper for P r i n t e d L i b r a r y M a t e r i a l s

Distributed by University of Hawaii Press Order Department 2840 Kolowalu Street Honolulu, Hawaii 96822

Contents

List of Tables vi List of Figures vii Foreword viii Map of Tonga. ix Executive Summary x Introduction 1

Economic Growth, Sectoral Performance, and Employment 7

Savings and Investment 18

Inflation 20

Fiscal Developments 24 Monetary Developments 30 The External Sector 36 Development Issues and Economic Policy 42 Conclusion 46

References 47

v

List of Tables

Table 1. Selected economic indicators, 1986-87 to 1990-91 2 Table 2. Manufacturing performance, 1984-85 to 1989-90

(T$'million) 13

Table 3. Investment, savings, and resource gaps, percent of GDP, 1983-84 to 1988-89 18

Table 4. Government expenditure (T$ million) 24 Table 5. Government revenue (T$ million) 25 Table 6. Financing of government deficit (T$ million) 26 Table 7. Government debt (T$ million) 29 Table 8. Monetary survey, 1984-88 to 1990-91 (T$ million,

end of period) 31

Table 9. Balance of payments (T$ million) 37

Table 10. Exports of major commodities, 1984-85 to 1989-90 (TS'OOO) 38

vi

List of Figures

Figure 1. Ratios of exports, aid, and migrants remittances to GDP 3

Figure 2. Structural change in Tonga's exports, 1986-88 compared with 1989-91 4

Figure 3. GDP growth, 1980-81 to 1990-91 7 Figure 4. Inflation in consumer prices, 1980-90 20 Figure 5. Comparison of manufacturing and public sector

wages with CPI (indexes based on 1984-85 = 100) 23 Figure 6. Recent trends in the current and overall budget

deficits *28 Figure 7. Domestic credit by sector (T$ million) 32

Figure 8. Real deposit and lending interest rates (nominal interest rates deflated by the consumer price index), 1985-91 34

Figure 9. Interest rate differential between Tongan and Australian commercial bank deposit rates, 1985-91 35

Figure 10. Coconut oil prices deflated by imported prices of CPI, 1974-90 (5-year moving averages; index based on 1970=100) 39

Figure 11. Terms of trade, 1982-90 (index based on 1982=100) 40 Figure 12. Nominal and real effective exchange rates (indices

based on 1980=100) 41

vii

This report is the fourth in a series of country reports relating to the Pacific island economies. The series is intended to fill the existing gap of available material about economic performance, policy, and prospects in the region. Because the economic survey reports issued by international agencies often have a restricted circulation and are not in the public domain, this PIDP series is designed to improve the awareness of the economic problems and circumstances facing the Pacific island countries today.

The series follows a standard format with parallel discussions of economic performance for the island countries. Subjects include analysis of economic growth, sectoral performance, inflation, monetary developments, fiscal policy, and the external sector. Economic prospects for the future are also discussed. Concluding sections highlight important economic policy and development issues.

Sitiveni Halapua Director Pacific Islands Development Program

viii

Map of Tonga

176°W 174*

2 2 <

100 200

• Niuafo'ou kilometers

Tafahi

Niuatoputapu

Kingdom of Tonga

oFonualei Vava'u •Toku Group

L a t e o

Vava'u-^

Ha'apai Group

Kao« Tofua*

Nomuka 0

.« ^ H a ' a n o " 9— Foa

'••<s^ Lifuka ' V \ Uoleva

\ Tatafa 'Uiha

Tongatapu

HfL. Tongatapu ( J E u a Group

16°S

18<

201

Tongatapu

alofa

ix

Executive Summary

This report analyzes the developments in the Tongan economy since the mid-1980s. Tonga is a very small open economy dependent on a limited range of primary commodity exports, migrants remittances, and development assistance. During the 1980s the economic performance was poor and the economy stagnated. Production of copra for export, which was the mainstay of the economy, collapsed in the 1970s and 1980s as international prices fell dramatically. During the same period the lack of rewarding economic opportunities led to wholesale migration to neighboring nations, and the drop in export earnings was replaced by workers remittances. Development assistance also became an important characteristic of the economic environment as donor nations tried to rekindle economic development.

During the mid- to late 1980s the economy underwent important structural change with diversification in agriculture, the development of a nascent manufacturing sector, and growth in tourism. Events in 1989 saw a dramatic change in economic circumstances as the development of the squash industry commenced in earnest. By 1991 the value of squash exports to Japan exceeded the average value of the total exports during the 1980s. These remarkable events indicate that private industry is very much alive in Tonga. They confront the skeptical view that development of the Polynesian economies is not viable and that they will remain forever dependent on development assistance and remittances.

Despite these encouraging events, maintenance of fiscal balance has been problematic. Large increases in remuneration to civil servants in fiscal 1989-90 and subsequent increases in development expenditures led to a series of budget deficits. Although substantial new revenue measures have been introduced, they have not entirely restored fiscal balance, and a series of unsatisfactory developments have occurred. First, the increased expenditures have resulted in crowding out of the private sector. Second, the revenue measures have distorted resource allocation by encouraging the production of inefficient import substitutes. Third, a significant rise in domestic inflation has led to a loss in competitiveness and an appreciation of the real exchange rate.

This report on Tonga discusses and analyzes all these, developments in detail. In addition, discussion is devoted to economic growth, sectoral performance, savings and investment, inflation, monetary devel-

x

Executive Summary / xi

opments, fiscal policy, and the external sector. Each section analyzes recent developments, new policies, and prospects for the future. The report concludes with a discussion of development issues and economic policy.

Introduction

Tonga is a very small developing island nation with a population of 96,000 and GDP per capita of approximately US$1,350 in 1989. Agriculture, fishing, manufacturing, tourism, and services provide the main economic activities, but traditional production for home consumption (subsistence) is an important component of economic life.

The high rates of migration to neighboring developed nations and a high level of dependency on foreign aid have distorted the economic structure. Transfers of aid and migrants remittances constitute more than 55 percent of current account receipts, while exports of merchandise represent just over 10 percent. The financial management of the economy has been sound, but the external account is fragile.

Developments Economic growth averaged 3.5 percent during the 1970s, declined to 3 during the 1980s percent during the first half of the 1980s, and fell substantially to 1

percent in the last half of the decade (see Table 1). Given the low rate of population growth of about 0.5 percent per annum, resulting from large outward flows of migrants, the figures for the 1970-85 period were satisfactory. The stagnation in the late 1980s can be attributed to various reasons.

The 1970-90 period witnessed a massive 50 percent decline in the real price of Tonga's major export, copra. As a consequence the coconut industry, whose share had represented more than 70 percent of total export earnings in 1970, was reduced to 20 percent by the end of the 1980s. The production of bananas, which had represented Tonga's second most important export earner, virtually vanished during the late 1980s due to natural disasters, quarantine restrictions, and the termination of the subsidy scheme in New Zealand.

Yet the period did experience important diversification. Vanilla growing became an important economy activity, government policies for the encouragement of a manufacturing sector had taken root in the Small Industries Centre (SIC), and the development of tourism was under way. However, these developments taken collectively were not sufficient to counterbalance the deterioration in the production of the traditional export commodities, and the economy entered a period of prolonged recession.

With the remarkable growth of squash exports to Japan in the early 1990s the economy emerged from the recession. Production com-

1

2 / Tonga: Development Through Agricultural Exports

Table 1. Selected economic indicators, 1986-87 to 1990-91

1986-87 1987-88 1988-89 1989-90 1990-91

Economic activity

GDP at constant prices* % increase 0.8 -1.5 1.9 2.8 3.9 Coconut oil tonnes 4342 2084 1533 1230 1172 Vanilla tonnes 15.0 13.0 31.7 10.5 44.9 Squash tonnes 0 0 970 3967 6246 Tourism numbers 16,805 18,096 20,011 21,338 20,659

Money and prices

CPI % increase 7.5 11.3 4.0 5.6 13.3 Money supply (M3) % increase 33.6 1.9 2.4 7.1 9.1 Private sector credit % increase 19.2 31.9 43.3 9.6 -5.5

External sector

Exchange rate T $ / U S $ 0.7142 0.7786 0 . 7 7 7 7 0.7702 0.7842 Current account T$ million 8.9 -9.3 * -2.3 13.8 -8.5 Overall balance T$ million 11.4 -2.5 -1.4 0.6 -0.6 External debt T$ million 40.9 44.3 48.1 N.A. N.A. Import coverage ** months 6.9 6.2 5.9 5.7 5.9

Fiscal

Deficit Deficit

T$ million %CDP

-6.6 -9.1

2.3 3.2

-0.1 -0.1

-3.6 -4.6

-4.0 -4.3

Source: Quarterly Bulletin, Vol. 2, No. 2, National Reserve Bank of Tonga. Notes: * Moneta ry GDP

** The number of months imports covered by net foreign assets.

menced in 1989 and by 1991 had grown to represent one and one-half times the combined total of all Tonga's other exports. This tremendous increase in production alone represents an 8 percent growth in GDP in the 1991-92 period; it arose from smallholder private sector initiatives despite the apparent lack of official interest in agriculture after the poor performance in the 1980s. The increase in squash productions force indicates that private initiative and entrepreneurship are indeed alive in Tonga and runs counter to the prevailing pessimism about Pacific island development.

Foreign The 1970s and 1980s have been marked by important structural shifts transfers and m th e economy, mostly notably the rise in importance both in devel-"Dutch disease" opment assistance and in workers remittances, as well as the reduc

tion of exports. Development assistance has risen from some 10 percent of GDP at the beginning of the 1970s to over 20 percent by the end of the 1980s. Similarly, migrants remittances have risen from 15 to 25 percent. At the same time exports of commodities have fallen from 20 to 10 percent. These trends are described in Figure 1.

Introduction / 3

4 0 %

0 % I 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 74-5 76-7 78-9 80-1 82-3 84-5 86-7 88-9 90-1

r "N Aid/GDP

- • - Remittances/GDP - o - Exports/GDP

V J

Figure 1. Ratios of exports, aid, and migrants remittances to GDP

The migration to neighboring developed nations in search of higher wages has been motivated by the lack of rewarding economic opportunities at home. The situation has been exacerbated by the continual decline throughout the 1970s and 1980s of the real prices of traditional exports (coconut products). Migration has permitted the release of these forces through the export of labor but has been accompanied by a prolonged stagnation in the production of exports.

At the same time the high level Of domestic demand supported by foreign transfers, currently 50 percent of GDP, has encouraged investment in activities oriented toward the home market (non-traded goods) and discouraged production for export (tradables). The Tongan economy displays all the characteristic markings of the "Dutch disease," where a dominant export activity attracts a disproportionate command over resources, pushes up domestic production costs, and reduces international competitiveness. In the Tongan case the "booming" sector has become development assistance and migrants remittances.

The decline in growth in the economy during the late 1980s is consistent with these trends. As foreign transfers have become more dominant, the lack of investment in productive activities with export potential has become more pronounced. The cumulative investment in activities dependent on a "booming" sector, which has little potential for secured long-term development, has resulted in economic stagnation.


