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Progress Report on Tranche Release

Project Number: 43152 Grant Number: 0185 May 2011

Tonga: Economic Support Program

CURRENCY EQUIVALENTS (as of 4 May 2011)

Currency Unit

– pa’anga (T$)

T$1.00 = $0.5743 $1.00 = T$1.7413

ABBREVIATIONS

ADB – Asian Development Bank EPSRP – Economic and Public Sector Reform Program ERC – Expenditure Review Committee ESP – Economic Support Program GDP – gross domestic product IMF – International Monetary Fund MOFNP – Ministry of Finance and National Planning MOH – Ministry of Health NIIP – national infrastructure investment plan NRBT – National Reserve Bank of Tonga PEFA – public expenditure and financial accountability PER – public expenditure review PFM – public financial management SPSO – Pacific Subregional Office TA – technical assistance

NOTES

(i) The fiscal year (FY) of the Government of Tonga and its agencies ends on 30 June. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2011 ends on 30 June 2011.

(ii) In this report, “$” refers to US dollars unless otherwise stated. Vice-President C. Lawrence Greenwood, Jr., Operations 2 Director General R. Wihtol, Pacific Department (PARD) Director A. Ruthenberg, Pacific Subregional Office, PARD Team leader E. Veve, Senior Country Specialist, PARD Team members L. Tora, Public Financial Management Officer, PARD S. Zaidansyah, Counsel, Office of the General Counsel

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS Page

I. INTRODUCTION 1

II. ECONOMIC PERFORMANCE 1 A. Macroeconomic Developments 1 B. Government Policy for Economic Recovery 2 C. ADB’s Development Experience in Tonga 4

III. STATUS OF SECOND TRANCHE POLICY ACTIONS 5 A. Maintenance of Fiscal Responsibility 6 B. Structural and Governance Improvements 11 C. Support the Vulnerable through Targeted Actions 14 D. Communication and Ownership of Economic and Fiscal Management Initiatives 15

IV. MAINTENANCE OF TRANCHE 1 CONDITIONS AND COVENANTS 16

V. CONCLUSIONS 19

VI. THE PRESIDENT’S RECOMMENDATION 20

APPENDIXES

1. Status of Compliance with Second Tranche Release Conditions 21

2. Expenditure on Basic Health and Education FY2010 25

I. INTRODUCTION

1. This paper seeks approval for release of the second tranche of the Economic Support Program (ESP).1 The ESP is designed to help Tonga mitigate the impact of the global economic crisis, establish the basis for higher more equitable and sustainable growth in the medium term, and create an economy more resilient to future shocks. The program impact will be higher and more inclusive economic growth, and the outcome will be a timely and effective response to the crisis. 2. The Asian Development Bank (ADB) approved the Asian Development Fund grant of $10.0 million to Tonga for the ESP on 3 December 2009. 2 Proceeds from the ESP were scheduled for release in two tranches of $5.0 million each. The second tranche of $5.0 million was tentatively scheduled for release in November 2010. The government made significant efforts to meet this target and provided some proof of compliance documents as early as July 2010. ADB undertook a review mission on 2–5 November 2010 to collect compliance documents and discuss progress in then-outstanding policy areas. The election of a new government in November 2010 slowed some areas of activity and details of Tonga’s implementation of the ESP were not finalized until the end of February 2011.

II. ECONOMIC PERFORMANCE

A. Macroeconomic Developments

3. Tonga’s economic growth has been modest during FY2001–FY2010, with real gross domestic product (GDP) growth averaging about 0.8% annually. During the same period, the average annual growth rate for real GDP per capita was lower, at a little under 0.2%. 4. Tonga’s economy was strongly impacted by the global economic crisis, with weaker remittances, exports, and tourism receipts in FY2010. The 1.4% contraction experienced in FY2010 was also influenced by domestic banking consolidation (which dampened economic activity) and delays in major construction works. 5. The predominant impact of the global economic crisis came from a sharp decline in remittances, resulting from the economic downturn in the key remittance-sending countries—Australia, New Zealand, and the United States. Prior to the global economic crisis, remittances were the equivalent of over 30% of GDP. In FY2009, remittances fell by about 14% in pa’anga, and again in FY2010 by more than 10% in pa’anga. By FY2010, remittances were the equivalent of only 22% of GDP—their lowest level of any year in the previous decade. This sharp decline in remittances reduced the income of remittance-receiving households in Tonga, reducing their expenditure and thereby contributing to the contraction in domestic economic activity. However, by November 2010, remittances were 2.2% higher than in November 2009.