Structural change

Although the Tongan economy has become more dependent on foreign resources, both private and public, there has been a beneficial structural adjustment reflecting sensitivity to market forces. Production of coconut products has declined from about 70 percent of exports in the 1970s to about 20 percent during the late 1980s. Bananas, which were also an important export to neighboring countries, had by 1990 virtually disappeared. Exports of vanilla, root crops, vegetables, fish, and manufactures have risen in significance to counterbalance the decline in the traditional exports. Tourism has also shown potential and now matches exports of merchandise in value. The reorientation of export production has moved toward commodities less susceptible to the vagaries of the international product cycle, and large swings in commodity prices, toward niche filling activities, which are more reliable as a source of real income earnings. Trends in Tonga's export structure are shown in Figure 2.

The emerging Fiscal policy during the 1980s was based on conservative principles. fiscal problem Balance on the government's recurrent budget was the main policy

objective with the aim of mobilizing some small savings for transfer to the development budget. This policy was largely achieved. The development budget was mainly funded through foreign grant aid and concessional borrowing from the main multilateral agencies; little use was made of domestic sources of finance.

In 1989-90 these policies changed when a large pay increase for civil servants was awarded to compensate for the erosion of real living standards due to cost of living increases. There were no offsetting revenue measures and a substantial deficit emerged. In fiscal year

1986-88

Manufactures 12.3%

1989-91

Manufactures 24.8%

Figure 2. Structural change in Tonga's exports, 1986-88 compared with 1989-91

Introduction / 5

1990-91 substantial new measures were adopted both in the budget and in a subsequent rnini-budget, which became necessary when the original measures were deemed inadequate. During the same period development expenditures grew rapidly requiring funding from domestic sources and departing from the conventional channels of aid and concessionary loan finance. By 1991-92 recurrent balance still had not been restored, and a tight budget had been adopted although doubt had been cast on the realism of the projections. Development expenditures were also still projected to rely heavily on domestic sources.

Monetary policy Until the National Reserve Bank of Tonga (NRBT) was established in July 1989, the Bank of Tonga, the sole commercial bank, was responsible for maintaining monetary stability. A guideline based on import coverage (foreign reserves to monthly imports) determined domestic credit policy. If foreign reserves fell below a certain level, credit creation was restricted and halted altogether if the reserve level fell further. This policy maintained external equilibrium, and foreign reserves have been held at the healthy level of five to six months' worth of imports during most of the 1970s and 1980s.

Toward the end of the 1980s a period of strong credit growth was experienced both to fund the emerging fiscal deficit and to encourage private sector development. The consequence was an erosion of the external situation toward the end of 1989. A period of credit restraint was instigated and external balance was restored. For the 1990-91 period the NRBT proposed a 10 percent credit guideline to the Bank of Tonga. The previous over-extension of credit to the private sector had led to a deterioration in the Bank of Tonga's loan portfolio, and the bank initiated a period of consolidation. The result was a fall in private sector credit, and the 10 percent guideline was largely absorbed by the increased need for public sector funding. This outcome was undesirable, and the Bank of Tonga was subsequently encouraged to initiate viable lending to the private sector.

Balance of payments equilibrium (with minor deviation) was maintained throughout the 1970s and '80s. In general, current account balance was maintained with some small surpluses on the capital account reflecting public sector foreign borrowing. The balance of payments structure reflects the trends discussed. In the latter part of the 1980s, exports represented only 15 percent of imports, with tourist receipts representing a similar proportion. Current account flows are heavily dominated by migrants remittances, which represent 50 percent of imports, and development assistance, another 15 percent. The structure-of the balance of payments is accordingly highly fragile de-

Balance of payments weakness


pending on remittances and foreign aid. Whether the present structure can be continued to be relied on as a sustainable earner of foreign exchange earnings is a critical question.

Until February 1991 Tonga pegged the Tongan dollar to the Australian dollar. This policy generated erratic movement in inflation and was subsequently abandoned. The Tongan dollar is now pegged to a basket of currencies, and greater stability in the price level has been achieved. However, the recent growth in public expenditures, growth in aggregate demand, and need for new revenue measures imparted strong domestic pressure to prices. The increase in Tongan prices, larger than that of its trading partners, incurred a loss in competitiveness and an appreciation in the real exchange rate. While currency depreciation is not appropriate given the prevailing conditions in Tonga's labor market, a return to fiscal balance is clearly warranted.

Economic Growth, Sectoral Performance, and Employment

GDP is estimated to have grown by 1.9 percent in fiscal 1988-89, to have increased by 2.8 percent in fiscal 1989-90, and to have grown by 3.9 percent in 1990-91 (see Figure 3.) The growth in 1988-89 represented the slow recovery of the economy to normal levels, from the severe drought, which affected agricultural production in 1987-88. The 1988-89 period showed strong growth in most of the productive sectors of the economy but was accompanied by decline in real public expenditure, which reduced the overall growth in GDP. During 1988-89 vanilla, squash, coconut products, fish, manufacturing, and tourism all indicated growth with the exception of bananas. However, copra prices fell by more than 40 percent offsetting the increase in production, and consequently export earnings fell.

In the following year, 1989-90, the recovery continued its momentum but with mixed performance in the productive sectors of the economy. Exports of squash valued at T$2 million (approximately 20 percent of total exports) began in earnest, quadrupling the previous year's production level. Root crop exports also showed significant growth reflecting strong demand from New Zealand following a cyclone in Western Samoa, which destroyed its crop. Manufacturing exports continued to expand and the tourist sector grew by 7 percent. On the negative side vanilla production declined following the biannual production cycle, and the traditional exports of coconut products

6%

81-82 83-84 84-85 90-91 4%

80-81 89-90 88-89

2% 82-83 85-86

0%

86-87 87-88

-2%

Figure 3. GDP growth, 1980-81 to 1990-91

7


and bananas continued their downward trend. However, as production trends were generally favorable, real government expenditures grew, and large pay awards to civil servants added strongly to demand. Overall GDP is estimated to have expanded by 2.8 percent.

In 1990-91 the economy continued expansion reflecting strong growth in the niche agricultural exports of vanilla and squash. Growth in these activities added T$5 million to total exports representing nearly 50 percent of the previous year's total. However, while growth in these activities was strong, performance in the rest of the economy was weak. Root crop production for export returned to a more normal level following the resumption of Western Samoa's production. Coconut products stagnated, and banana production disappeared. Performance in the manufacturing sector failed to continue its previous upward trend, and exports declined by 30 percent. Tourist arrivals also fell by 3 percent Government expenditures and aid projects continued to grow strongly in real terms, although the need for substantial new revenue measures counteracted the inflationary pressure of past civil servant pay awards.

For 1991-92 the anticipated rise in production of squash exports to 19,000 tonnes, trebling the production of the previous year, dominates all other economic activity. The increase in anticipated squash exports to T$15 million will in itself add about 8-10 percent to GDP growth. The massive effort in producing squash will have had a negative impact on the production of other agricultural products. However, these counter-prevailing forces will be minor, and GDP growth can be expected to reach rates not experienced in Tonga's recent history. At the time of writing, trends in Tonga's other major activities are not known, but the effect of the world recession can be expected to be negative on the tourism sector. The continuing difficulties with maintaining fiscal balance and the need for expenditure restraint will also reduce inflationary pressure.

Agriculture Agriculture is the single most important sector of the Tongan economy, which in 1989 contributed 27 percent to GDP. However, this statistic disguises the real importance of the sector, which in terms of employment represented 49 percent of those gainfully employed at the time of the most recent population census. The sector is dominated by smallholder production, and consequently agricultural performance is a very important indicator of the well-being of the population. Sustained development that occurs through agriculture is likely to have an important beneficial impact on the distribution of income. Tonga is blessed with fertile land and has a climatic advantage in producing tropical and non-tropical products. Its location in

Economic Growth, Sectoral Performance, and Employment / 9

the southern hemisphere also confers a favorable advantage in the provision of off-season exports to northern hemisphere markets.

However, the performance of the agriculture sector in the 1980s was dismal. Production of all the traditional commodities, coconuts, bananas, and watermelons, stagnated significantly. By the end of the 1980s there was general disillusionment in the ability of the sector to contribute in a substantial way to development. Manufacturing and tourism were regarded as offering greater long-run potential.

Adverse terms of The reasons for this situation are numerous, but perhaps the most im-trade portant was the adverse movement in the price of copra, the mainstay

of the agriculture sector during the 1970s and 1980s. Real prices in terms of imports fell by 50 percent, but this was coupled with a rising real cost of labor. Migration to neighboring nations imparted upward pressure on domestic wages and increased the floor price of labor. These combined movements in product and factor prices proved very unfavorable and led to the collapse of the copra industry as it had been previously known. However, the movement in real wage costs was not confined to the agriculture sector and had important implications for development and economic policy at large.

A variety of other important negative influences affected agricultural production in the 1980s. Poor disease control led to quarantine restrictions being placed on exports from Tonga by the New Zealand authorities, which resulted in the termination of export of watermelons in 1986. The same restrictions were subsequently applied to banana exports. Adverse climatic conditions have frequently depressed output, and the severe draught during the latter half of 1987 resulted in reduced output in many commodities including coconuts. In 1988 production returned to normal levels, but in early 1989 strong winds flattened much of the banana crop.

The availability of land is always considered an important constraint on agricultural production in the Pacific islands. Adverse land tenure systems have inhibited development restricting the availability of a scarce resource. However, informal and formal leasing arrangements are well established in Tonga and certainly have not limited the rapid rise of squash production. Nevertheless, existing arrangements do inhibit the incorporation of productive land into production and limit the production frontier in the long term. Problems have also been experienced with existing marketing arrangements and inefficiencies in the operation of the Commodities Board. The deregulation of the many activities of the Commodities Board should improve this situation.


While a variety of different factors emerged during the 1980s, which imparted a negative influence on agricultural production, the basic comparative advantage of the Tongan economy in the provision of agricultural products did not cease. The collapse of traditional exports due either to profitability or to restrictions placed on exports left a vacuum. During the 1980s Tongan farmers developed expertise in vanilla production, which by the end of the decade had risen substantially and represented 20 percent of total exports. However, the most important development was the rapid growth in production of squash for export to Japan; this trade had not existed in 1987 but had grown to a level in 1991 that represented 150 percent of the total value of exports of 1989. Both the success of vanilla and squash indicate the ability of Tongan farmers to enter niche markets in horticultural products. Clearly, the missing factor was the possibility of a profitable opportunity, which once identified was quickly exploited.

While it had been hoped that the coconut industry would improve after the 1987 drought, this did not occur. The labor intensive desiccated coconut factory ceased operations in early 1989 and experienced difficulties in hiring labor in an attempt to re-open. Unfavorable conditions and poor profitability suggest this section of the industry is not viable at the present factor and commodity prices. The same attitude of labor to working in the desiccated coconut factory is also reflected in the copra industry. The lack of alternative sources of cash incomes in some of the remoter islands keeps production levels from falling further, but the long-run trend continues downward.

Vanilla growing is one of the brighter components of Tonga's agriculture although difficulties have been experienced in husbandry and marketing. World prices for vanilla dropped during 1988-89 from the high levels of 1986-87 but have since remained more or less stable. Prices for this high value commodity are generally favorable, and vanilla production continues to provide an attractive return to growers labor. World prices are dominated by the main producer in Madagascar, and political uncertainties over the distribution of the present high levels of stocks present the possibility of price destabili-zation. Vanilla production increased from the depressed export level of 11 tonnes in 1989-90 to 45 tonnes in 1990-91 but is expected to fall back to 40 tonnes in 1991-92. This variation is part of the cyclical nature of vanilla production, but the underlying trend is upward.

During the fourth quarter of 1988 Tonga exported its first consignment of squash to Japan, and the value of exports for the year reached T$0.5 million. In 1989 production had risen to T$2 million, which represented 20 percent of total exports and by 1990 had grown to TS4.8 million. For the Japanese squash market the period from November to

Coconut production

V a n i l l a

Squash


early January is one of short supply and relatively high prices and coincides with the production period in Tonga. The industry was heavily subsidized by government during the first year of operation, but this subsidy has subsequently been removed and now provides a very lucrative return to growers. In 1991 a record crop of 19,000 tonnes is expected approximating T$15 million.

Toward the end of the 1991 season the discovery of a virus carried by aphids generated concern although its impact on the current crop was slight. However, the potential for damage to future crops is very substantial, and similar viruses have caused severe epidemics in other parts of the world with losses up to 100 percent (Ullman, Cho, and German 1991). Tongan farmers can take a variety of protective measures, which include cleaning diseased plants, plowing in last season's crop, applying chemical control, and planting fronts such as maize to distract the aphids. However, each of these measures is costly and requires more efficient husbandry. Whether existing farm management techniques will be sufficient to meet the challenge is yet to be seen. Failure to do so could well jeopardize what has become the single most important component of the Tonga economy.

Improved quarantine facilities in Nuku'alofa have resulted in the recommencement in mid-1990 of watermelon exports to New Zealand; 204 tonnes of watermelon were exported compared with the previous year's level of 29 tonnes. This level of watermelon production is envisaged to continue although higher levels might be reached if squash production is adversely affected in the coming season. With the deregulation of the New Zealand economy, imports of bananas from Tonga no longer receive preferential treatment Consequently, the banana industry is not expected to return to its previous level of significance even if quarantine restrictions are lifted.

The export of root crops to migrant communities overseas is a lesser known commodity export but one that has performed favorably in recent years. A cyclone in Western Samoa during December of 1991 virtually destroyed Samoan production, the major supplier to migrant communities resident in Australia and New Zealand. The Samoan crop failure presents the.opportunity to other producers in the region such as Fiji and Tonga to pick up the temporary reduction in supply.

Having a relatively small EEZ (700,000 sq km) and lying to the south of the main tuna grounds, Tonga does not possess a major tuna resource. However, sustained efforts have been made with some success to establish a domestic fishery based on alba core tuna. At present tuna is caught by the government operated vessel MFV Lofa, which catches about 10 percent of the resource, and is canned in the Pago

12 / Tonga*. Development Through Agricultural Exports

Pago cannery. Efforts are being made to privatize the tuna industry, which is not yet in operation. A company has been formed and a board has been appointed, but it has not yet become active. The ADB has agreed to make available loan finance to purchase two vessels to expand operations, but disagreement over the optimal size of the boats has stalled action. Plans are to progressively increase the size of the domestic longline fleet.

Exploratory work on the bottom fishery has generated snapper exports to Hawaii of around 100 tonnes annually worth US$500,000, although about 20 percent of the catch is consumed locally. The industry was initiated about five years ago through an aid project and comprises about 40 boats run by small businesses. At present with the repayment of loans to the Tongan Development Bank, it is expected that sufficient funds will have accumulated to re-finance an additional 10 boats. Significant production increases cannot be expected without depleting the resource. The potential exists, however, to increase the level of exports from the existing catch with improved air services and marketing.

Manufacturing The industrial sector in Tonga has attracted some attention in the Pacific islands because of its active promotion by the government and because of the establishment of the Small Industries Centre (SIC). With the exception of Fiji, which has experienced substantial growth in the manufacturing sector due to rapidly growing garment exports, little industrial development has occurred in the Pacific islands. The establishment of a manufacturing sector in Tonga provides important evidence of the potential for industrialization in the region.

The contribution of the manufacturing sector to the cash economy was recorded as 4.8 percent in 1982-83 and rose to 6.3 percent by 1988-89, implying a 4.6 percent real rate of growth. However, these statistics are not representative of the underlying trends due to the inclusion of coconut products in the figures, which more realistically reflect agricultural conditions than manufacturing activity. During the period 1982-83 through 1988-89 the severe decline in the coconut industry was reflected in the reduction of coconut exports from T$6.6 million in 1984-95 to T$0.4 million in 1989-90. The exclusion of coconut products reveals a different picture, and real sales of manufactures grew by 6.3 percent (deflating by the CPI). These trends are satisfactory but not of the order of magnitude experienced by some of the more rapidly growing developing economies, especially given the very small manufacturing base that exists in Tonga. Recent trends in the manufacturing sector are illustrated in Table 2.


Table 2. Manufacturing performance, 1984-85 to 1989-90 (T$* million)

1984-85 1985-86 1986-87 1987-88 1988-89 1989-90

Sales 12.4 11.3 12.1 14.9 14.4 15.8 Sales less coconut

products 6.5 8.6 9.5 13.1 13.0 15.2 Mfg. exports 6.6 3.7 4.0 3.6 4.4 4.1 Exports, coconut

products 6.0 2.7 2.6 1.7 1.3 0.7 Other exports 0.7 1.0 1.4 1.9 3.0 3.4 Employment 969 1,175 1,379 1,658 1,311 1,137 Average weekly

wages (T$'s) 26.2 27.1 28.9 28.7 40.2 48.5

Sources: Statistical Bulletin on Manufacturing Output, Employment, and Wages/Salaries 1984-1989; Statistics Department, Government of Tonga, July 1991; Quarterly Bulletin, Vol. 2, No. 2, National Reserve Bank of Tonga.

Manufacturing production may be classified as destined for either the export or the domestic market. Production for the home market has dominated recent growth although export development has been significant. Approximately one-third of recent growth (excluding coconut production) has been generated from the export sector. Given the lack of potential for import substitution in a very small economy like Tonga, the failure of the manufacturing sector to achieve higher rates of growth must be attributed to the concentration of production in the home market.

At the firm level the sector is composed of about 100 small enterprises with the largest employing little more than 100 employees. The main export activities include knitwear products and the manufacture of leather garments, which account for about two-thirds of manufactured exports. The main items of manufacture for the domestic market include (1) food products: beer, fruit processing, snack foods, biscuits, meat products, soft drinks; (2) construction materials: paints, varnishes, furniture, cement blocks; and (3) miscellaneous items: sandals, stationery products, etc.

The business environment for manufacturing in Tonga has both advantages and disadvantages. The small size of the domestic market and the high transport costs associated with the import of raw materials and the export of finished products confer disadvantages, which are common to all small remote economies. However, the literature on development experience has not inhibited small economies from achieving high rates of growth. Wage rates are low in Tonga com-

I m p o r t substitutes dominate


pared with developed country standards, although labor availability is restricted. The government of Tonga provides a range of incentives with the usual tax holiday attractions under the Industrial Development Incentives Act. The Tongan Development Bank encourages industrial development through the provision of resources for financially viable projects. The National Reserve Bank of Tonga encourages the development of export markets through the export finance facility. A sole government agency deals with all bureaucratic requirements needed for the establishment of a manufacturing enterprise, which avoids the long delays experienced in many other Pacific island

i countries. The availability of preferential access to Australia and New Zealand markets for Pacific island exports under the SPARTECA arrangements also provides important attractions. Last, the establishment of SIC, under which the government provides industrial sites and in some cases factory buildings, is;a pivotal component of the industrial policy. I

Labor shortages The performance in the manufacturing sector has been mixed. The main successes have been the production of knitwear and leather garments for export. Production of certain other export commodities, such as light machinery and fiberglass boats was not profitable and operations ceased. A major problem associated with industrial development has been labor availability. In the knitwear sector labor was found to be well suited to handicraft production of a labor intensive nature. However, out of every 200 employees selected an average of only 50 survived the three-month training period. In 1988 the knitwear factory mechanized, replacing labor with modern machinery. Employment fell from about 300 employees to the present level of about 150. The inability of the desiccated coconut factory to recommence operations has in part been the inability to find labor willing to work in the factory. The figures in Table 2 reflect these developments; industrial employment rose rapidly in the mid-1980s but had fallen off significantly by the end of the decade.

Table 2 provides information on wages and indicates nominal wages rose by 13 percent per annum between 1984-85 and 1989-90. Conventional wisdom suggests that this rapid increase in wage costs reflects the generally tight market conditions. However, this rapid rise in nominal wages barely kept pace with inflation, and real wages rose by only 1 percent per annum.

Industrial incentives administered under the Industrial Development Incentives Act provide a range of attractions to encourage investment in Tonga. Certain features of the Act provide genuine incentives such as generous income tax holidays: five years for small industries, rising


to 15 years for investments of greater than T$5 million. Others relating to duty free allowances for importation of raw materials are designed to counteract the biases in the indirect tax structure. Indirect taxes on imports are composed of customs taxes and Port Service Tax (PST). The level of customs taxes varies, with low rates on raw materials; however, finished goods competing with Tongan manufactures attract much higher rates. The present level of PST is 17.5 percent but has risen rapidly in recent years due to efforts to maintain fiscal balance. While import substituting industries are subject to both taxes, exporters are given tax free concessions.

No study of the effects of the tax structure on resource allocation has been conducted for Tonga, but the higher rates of nominal tariffs on manufactures suggest that high levels of effective protection must exist. The bias in Tongan manufacturing toward import substitution and failure to achieve a more rapid growth in exports is in part the outcome of these policies. Dependence on import substitution in a very small economy like Tonga will result in poor economic performance similar to what Fiji experienced in the 1980s. Given the attempts in Tonga to encourage manufacturing as an important part of the overall development strategy, careful reassessment of existing policies is warranted to ensure they are consistent with the desired outcome.

Given the existing set of policies and industrial environment, only moderate growth is anticipated in the near future. Recent evaluations undertaken by the Tongan Development Bank revealed that many establishments are marginal. Certain business operations have wound up and production has ceased. An additional disadvantage to Tonga has been the greater attractions that exist in nearby neighboring Pacific islands such as Fiji, which present more established bases for export (with similar incentive packages), an assured labor supply, and improved communications with overseas markets. However, Tonga possesses a comparative advantage in certain skills found in traditional handicraft production, and activities such as knitwear or other specialized garment enterprises may be expected to expand.

Tourism Average growth of total air visitor arrivals averaged 7 percent per annum during the 1980s and totaled 20,659 in 1990-91. Growth in both 1988-89 and 1989-90 was 11 and 7 percent, respectively. In 1990-91 the number of arrivals fell by 3 percent reflecting the onset of the world recession and the effects of the gulf crisis. Cruise ship passengers, which have been an important component of Tonga's tourism industry, averaged 45,000 in the early 1980s, stagnated in the second half of the decade averaging about 10,000, and in 1990-91 dropped to a mere 863. The estimated value of tourist receipts was approximately T$9.2

H i g h levels of protection


million in 1988-89 but fell to T$8.8 million in 1989-90, rising to T$9.6 million in 1990-91. These figures are questionable given the movement in arrivals and the implied erratic movement in per capita expenditures.

The visitor base is small by international standards, and the value added of the tourist dollar is less than the value of agricultural exports due to the large import content (typically 50 percent in most South Pacific island economies). However, tourism including business visitors has grown to be a major contributor to the economy. While no estimates of employment in the industry are available, a ratio of 1:2 between hotel rooms to employment suggests approximately 1,000 jobs have been created, which is approximately equivalent to the size of the manufacturing sector.

Like manufacturing the tourism sector is composed of various small-scale operators. There are 35 hotels and accommodation units, and only two operate more than 50 rooms. In all, Tonga supports approximately 500 rooms. There are no high class tourist resorts, and 80 percent are of the budget type operated mainly by Tongans with little foreign involvement. There has been a fairly rapid growth in capacity in recent years, and the number of rooms expanded by 25 percent between 1986 and 1990. Although the growth in tourist arrivals has matched this rate of growth, the industry continues to suffer substantial excess capacity with occupancy rates averaging 40 percent. As a consequence, rates of profitability are well below those considered sustainable in the longer term. The Tongan Development Bank has reported problems with poor management with many operators finding difficulty in meeting their loan repayments to the bank.

Tongatapu, the main island in Tonga, does not have the visitor attractions that other South Pacific Countries can offer. Nevertheless, the lengthening of the runway and the rebuilding of the air terminal at the international airport provide the infrastructure to receive wide bodied jets of all sizes. Air services are limited although seat capacity wil l increase with the commencement of a national carrier, Royal Tongan Airlines, in August 1991 and of Air New Zealand flights from the west coast of the United States to Auckland with a stopover in Tonga. The previous carriers serving Tonga have not had a reputation for reliability, and the provision of new services will make an improvement.

Although performance has been modest, development of the tourism industry is a major component of the government's development strategy. The tourism sector benefits from the Industrial Development


Incentives Act and enjoys income tax holidays ranging from five to 15 years depending on the size of the original investment. However, the present excess capacity in hotel plant suggests that any immediate interest in hotel construction is unlikely, certainly in the budget end of the market. This does not deny the possibility of expansion in the luxury side of the business, and a recent ADB tourism master plan has identified a site for a 5-star hotel. In conclusion, the outlook for the coming years is one of modest growth, certainly until the world emerges from the present economic recession.

Employment There is no detailed or up-to-date statistical information concerning employment or unemployment in Tonga, but evidence suggests that the labor market is in equilibrium with matching supply and demand. The only available data are from recent population censuses and indicate that the market tightened between 1976 and 1986 when the open rate of unemployment fell from 13 percent to 9 percent. The rapid decline in the copra industry and the experience of the knitwear and desiccated coconut factories suggest labor supply is sensitive to price, and only if real wages maintain a certain level is supply responsive. The availability of migration to neighboring countries for higher wages, the existence of the subsistence economy, and the high value attached to leisure and cultural activities give rise to a high floor price for unskilled labor with an associated high elasticity of supply.

However, evidence gained from personal interviews suggests that many small employers find no difficulty in hiring unskilled labor and that although labor is not generally an unemployed factor, neither is it scarce. What little evidence exists concerning wages (see Table 2) suggests that real wages have more or less matched inflation but that the cost of labor has not risen significantly. These factors tend to suggest that the labor market is in equilibrium at the going rate, which has important consequences for the economic policy that is developed in the following sections.

Savings and Investment

Table 3 indicates recent movements in investment, savings, and the external resource gap. The figures show that Tonga has maintained a high ratio of gross capital formation to GDP. However, while the rate of investment has been high, averaging 35 percent, economic growth has been sluggish and recorded an average of only 2 percent during the 1980s. This implies a poor rate of capital productivity and a very high incremental capital output ratio (IGOR), which approximates 15. Investment in the economy, as the table indicates, has three main components: private investment in housing, productive activities, and public investment. Private investment, which is a main determinant of an economy's performance, is a small proportion of the total and averages 15 percent of GDP. While investment in housing and the public sector performs a useful social function and adds to a nation's stock of infrastructure, it is not necessarily related to greater economic output. The poor relationship between investment and growth in Tonga underlines this point. However, even the relationship between private sector investment and economic growth indicates that the productivity of private capital is low.

Table 3. Investment, savings, and resource gaps, percent of GDP, 1983-84 to 1988-89

1983-84 1984-85 1985-86 1986-87 1987-88 1988-89

Gross capital formation 37.3 35.1 36.0 32.9 32.7 33.0 Investment 36.8 31.4 34.0 33.3 32.0 32.9

Private 25.6 22.2 23.6 21.3 21.5 20.6 Dwellings 8.2 6.9 8.4 8.0 8.7 8.3 Production 17.4 15.3 15.2 13.2 12.8 12.4

Public 11.2 9.2 10.4 12.0 10.4 12.2 Stocks 0.5 3.7 2.0 -0.4 0.7 0.1

Domestic savings -9.2 -14.0 -16.2 -11.7 -19.9 -10.5 Resource gap 46.6 49.1 52.1 44.6 52.6 ' 43.5

Net factor incomes 5.7 5.4 5.2 6.4 8.0 3.4 Remittances 29.0 36.5 40.3 36.3 29.3 28.1 Aid 12.4 5.8 5.3 10.3 7.8 11.3 Capital flows 7.9 3.4 0.2 0.0 6.6 1.4 Residual movements* 8.4 1.8 -1.2 8.4 -0.8 0.7

Sources: National Accounts of Tonga 1982-83-1988-89, Unpublished estimates. Quarterly Bulletin, Vol. 2, No. 2. National Reserve Bank of Tonga.

Note: * Includes movement in net foreign assets, and errors and omissions.

18

Savings and Investment / 19

Large negative Table 3 indicates the very sizable level of negative domestic savings, savings revealing the critical importance of remittances to the economy. The

public sector with the exception of recent years has maintained a tight fiscal stance with revenues matching recurrent expenditures and aid flows together with foreign borrowing matching development outlays. This situation has meant that the government has not been a large absorber of domestic savings. The household sector, however, has had a large negative position and has supplemented domestic incomes with relatives' earnings overseas to support the level of consumption. With a lack of rewarding opportunities at home either in agriculture or in wage employment, coupled with migration possibilities to neighboring nations, the export of labor has been a major opportunity for households to boost low domestic incomes.

The excess of investment over domestic savings (the foreign resource gap) is made up of a variety of important elements. Net factor incomes include positive earnings on foreign assets and negative payments for debt service. Foreign debt has been low in Tonga and mostly on concessionary terms so that factor receipts have dominated payments. Remittances have been large and are by far the most important element bridging the resource gap. The figures on aid are the levels recorded in the balance of payments, which are substantially different from those quoted from UN sources derived from the donor statistics. A sizable proportion of aid never directly impacts the recipient nation's domestic economy; this aid includes overseas scholarships, the direct payment of contractor's fees in the donor country, consultant's reports, etc. Capital inflows include both foreign borrowing and direct investment, which in Tonga have been less important.

The above discussion suggests two major problems face the long-run sustainability of economic growth in Tonga. The first relates to the problem associated with the poor productivity of capital and is a problem of financial intermediation. The second problem is how to reduce dependence on a vulnerable source of investable funds controlled by overseas households and governments.

Inflation

The Tongan economy has experienced erratic and substantial changes in the rate of inflation as measured by the CPI during the 1980s. Figure 4 indicates the annual rates of change during the period, which varied from approximately 2 percent in 1984-85 to nearly 30 percent in 1985-86 and 13 percent in 1990-91. The average rate of inflation of the CPI during the period was 10 percent. During 1988-89 inflation averaged a modest 3.9, but in 1989-90 had accelerated to 5.6 percent. This trend continued, and inflation recorded a substantial 13.3 percent in 1990-91.

Current trends Various forces have recently affected the Tongan economy and rein inflation suited in a sharp rise in the CPI in 1990-91, which peaked at 15.1 per

cent in the first quarter of 1991. During this period the rate of inflation imported from Tonga's trading partners averaged 6 percent. Significant new revenue measures, mainly increases in indirect taxes, were required in the budget for 1990-91 to maintain fiscal balance and are estimated to have added about 6.5 percent to the CPI. The period also included the gulf crisis when there was a temporary increase in oil prices. The recent increases in civil servants salaries, which were also applied to public enterprise employees, were also inflationary. Because the cost of civil servants does not directly affect the rate of inflation in the CPI, the impact was not as strong as the implied increase in salary levels. However, the additional demand in the economy would be considerable. Adding these various forces together provides

30%

20%

10%

0%

81-82 82-83 83-84 84-85 85-86 86-87 87-88 88-89 89-90 90-91

Figure 4. Inflation in consumer prices, 1980-90

•

-

•

\ -

1 1

•

1 1 \ 20

Inflation / 21

an explanation of why Tonga's inflation rate has risen when similar trends in other neighboring economies have been modest.

Toward the end of 1991 inflation was moderating and had dropped to 6.7 percent by October reflecting a more favorable situation. Rates of inflation in New Zealand and in Australia had fallen to historically very low levels, 3 and 4 percent, respectively, and had resulted from the current world recession. The 1991-92 budget introduced no additional revenue measures and the effects of the earlier increases had worked their way through the system. The gulf crisis had proved to be a short-lived affair, and civil servants pay levels remained unaltered.

However, while these various trends had worked to reduce the rate of inflation from the high levels experienced in 1990-91, the emerging boom in squash production is likely to add substantially to aggregate demand imparting inflationary pressure. Furthermore, although no additional increases in indirect taxes were included in the recent budget, the continual poor fiscal position suggests that future increases may be required. Thus, while the present trend is downward, various existing forces may inhibit additional reductions in 1992.

Erratic There are two main reasons for the erratic behavior of consumer movement in prices. The first is the combination of the high proportion of domestic CPI food items in the consumption basket (27 percent), as well as the vari

ability of food prices. During the 1980s Tonga was beset by a series of destabilizing climatic conditions, cyclones and drought, which reduced food supplies and escalated food prices. With a resumption of normal climatic conditions, food prices returned to their earlier levels but not without imparting substantial variation to the overall level of consumer prices. In 1985-86, for example, the prices of domestic food items rose by 35 percent due to a severe drought, but earlier in 1984-85 they had fallen by 5 percent when production returned to normal after the 1982 cyclone.

The second main reason for variation in consumer prices was the policy prior to February 1991 of pegging the Tongan dollar to the Australian dollar. Tonga imported an average of 28 and 37 percent of its import requirements from Australia and New Zealand, respectively, during the 1980s. Variations in the rate of exchange between these two currencies, which both experienced high levels of inflation in domestic prices, had significant consequences for the rate of inflation imported to Tonga. During the 1984-87 period the value of the New Zealand dollar appreciated against the Australian dollar by 28 percent. Coupled with strong inflation in New Zealand of over 50 percent during


the same period, the prices of items imported from New Zealand are estimated to have risen by an average annual rate of 25 percent.

Movements in prices of both imports and domestic food items of the order of magnitude experienced in Tonga during the 1980s did not provide the type of environment suitable for stable economic development. Fluctuations in domestic food prices is outside the bounds of policy given climatic vagaries. The conduct of monetary and wage policy during the decade and up until 1989-90 favored price stability. The main destabilizing influence was the selection of an inappropriate currency peg for the Tongan dollar. This policy has subsequently been changed as of February 1991, and the Tongan dollar is now pegged to a basket of currencies. The new currency peg will help reduce the impact of erratic currency fluctuations on the domestic price level.

Price control By the end of 1990 Tonga had established an extensive range of controls in the regulation of prices. In certain cases, controls took the form of price regulation and in others traders margins were controlled. For example, the price of bread, bus fares, taxi rates, and petroleum products were all set. In the case of most imported items the margin was regulated. In effect the only items not under price control were locally grown agricultural and fish products.

In the earlier stages of Tonga's development when competition in the trading sector was limited and when rapid, increases in inflation occurred, it was felt the consumer needed protection. However, with mounting evidence to suggest that competition was keen based on the growing number of emerging trading establishments, it was believed that the widespread involvement of the bureaucracy in regulating prices was no longer in the public interest. Greater benefits were expected to be gained by allowing prices to reflect their economic costs, which would ensure the allocation of resources to the most productive sectors. To reflect these changes the old list of items under price control was scraped in late 1990 and replaced by a new set that restricted regulation to essential foods, cars and motor parts, fuels, and agricultural inputs. These changes constitute^ welcome move toward a more deregulated economy, and the concern for the provision of basic commodities, which remain under regulation, is understandable. However, there is no economic reason to suggest why even these remaining items should not be freed from control.

Wages There is only partial information about the movement in wages. Two sources currently exist: the survey of manufacturing conducted quarterly by the Statistics Department and the remuneration of civil servants. Trends in these categories are revealed in Figure 5. However, care should be used in analyzing the trends, given the limited cover-

Inflation / 23

200

84-85 65-86 86-87 87-88 88-89 69-90 90-91

Figure 5. Comparison of manufacturing and public sector wages with CPI (indexes based on 1984-85 = 100)

age and accuracy of the data. In 1984-87 the cost of living rose faster than nominal wages, and the rapid increases in inflation substantially eroded real wages. In 1988-90 there was a rapid adjustment in both manufacturing and civil servants wages; manufacturing wages catapulted upward by 40 and 20 percent, respectively. In 1989-90 the civil servants were awarded a 34 percent pay increase. Similar awards were made to other public sector employees in statutory bodies and public enterprises.

No institutional arrangements exist in Tonga for the determination of wages, and in the private sector market forces largely determine the going rate. This situation is desirable because it means the economy can adjust to changes in both domestic and external circumstances. However, while no formal indexation process exists, the large increases in both manufacturing and civil servants pay would appear to have occurred in response to the previous high rates of inflation. Thus, although no formal process of wage indexation exists, the strong bargaining power of the public servants may make the process implicit. This reduces the economy's ability for adjustment and erodes competitiveness.

Fiscal Developments

Fiscal policy has attempted to adopt a balanced budgetary approach with respect to both the current and the development budgets. This was largely successful during the 1980s until 1989-90 when rapid growth in expenditures changed the outcome. Policy attempted to maintain balance on the current budget and where possible to generate small savings for transfer to the development budget. The development budget was largely financed through foreign aid and concessionary loans, and little recourse was made to either the domestic banking system or foreign borrowing at commercial rates. During the 1980s the fiscal position accumulated positive deposits (negative credit) with the banking system. These policies helped maintain financial stability and allowed adequate resources for private sector development. In 1989-90 large additional wage payments to civil servants and an expanded development budget altered these trends.

Radical changes Both current revenue and expenditure maintained an approximate in income taxes constant relationship with GDP during the mid-to late 1980s falling in

the 30-32 percent range of GDP (see Tables 4 and 5). This outcome was not achieved, however, without both additional revenue measures and fiscal restraint, coupled with certain important re-directions

Table 4. Government expenditure (T$ million)

1986-87 1987-88 1988-89 1989-90 1990-91 1991-92

Current expenditure** 30.4 31.7 32.9 41.5 48.3 48.1 Development expenditure*** 15.7 19.0 25.1 35.3 34.0 69.3

Onshore 7.1 6.4 6.3 9.8 15.6 36.0 Offshore 8.7 12.6 18.7 25.5 18.4 33.2

Total expenditure 46.1 50.7 58.0 76.8 82.3 117.3 Current expenditure/GDP 32.6% 31.7% 30.3% 35.2% 34.8% 30.2% Development expenditure/GDP 16.9% 19.1% 23.0% 29.9% 24.5% 43.6% Total expenditure/GDP 49.5% 50.8% 53.4% 65.1% 59.3% 73.8%

Source: Quarterly Bulletin, Vol. 2, No. 2, National Reserve Bank of Tonga. Notes: * Figures for 1990-91 are provisional; those for 1991-92 are budget

estimates. ** Current expenditure does not include contributions to the development budget. *** Onshore expenditure relates to projects accounted for by government, and offshore outlays are controlled by donor governments and not recorded in the government accounts.

24

Fiscal Developments / 25

Table 5. Government revenue (T$ million)

1986-87 1987-88 1988-89 1989-90 1990-91 1991-92

Revenue & grants 45.3 49.4 57.1 68.4 71.6 101.9 Recurrent revenue 29.5 34.0 33.2 39.3 47.0 50.1

Tax 21.0 24.3 24.7 27.4 34.4 37.6 Direct taxes 2.7 3.7 3.9 3.9 4.3 4.5 Indirect taxes 18.3 20.6 20.8 23.5 30.1 33.1 Domestic 2.6 2.9 3.0 3.2 4.2 4.7 Trade 15.7 17.7 17.8 20.3 25.9 28.4

Other 8.5 9.7 8.5 11.8 12.6 12.5 C rants 15.9 15.4 23.9 29.1 24.6 51.9 Revenue/GDP 31.6% 341% 30.6% 33.3% 33.8% 31.5% Tax revenue/CDP 22.5% 24.3% 22.7% 23.3% 248% 23.7%

Source: Quarterly Bulletin, Vol. 2, No. 2, National Reserve Bank of Tonga. Note: * Figures for 1990-91 are provisional; those for 1991-92 are budget

estimates.

in policy. As part of the 1986-87 budget the government decided to radically alter the system of income tax to encourage private sector activity. The high rates of marginal tax, reaching 40 percent of incomes in excess of T$7,600, were abolished, and a flat rate of 10 percent was instigated across the board. This policy was also applied to company tax, and rates fell for resident companies with incomes less than T$50,000 from 25 percent to 15 percent, and from 35 to 30 percent for companies with incomes in excess of T$50,000. Rates for non-resident companies remained unaltered.

Compensating Corresponding to the drop in income tax rates, indirect taxes were in-rises in indirect creased to maintain fiscal balance. Port and services tax on imports, taxes which had been raised from 12.5 percent to 15 percent in 1985-86, was

raised again to 17.5 percent in 1986-87, and a 5 percent sales tax was also introduced. These substantial changes in the system resulted in indirect tax collections rising from 54 to 63 percent of total tax collections during the period. However, these changes in the tax system while encouraging entrepreneurial investment would have imparted a significant increase in inflation and raised the cost of production and the cost of living. They also had important consequences for resource allocation.

While important changes occurred in taxation, important trends emerged on the expenditure side. Expenditures on social services had maintained a relatively static share of total outlays, the expenditures on administration had risen disproportionately, and those on infra-


structure and economic services had fallen. These trends are not encouraging. If Tonga is to develop its productive base, attempts must be made to increase the allocations on infrastructure and economic services to complement the development of the private sector and the changes implemented in the tax system.

During 1989-90 the government decided to address what was considered to be a loss in competitiveness in civil service wages and salaries (see Figure 4), and remunerations were increased on average by 34 percent. However, the 1989-90 budget made no allowance for additional revenue measures to maintain fiscal balance, and consequently a significant increase in the current deficit emerged to T$2.3 million (see Table 6). During the second quarter of 1990 the National Reserve Bank of Tonga (NRBT) advanced T$4.4 million to the government to cover the expected deficit for the year. By the end of the fiscal year it was evident that substantial new revenue measures were required in the new budget for 1990-91.

The deterioration in the budget outturn of 1989-90 led to a series of additional revenue measures in the 1990-91 budget in an attempt to regain recurrent balance. First, the tax on imported beer and tobacco was increased significantly and projected to raise an additional T$1.5 million or 3 percent of total revenue. Taxes on imported fuels were increased from very low levels by international standards and anticipated to generate a similar volume of revenue. Tariffs were also levied on selected meat items and anticipated to generate an additional T$0.75 million. However, this latter measure was in part protective and aimed at encouraging local producers. Finally, changes in the

Table 6. Financing of government deficit (T$ million)

1986-87 1987-88 1988-89 1989-90 1990-91 1991-92

Current savings -1.0 2.3 0.3 -2.3 -1.3 2.0 Overall deficit and funding -0.7 -1.3 -0.6 -5.3 -8.2 -15.4

Domestic 0.7 0.4 -0.4 1.7 8.2 9.7 Bond issues 0.0 0.7 1.6 0.0 4.0 4.0 Tonga trust funds 0.0 0.0 0.0 2.0 2.6 7.5 Residual 0.7 -0.3 -2.0 -0.3 1.6 -1.7

Foreign borrowing 0.0 0.9 1.0 3.6 0.0 5.7 Recurrent savings/GDP -1.0% 2.3% 0.3% -1.9% -1.0% 1.3% Overall deficit/GDP -0.8% -1.3% -0.6% -4.5% -5.9% -9.7%


estimates.

Rising wages and deteriorating fiscal position


method of collecting sales taxes (shifting collections from retailers to wholesalers) was projected to raise an additional T$15 million.

These additional revenue measures were thought sufficient to restore recurrent balance and generate some savings for transfer to the development budget. However, by October 1990 the budget measures were found insufficient, and a mini-budget was required. A general increase in the port service tax of 2.5 percent was levied bringing the total to 20 percent At the same time certain indirect taxes were altered from a specific basis to ad valorem. These latter measures also ensured a greater elasticity of the tax system in the longer run. However, by the end of 1990-91 the current budget remained in deficit at T$13 million, although an improvement on the previous fiscal year.

At the same time that problems were emerging in the current budget, the normal procedure-funding development expenditures from aid and concessionary loan finance-was departed from. Even though development expenditures were estimated to have fallen marginally from the level of the 1989-90 budget, a substantial increase in the overall deficit emerged. The projected outcome for the development budget in 1990-91 indicates that T$4 million of the overall deficit were funded from the sale of development bonds and T$2.6 million from the Tongan Trust Funds (proceeds from the sale of Tongan passports), while no use of foreign loan finance was made. The existing tightness in local money markets, and the limitations to raising funds through the sale of bonds, meant that T$3.4 million of the bond issue were realized through inflationary finance from the NRBT.

The 1991-92 budget estimates indicate that the current balance is to be restored but that a substantial overall deficit is envisaged. The proposals contain no new revenue measures, which is appropriate given the large recent increases in indirect taxes. However, that balance is to be achieved through expenditure restraint. If inflation is allowed for, the budget implies real reductions in the level of expenditures that raises questions as to the realism of the projections (see NRBT 1991). First, the level of restraint implied has not been achieved in recent years, and without specific proposals the NRBT argues that it is difficult to see where the savings will be achieved. Second, the NRBT indicates that increases in certain expenditures such as maintenance on previous projects and counterpart funds for aid projects need to be increased, thus making cuts in other areas more extreme. The provision of funds to maintain previous projects has received some attention as past allocations for repairs and maintenance have been curtailed to achieve expenditure restraint and to avoid cuts in other areas such as payroll.


Need for fiscal adjustment

The development budget in Tonga includes a list of projects awaiting funding regardless of whether or not the project is to be undertaken in the current fiscal year. In the past only about half of the budget estimates were achieved. In these circumstances it is difficult to assess the size and composition of the overall deficit or the impact of the funding requirements on the domestic economy and money supply. Because it is unclear which projects will go ahead and, accordingly, whether aid funding will be formcoming or domestic finance will be required, it is not possible to estimate a more realistic projection of the deficit. However, the size of the domestic funding projected in the estimates suggests that substantial domestic funds will be needed even if not to the extent projected.

Figure 6 indicates recent trends in the current and overall deficits. Clearly, a problem has emerged in recent years, which requires serious attention. The large additional wage payments made in 1989-90 required both restraint and new revenue measures to restore current balance. The measures that were introduced have not adequately resolved the situation and the problem remains. In 1991-92 adjustment may be avoided through a sizable increase in revenue resulting from the inflow of squash exports, which was not allowed for in the budget estimates. However, eventual adjustment will be needed, which not only restores equilibrium but also improves the composition of expenditures, and provide greater allowance for economic services and maintenance for past projects. The growing overall deficit also needs attention given the lack of domestic funding possibilities, the threat this poses to financial stability, and the crowding out of what little domestic resources are available to the private sector.

Table 7 indicates the size and composition of public sector debt. As the discussion indicates, domestic debt has risen sharply in recent

12%

9%

6%

3 %

0%

• 3%

f~l Current aeficit/G DP

[W1 Overall deficit/GDP

1985-86 1986-87 1987-88 1988-89 1989-90 1990-91 1991-92

Figure 6. Recent trends in the current and overall budget deficits


Table 7. Government debt (T$ million) 1986-87 1987-88 1988-89 1989-90 1990-91 1991-92

Debt outstanding 42.7 44.5 48.3 52.2 N.A. N.A. Domestic 4.0 3.6 4.0 4.0 8.2 11.8 Foreign 38.7 40.9 44.3 48.2 N.A. N.A.

Debt/GDP 51.8% 47.8% 48.4%. 48.0% N.A. N.A.


estimates.

years even if from a low base. Foreign debt has also grown substantially, and although the concessionary nature of most borrowing has resulted in low debt service requirements in recent years, projections indicate that this comfortable position will deteriorate.

Monetary Developments

Until June 1989 the Bank of Tonga was the sole monetary institution in Tonga. The bank was established in 1974 as a joint venture between the government and three foreign banks; the government held 40 percent of equity, and the foreign banks held 20 percent each. During this period the bank conducted both standard commercial banking operations, receiving deposits and extending credit, as well as fulfilling certain central banking functions. The bank's liabilities, or its deposits, were backed both by domestic loans and foreign assets, which also acted as Tonga's foreign reserves. Interest rates were fixed by law and a maximum lending rate of 10 percent prevailed. During 1990 one of the foreign partners in the Bank of Tonga sold its share to the other two private owners as part of a restructuring exercise of its South Pacific operations.

This situation preserved financial stability during the 1970s and '80s. However, the need for greater innovation and sophistication in the financial sector was evolving, and to meet these requirements the NRBT was created in June 1989. The creation of a separate institution permitted the central bank to specialize in the formulation and conduct of monetary policy. The NRBT was entrusted with the maintenance of Tonga's foreign reserves, as well as other central banking functions such as acting as adviser and banker to the government. By the end of 1989 the nascent institution had taken over the foreign assets of the Bank of Tonga and was establishing its position as a financial institution.

Given the institutional environment up to the creation of the NRBT, monetary policy was necessarily limited and followed a passive approach. There was no active attempt to control the level of liquidity or credit in the economy. However, a guideline was in effect that required the Bank of Tonga to limit new lending if the foreign reserves fell below four months worth of imports and to cease new lending altogether if the ratio declined as low as three months.

Money supply Table 8 describes recent monetary developments. Growth in the nominal money supply (currency, demand, savings, and time deposits) shows relatively moderate growth and was 2 percent above the rate of inflation in the consumer price index during the 1986-91 period. Given the relationship that exists in most economies between the demand for money and real incomes, the monetary data are consistent with the sluggish economic growth experienced in mat

Institutional arrangements

30

Monetary Developments / 31

Table 8. Monetary survey, 1984-88 to 1990-91 (T$ million, end of period)

1985-86 1986-87 1987-88 1988-89 1989-90 1990-91

Money supply 27.0 36.0 36.7 37.6 40.3 44.0

Domestic credit 12.8 11.9 18.9 22.5 30.9 35.4 Government -4.1 -7.1 -6.4 -11.8 -6.5 0.5 Public enterprises 2.6 2.0 2.9 2.1 2.1 1.6 Private 14.3 17.0 22.5 32.2 35.3 33.3

Foreign reserves 25.1 37.0 34.8 33.3 33.1 32.9 Other items -10.9 -12.8 -16.9 -18.1 -23.7 -24.3

Source: Quarterly Bulletin, Vol. 2, No. 2, National Reserve Bank of Tonga.

period. While liquidity growth has been moderate, growth in domestic credit has been buoyant. The Tongan monetary situation is unusual in a number of important respects. First, the historical accumulation of budgetary surpluses has led to a large accumulation of government deposits with the banking system, effectively negative credit. Second, the Bank of Tonga has a high level of capital and accumulated reserves. Monetary developments must be reviewed in this context.

The demand for private sector credit was strong until the end of the 1980s, and doubled during a three year period from the level outstanding during 1987-90. Admittedly, the rapid growth in private sector credit has been from a low base, but it also arose from the policies of the Bank of Tonga to diversify its portfolio with the emergence of the NRBT and the loss of its high yielding foreign exchange reserves. In fiscal 1989-90 the rapid expansion in government expenditures with the 34 percent increase in salaries and the absence of additional revenue measures led to increased funding requirements. This was met through the floatation of government bonds and extension of credit by the NRBT to the government, which rose by T$5.3 million. Trends in domestic credit are illustrated in Figure 7.

The moderate increases in domestic liquidity coupled with buoyant growth in both private and public sector credit led to an erosion of foreign reserves (even allowing for the large offsetting movements in "other items net," mainly Bank of Tonga retained earnings). The ratio of foreign reserves to imports (import coverage) had been maintained in excess of six months of imports up until June 1989. From this period the level of import coverage began to slide and had reached five months at the end of September 1989. The rapid growth in private sector credit coupled with the increasing needs of the public sector led to a growing concern for external stability, and corrective measures were needed.

Strong credit growth


12

8

4

0

-4

-8 85-86 86-87 87-88 88-89 89-90 90-91

Figure 7. Domestic credit by sector (T$ million)

Credit restraint The NRBT indicated that the loans-to-deposit ratio (including reserves) of the Bank of Tonga should be brought down from the level of 68 percent, which had been reached at the end of August 1989, to 60 percent, a previous target level. Coupled with these restrictive credit guidelines, the NRBT suggested that a selective credit policy should be maintained favoring productive activities in agriculture, manufacturing, and tourism. Although the monetary system experienced some sluggishness in adapting to the new guidelines, the policy was successful, the level of foreign exchange reserves returned to more acceptable levels in 1990, and external stability was reestablished.

For fiscal 1990-91 the NRBT set a suggested rate of credit growth of 10 percent and raised the maximum desired level of the loans-to-deposits (plus reserves) ratio from 60 to 65 percent. This increase in the loans-to-deposit ratio, although above previous guidelines, was thought more appropriate to the prevailing conditions in the economy. Maintenance of the 60 percent ratio would have implied credit growth of only 4 or 5 percent, which would have been unduly restrictive, given the rate of imported inflation and GDP growth. During the year domestic credit expanded by 14 percent, which was above the official guideline, but owing to the increase in the deposit base, the loans-to-deposits ratio remained below 60 percent.

While this result was in accord with financial stability, the direction of the expansion of credit was less desirable. The increase was entirely absorbed by the public sector and reflects the deteriorating fiscal situation described in the earlier section on fiscal developments.

Excessive public sector credit demand


During 1990-91 the government ran down its deposits with the banking system by T$3.9 million and increased the stock of government securities held by the banking sector by T$3.4 million. Credit to the private sector actually fell by T$2 million.

Weak private Part of the curtailment of credit to the private sector occurred with credit demand m e intention of improving the quality of the loan portfolio of the Bank

of Tonga. The previous rapid expansion of private sector credit had occurred with lenient lending policies and ever mounting poor loan performance. However, the Bank of Tonga also reported a lack of viable borrowing projects that, coupled with the restrictive lending policies, resulted in a rate of real decline in domestic credit. This procedure was described by the NRBT as "ferocious tightening" (see NRBT 1991). The NRBT expressed its dissatisfaction with the contraction of lending to the private sector and encouraged the Bank of Tonga to revive private sector credit extension in the 1991-92 period. As part of its guidelines in the future the NRBT intends to stipulate not only a target for the creation of domestic credit but also separate guidelines for both the private and public sectors.

The weak expansion in domestic credit during 1990-91 resulted in a low loans-to-deposits ratio and liquid monetary conditions at year end. Coupled with the large deposits held by the Bank of Tonga at the NRBT, this situation gave cause for concern in some quarters (Fairbairn 1991) that large excess liquidity could provide the potential for a destabilizing credit boom if left unchecked. At present no suitable monetary instruments exist in Tonga to absorb domestic liquidity, and stabilization must be left to central bank persuasion. The creation of central bank bonds would rectify this omission and help develop standard "open market" operations. However, at the time of writing the fear of any destabilizing credit expansion is overstated given the Bank of Tonga's existing policies toward private sector lending and the reported lack of viable projects.

Interest rate From July 1989 the NRBT raised the interest rate ceiling on credit policy f r o m 10 percent to 13.5 percent on all new loans. This policy was mo

tivated for a variety of reasons. First, interest rate differentials with neighboring countries had discouraged financial development in Tonga. The ease of investment in higher yielding securities in Australia and New Zealand by large migrant communities had acted as a disincentive to deposit growth in Tonga. A more attractive return on domestic instruments would help mobilize domestic savings for reinvestment in Tonga. Second, a move toward deregulation of interest rate ceilings would encourage more efficient allocation of resources and avoidance of credit rationing. Third, certain multilateral institutions had required interest rate reform as a condition of loan finance.


Negative real interest rates

Large interest rate differential

The reforms begun in 1989 were followed through in June 1991 with the complete removal of all interest rate restrictions with the exception that existing loans would be subject to the old rates. Although this constraint on interest rate policy will dampen flexibility, the long-run situation after all the old loans have come up for renewal will provide Tonga with a deregulated environment appropriate to financial development.

Figure 8 reveals movements in real deposit and lending rates since the second half of the 1980s. During much of the period real deposit rates have been negative with the rate of inflation exceeding the rate of interest. The reforms in July 1989, which resulted in an increase in average deposit rates by 1.4 percent during the following two years, occurred during a period of generally low rates of inflation. The result was a period of positive if not low real rates of interest on deposit. With the new fiscal measures imposed in June 1990 and the rising levels of aggregate demand subsequent to the substantial civil servants pay awards, inflation jumped and peaked at 15 percent in the first quarter of 1991. This reversed the previous beneficial movements in real rates. However, the increase in inflation was a once and for all shock, and after the impact works its way through the system the rate of inflation will return to more moderate levels. With inflation falling in Tonga's import supplies to very low levels, the implications would be for real interest rates to rise substantially. This would suggest some pressure in the coming year for downward movement in Tonga's interest rates.

Figure 9 indicates the differential deposit interest rates between Tonga and Australia. The very high rates of interest that existed in Australia, which prevailed during the period that the Tongan dollar pegged to

10%

-30%

-20%

-10%

0%

^Jl Real lending ratesj

Y I I I I I I I I I I I I I I I I I I I I I 86 87 88 89 90 91 85

Figure 8. Real deposit and lending interest rates (nominal interest rates deflated by the consumer price index), 1985-91


2%

0% I I I I I I I I I I I I I I I I I I I I I I I I I I 65 66 67 86 69 90 91

Figure 9. Interest rate differential between Tongan and Australian commercial bank deposit rates, 1985-91

the Australian dollar, gave a large impetus to investment offshore. With the deregulation in Tonga and downward movement in interest rates in Australia and New Zealand, the differential is vanishing, and Tonga presents a more favorable location for financial investment. The incentive to invest in Tonga was further advanced with the delinking of the Tongan dollar from the Australian dollar on February 11, 1991. The inclusion of risk into the investment equation encouraged onshore investment.

The External Sector

The balance of payments has in recent years been characterized by a substantial and growing deficit in the balance of trade. This has been matched by surplus in the services and transfers accounts resulting in approximate balance on the current account. Capital account transactions are sparse with the recent exception of changes in the assets of the Tongan Trust Funds (passport sales). Overall the balance of payments was in surplus in the early 1980s up to 1986-87 but since that date has recorded some small deficits. The level of foreign reserves reached a peak of T$38 in 1986-87 and fell to T$34 million by the end of June 1991. Balance of payments trends are indicated in Table 9.

In recent years exports have declined as a generator of foreign exchange despite efforts to encourage and stimulate growth. These trends follow earlier patterns dating from the late 1960s when exports were able to finance 67 percent of imports. This ratio declined to 36 percent at the beginning of the 1970s and had fallen further to 24 percent by the end of the 1970s and 17 percent by the end of the 1980s. The recent exports of large volumes of squash are reversing these trends, and the export to import ratio rose to 22 percent in 1990-91 and will likely rise to 33 percent in 1991-92.

Exports of individual commodities match the earlier discussion of sectoral economic performance and are given in Table 10. The most important development has been the massive rise in the value of squash exports. From a non-existent level in 1985-86 squash exports were valued at nearly T$5 million in 1990-91. In 1991-92 a record level of T$15 million is anticipated. Exports of coconut products declined throughout the period and hit an all time low in 1990-91. As already discussed, the figures reflect the low profitability of this once important export item.

In recent years non-traditional agricultural exports have been a growth area. Vanilla exports reveal an oscillating but upward trend, and the fall in 1989-90 reflects the variation in the product cycle. Watermelon exports virtually ceased in 1986 with quarantine bans to New Zealand. These have recently been lifted, and some increases in exports of this item can be expected. Root crops showed strong upward movement through most of the period and peaked in 1989-90 due to the failure of the export crop from Western Samoa. In 1990-91 exports returned to more normal levels but reveal a depressed value.

Declining value of exports

Rising importance of non-traditional exports

36

The External Sector / 37

Table 9. Balance of payments (T$ million)

1985-86 1986-87 1987-88 1988-89 1989-90 1990-91

Merchandise trade

Exports, f.o.b. 8.40 10.65 8.84 12.06 10.86 16.22 Imports, f.o.b. 49.28 54.68 60.44 59.07 64.20 74.35

Balance of trade -40.88 -44.03 -51.60 -47.02 -53.33 -58.13

Services

Receipts 21.12 29.34 25.69 27.58 40.18 30.01 Payments 23.40 25.58 26.63 27.79 28.70 31.22

Balance on services -2.28 3.77 -0.94 -0:21 11.48 -1.21

Investment income

Receipts 4.29 5.99 8.02 3.66 5.72 5.12 Payments 0.57 0.19 1.86 1.58 1.42 1.35

Balance on income 3.71 5.79 6.17 2.08 4.30 3.76

Transfers

Private receipts 36.58 38.39 36.77 35.63 44.98 46.02 Official receipts 5.96 10.43 9.23 13.49 13.84 8.50 Private payments 3.38 .4.57 7.54 5.14 6.84 6.49 Official payments 1.62 0.84 1.41 1.16 0.67 0.93 Balance on transfers 37.54 43.40 37.05 42.82 51.32 47.10

Current account balance -1.91 8.91 -9.32 -2.33 13.76 -8.48

Direct investment 0.17 0.30 0.08 0.13 0.13 0.23 Portfolio investment - - - -2.72 -17.66 -4.67 Long-term capital -1.36 0.58 4.90 3.51 -2.10 2.90 Other short term 1:38 -0.90 1.63 0.59 2.06 1.71

Capital account balance 0.19 -0.01 6.62 1.51 -17.57 0.16

Net errors and omissions 2.72 2.48 0.18 -0.61 4.37 7.77

Overall balance 1.00 11.39 -2.52 -1.44 0.57 -0.56

Source: Quarterly Bulletin, Vol. 2, No. 2, National Reserve Bank of Tonga.

It is likely that root crop exports are significantly underestimated because considerable quantities leave Tonga as "unaccompanied baggage-"

Exports of fish have generally performed satisfactorily. (The large rise in 1988-89 is due to T$1.3 million of fish exported but for which no value was received in Tonga.) Exports of manufactures have risen strongly throughout most of the period but reveal a low level in 1990-91 due to the poor performance of knitwear products. In conclusion, the secular decline in exports of coconut products has been matched


Table 10. Exports of major commodities, 1984-85 to 1989-90 (T$'000)

1985-86 1986-87 1987-88 1988-89 1989-90 1990-91

Coconut products 2,994 2,935 1,830 1,522 832 587 Vanilla 1,182 1,418 1,191 2,504 829 3,320 Squash 0 0 0 410 1,983 4,838 Bananas 1,042 1,859 798 517 185 10 Watermelons 195 2 16 6 15 118 Root crops 284 353 545 865 1823 601 Fish 650 1,250 1,292 2,048 1,445 1,222

Manufactures 1,045 1,419 1,865 3,060 3,420 2,482

Total 7,524 9,372 8,061 10,923 10,798 14,441

Tourism receipts 9,435 13,599 12,174 9,231 8,764 9,637 Air arrivals 14,882 16,805 18,096 20,011 22,100 20,659

Source: Statistics Department, Quarterly Trade Statistics, various issues, Government of Tonga.

by growth in many other commodities, in particular, diversified agricultural products.

During 1980-1990 real import demand (deflating nominal imports by the import component of the CPI) appears weak and averaged 1 percent per annum. This figure is below the rate of real GDP growth of the magnetized sector of 2 percent. It is not realistic to suggest that the Tongan economy has become any less dependent on imports; if anything the reverse would appear to be the case. (It may be questionable whether the import component of the CPI is either a reliable or an appropriate indicator to deflate nominal imports.) The composition of imports by consumer and intermediate and capital goods has remained relatively static in recent years with capital goods accounting for 10 percent of imports, consumption goods 40 percent, and intermediates the remainder.

The strong demand for nominal imports has been sustained by the growth in official and private remittances. Significant migration and a commitment to relatives at home in Tonga have meant a growing stream of receipts; which are now the single most important,item in Tonga's external account. Development assistance has also become an important source of funds to the economy and now generates more foreign exchange than exports. On the service account, tourism has become a significant contributor to the balance of payments. While the

Weak demand for imports


data in Table 10 suggest a growing number of visitors to Tonga, the balance of payments foreign exchange receipts are quite erratic, and the statistics cannot be accorded credibility.

Terms of trade Figures 10 and 11 display recent movements in the external terms of trade. Figure 10 shows the ratio of coconut oil prices to import prices. Throughout the 1970s and '80s the trend has been downward, and over the period real prices dropped by more than half. The graph vividly indicates the reason for the fall in production.

Figure 11 reveals movement in the terms of trade during the 1980s with and without the effect of coconut prices. The graph indicates the significant negative impact that coconut products have had on the terms of trade: without coconuts the external environment facing Tonga has improved substantially. The graph reveals the high prices received by coconut producers in 1983 and 1984 and the declining trend from that date. While coconut price movements have not been favorable, movements in other commodity prices have been more beneficial. Vanilla prices rose substantially in the mid-1980s but have since returned to more moderate levels. Root crop prices have moved strongly upward, and movements in fish prices have been favorable. In the longer term the restructuring of the economy away from coconut products toward niche filling differentiated agricultural exports will insulate the economy from the adverse price movements of commodities like coconuts. Thus, while the lack of growth in exports until the beginning of the 1990s was disappointing, the restructuring toward commodities with more favorable price behavior should be beneficial.

Figure 10. Coconut oil prices deflated by imported prices of CPI, 1974-90 (5-year moving averages, index based on 1970=100)


200

150

100

50

0

82 83 84 85 86 87 88 89 90

Figure 11. Terms of trade, 1982-90 (index based on 1982=100)

The Tongan balance of payments displays a lack of capital account transactions with the exception of portfolio adjustment representing changes in the assets of the Tongan Trust Funds (sale of Tongan passports). Direct foreign investment has been negligible, and although foreign borrowing by the government has been increasing it has remained manageable.

At the end of fiscal 1988-89 foreign debt was estimated to be T$48 million or approximately 30 percent of GDP. Tongan external debt is largely composed of loans on concessional terms from the main international agencies and bilateral donors. This results in a very favorable debt service ratio, which represents about 5 percent of exports of goods and services. If debt service is related to current account receipts including foreign transfers, a more appropriate indicator of servicing ability in Tonga's case, this ratio falls to about 2.5 percent.

Exchange rates Exchange rate policy under a pegged regime may be analyzed from two viewpoints: what is the appropriate composition of the peg and what is the right level of the exchange rate. The first issue concerns maintaining a stable and automatic adjustment mechanism of the exchange rate to variations in third country exchange rate movements. The second issue concerns setting the absolute value of the exchange rate at a level conducive to maintaining full employment of resources at home. It is concerned with providing the right price and cost environment for productive economic decisions.

The earlier discussion on inflation pointed out the inefficiencies of pegging to the Australian dollar and showed greater price stability could have been maintained through pegging to a basket of curren-

Financial flows and external debt


cies. The question of whether the level of the peg is appropriate is often accessed through measures of the real exchange rate. The real exchange rate is a measure of a nation's competitiveness. It compares domestic prices to prices in competing nations adjusted for exchange rate differences. Figure 12 provides an indicator of both the nominal and real effective exchange rates. The nominal effective exchange rate is an index of exchange rate movements of Tonga's trading partners with the Tongan dollar weighted by their share in trade.

The graph shows that the nominal effective exchange rate depreciated against Tonga's main trading partners. This reflects the depreciation of the Australian dollar against the major currencies in the mid 1980s. Toward the end of the period the Australian dollar strengthened and the nominal effective exchange rate appreciated.

Loss in The real exchange rate, however, remained more or less unchanged competitiveness between 1981 and 1988, but in 1988 there was a marked increase. The

increase reflects the substantial rise in domestic inflation relative to Tonga's trading partners following the large increases in civil servants pay in 1989 and the new fiscal measures of the 1990-91 budget. The graph indicates that Tonga has lost between 10 and 15 percent in international competitiveness since 1987. From this information it might be tempting to suggest that the currency is overvalued and argue for depreciation. However, a precondition for successful depreciation is the existence of unemployed resources. As argued earlier, the labor market exhibits signs of full employment at the going wage. Under these conditions any attempt to restore competitiveness through depreciation would be unsuccessful and highly inflationary.

120

80 I 1 1 1 1 1 1 1 1 1 1 80 81 82 83 84 85 86 87 88 89 90

Figure 12. Nominal and real effective exchange rates (indices based on 1980=100)

Development Issues and Economic Policy

The lack of economic growth and the poor economic performance during much of the 1980s suggest the need to thoroughly evaluate the reasons for this outcome and to design appropriate policies for the 1990s. It has been argued that the poor prices of coconut products during the 1970s and 1980s led to stagnation in exports. Even though new initiatives were instigated, they were inadequate to counteract the demise of the copra industry, although the recent rapid development of squash has altered this perspective. The stagnation in the economy occurred at the same time as aid and migrant remittances reached record levels and were being viewed as the major economic force. The growth in transfers displayed symptoms of "Dutch disease," dominating economic activity, pulling resources away from more productive sectors, and encouraging investment in goods and services destined for the home market.

If aid and remittances could be guaranteed to provide a source of sustained and expanding foreign exchange, it might be argued that they should form a core component of development strategy. However, the reliability of growth in transfers in the longer term must be doubted, and the most that can be expected is a continuation of the present volume. The longer migrants remain overseas and ties with home are weakened, the less reliance can be placed on remittances. However, family reunification will permit a continued avenue for migration even if the destination countries continue to tighten immigration possibilities. Continued potential for grant aid at present levels seems likely for some time into the future even though the long-run philosophy of aid is to promote self-reliance and make the need for aid unnecessary.

Sustainable A long-run sustainable development strategy for Tonga accordingly development suggests it will need to shift its emphasis from a dependence on trans

fers to investing in productive activities and developing the private sector. However, the focus of the strategy must originate out of the cause of stagnation and thereby generate new private initiatives. It is the lack of rewarding activities in Tonga that has led to migration to support domestic incomes. If new rewarding initiatives are found, migration will fall and the need for aid will be reduced. If, however, the focus is placed on greater self-reliance and reduced dependence, efforts are likely to be misplaced. For example, greater domestic resource mobilization while reducing foreign dependence may be counterproductive in the short run. Given the excess of investable

42

Development Issues and Economic Policy / 43

funds, additions to domestic savings will not generate greater real investment. The consequence would be deflation and reduced output.

It has been argued that dependency on aid and remittances generates a dependency syndrome, which discourages any real effort on the part of the Pacific islands to improve their economic situation. In such a case foreign aid is seen as a welfare payment, and no effort is made to turn the additional resources into productive activity. Reliance on domestic resources encourages greater economy in the use of funds and results in increased productive activity. Although the short-run impact might be deflationary, the long-run impact would hopefully be greater economic growth.

Various policies could be implemented to stimulate domestic savings. Interest rates have now been deregulated and market rates should yield positive real returns and encourage greater savings. Fiscal restraint, which is greatly needed, would also generate domestic savings. The introduction of a national provident fund, much delayed in Tonga, would also provide a stream of funds, although considerable care should be taken to ensure these funds are used to fund private initiatives and are not simply used to augment public sector investment. Fiji is a case in hand that has generated a tremendous stream of resources through the Fiji National Provident Fund. Unfortunately 85 percent of this resource has been used to fund the government's development budget, and the failure of appropriate financial intermediation must be one of the causes of Fiji's poor growth performance in the 1980s. It has been suggested that remittances themselves are a fund for savings. However, this is improbable if the main function of remittances is to support consumption.

Problems in Unlike most developing economies, development in Tonga has not financial been constrained by the availability of capital. In recent years gross intermediation investment has averaged 33 percent of GDP, but most of the available

funds have either been used for housing or aid projects, neither of which adds directly to the productive stock of fixed capital. The problem is one of financial intermediation, or how to effectively channel these very sizable volumes of resources into the private sector. To date no satisfactory resolution to the problem has been found. While investment in development banks is an obvious solution, performance has been poor, and at present a lack of viable initiatives is reported by the Tonga Development Bank.

Greater emphasis needs to be given by the donors to identify and fund productive private sector initiatives, which directly result in increased output. Continuation of present policies, while supporting


current levels of income and consumption, will not improve long-run growth prospects. The situation is self-perpetuating: to encourage economic growth and reduce long-run dependence, donors maintain high volumes of aid. The majority of aid projects have not been specifically designed to stimulate private initiative and do little to improve the original poor economic performance. The continuing poor performance in turn provides further justification for more aid. However, the extra funds boost domestic incomes and consumption, and the recipient governments become dependent on a revenue source without which an economic recession would result.

The recommendation that aid be channeled into the private sector is problematic because donors are not structured to achieve this and no existing institutional framework exists. However, new initiatives are required because the existing pattern of aid has not resulted in improved economic performance and, some may argue, has directly contributed to the stagnation experienced during the 1980s.

Fiscal reforms The recent growth in the public sector has been inappropriate and has needed n a c * several distorting consequences. First, the higher rate of remu

neration of civil servants attracts scarce manpower away from private sector activities, although some adjustment was warranted to bring remuneration of higher skilled civil servants up to more realistic levels. Second, the increase in public expenditures necessitated increased taxes and greater public sector borrowing to maintain fiscal balance. With stagnation in the economy this situation implied both a redistribution of income away from the private sector and a reduction in funds available for private development efforts.

Third, the increases in taxes raised the rates of indirect taxes, which translate into greater taxes on international trade or imports, given the structure of taxation in Tonga. Increased tariffs raise the attractiveness of producing import substitutes and discriminate against exports at a time when export diversification is starting to take off. The effect on resource allocation will re-emphasize an area of economic activity that has little comparative advantage in a very small open economy like Tonga. Last, the higher taxes and increased aggregate demand have pushed up domestic prices and resulted in a loss of competitiveness, which has resulted in a real appreciation of the exchange rate. In summary, recent fiscal policies have augmented an economic system that has already had strong bias favoring non-traded goods production and import substitutes, which have little long-run growth potential.

There is an emerging need to re-evaluate and streamline the tax system. Direct taxes were appropriately reduced in 1986-87 from unrea-

Development Issues and Economic Policy / 45

sonably high rates to levels that were, however, exceptionally low by world standards. The reductions, while resulting in a revenue loss, were also regressive. The consequences of these measures together with recent expenditure growth have resulted in increases in indirect taxes, which have had undesirable if not unintended consequences for resource allocation. There is a growing need for a comprehensive assessment and review of the tax system to suggest a more appropriate set of incentives to encourage outward looking development that is appropriate to the 1990s.

The recent structural diversification of exports, away from low profitable traditional commodities toward high yielding activities, suggests that private entrepreneurship is alive in Tonga. The rapid growth of squash exports and to a lesser extent vanilla indicates the willingness of Tongan entrepreneurs to exploit profitable opportunities. This experience confronts the skeptics, whose analysis suggests that migration, remittances, aid, and public expenditure are the sole driving forces of Pacific island economies. While remittances and aid have assumed an overwhelming importance in Polynesian economies, it has been in response to a lack of profitable opportunities. The squash example indicates the far-reaching consequences for development if the opportunities and incentives are right.

The sensitivity to profit in Tonga emphasizes the need for policy reform. The sluggish growth experienced during the 1980s and the general disillusionment with development resulted in a neglect of policy. The very real and recent successes of the economy during the past three years virtually demand a revision and update of policy to reflect reality.

46

References

Fairbairn, Teo Ian 1991 The Tongan Economy: Setting the Stage for Accelerated

Development. Australian International Development Assistance Bureau.

National Reserve Bank of Tonga (NRBT) 1991 Quarterly Bulletin, Vol. 2, No. 2.

Ullman, D. E., Cho, J. J., and German, T. L. 1991 "Occurrence and Distribution of Cucurbit Viruses in the

Hawaiian Islands," Plant Disease, Vol . 75, No. 4, pp. 367-70.

47

Pacific Islands Development Program

The purpose of the Pacific Islands Development Program (PIDP) of the East-West Center is to help meet the special development needs of the Pacific islands region through cooperative research and training. PIDP conducts specific research and training activities based on the issues and problems prioritized by the Pacific Islands Conference of Leaders, which meets every three years. The Standing Committee, composed of eleven island leaders, reviews PIDP's research projects annually to ensure that they respond to the issues and challenges raised at each Pacific Islands Conference. This unique process enhances the East-West Center's capability in serving the Pacific.

East-West Center

The East-West Center was established in Hawaii in 1960 by the United States Congress "to promote better relations and understanding between the United States and the nations of Asia and the Pacific through cooperative study, training, and research."

Some two thousand research fellows, graduate students, and professionals in business and government each year work with the Center's international staff on major Asia-Pacific issues relating to population, economic and trade policies, resources and the environment, culture and communication, and international relations. Since 1960, more than twenty-seven thousand men and women from the region have participated in the Center's cooperative programs.

Officially known as the Center for Cultural and Technical Interchange Between East and West, Inc., the Center is a public, nonprofit institution with an international board of governors. Principal funding comes from the United States Congress. Support also comes from more than twenty Asian and Pacific governments, as well as from private agencies and corporations.

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Tonga : development through agricultural exports

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