1 ADB. 2009. Report and Recommendation of the President to the Board of Directors: Proposed Asian Development

Fund Grant to Tonga for the Economic Support Program. Manila (Grant 0185-TON). 2 The grant agreement was signed on 21 December 2009 and became effective on 26 February 2010. The first

tranche was disbursed on 24 March 2010. Original grant closing was 31 December 2010 but this was extended to 31 March 2011 (approved on 14 December 2010) and subsequently to 30 June 2011 (extension approved on 31 March 2011).

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6. Economic activity was also dampened by a decline in tourism receipts and a contraction in exports. After rising in FY2009, tourism receipts fell by over 13% in pa’anga in FY2010. In FY2009, the nominal value of exports fell by just over 50% in pa’anga. In FY2010, this situation had stabilized and the nominal value of exports remained constant in pa’anga. 7. Private sector credit growth contracted by about 13% in FY2010, reflecting the slow pace of recovery in major markets, further consolidation in the banking sector, and the write-off of bad debts in the business sector. Lending to the business sector declined by 14.4% in FY2010 and lending to households fell by 3.8%. At the same time, foreign reserves continued to increase (peaking at the equivalent of 7.5 months of imports in December 2010), reflecting continuing weak domestic demand, slow economic activity, and tight credit conditions. At the end of February 2011, official foreign reserves were equivalent to 6.5 months of imports, still well above the target level. 8. During FY2010, the country was impacted by three natural disasters. The tsunami of September 2009 affected the island of Niuatoputapu, causing loss of life and significant material damage. Then a cyclone hit Tonga in February 2010, causing material damage—including to agricultural crops. In addition, Tonga was subject to drought, affecting production in the agricultural sector. 9. These events affected government tax revenue. In FY2010, tax revenues fell by 11.0% in nominal terms. The impact of the global economic crisis in reducing the tax base, primarily through the decline in remittances, was overlaid by the implementation of the second phase of taxation reforms and the end of the domestic credit bubble which saw reduced corporate tax revenue. In the budget for FY2011, tax revenues are forecast to undergo a more modest drop of 2.3%, suggesting a bottoming out of the decline.

10. Despite implementation of strict expenditure control measures to maintain a manageable deficit position for FY2010, a budget deficit of 0.9% of GDP was posted. 3 Without grants for budget support from Tonga’s development partners, this deficit would have been about 3.4% of GDP and it would have been a more significant drag on growth.4

11. Expectations surrounding economic activity in FY2011 are mixed. ADB projects growth of 0.5% for 2011, driven by development partner-funded construction and infrastructure activities, rising to 1.8% in 2012. The International Monetary Fund (IMF) forecast for FY2011 is more optimistic at 1.7%, with the same expected for FY2012. The government, however, has revised its initial projections downward to a contraction of 0.5% in FY2011, and growth of 0.6% in FY2012. All agree that underlying fiscal conditions remain tight. B. Government Policy for Economic Recovery

12. The government’s approach to facilitating an economic recovery has comprised a broad-based program consisting of short-term actions (strengthened expenditure controls, revenue expansion, and monetary policy settings) as well as medium-term actions to improve public financial management (PFM), promote structural reform, and increase self-funded capital expenditure. The government has also made more economic information publicly available. 3 MOFNP. 2011. Budget Statements for the Year Ending 30th June 2011. Budget Paper 2: Fiscal Analysis and

Outlook, Table 2, p.30. Nuku’alofa. http://www.finance.gov.to/publications/budget-statements. 4 Budget support in FY2010 comprised T$9.4 million from ADB in February 2010 and T$1.6 million from the Australian

Agency for International Development in June 2010. In FY2011, budget support is expected to include the ADB grant second tranche of T$9.4 million, in addition to the World Bank grant of T$9.4 million (December 2010).

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This consultant’s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project’s design.]

13. The government took stringent measures to maintain a manageable deficit position for FY2010. The Expenditure Review Committee of cabinet (reestablished in 2008) monitors monthly revenue and expenditure and makes expenditure adjustments where necessary to manage any potential deficit. The committee’s role became extremely important in FY2010 when expenditure programs were being continuously adjusted as revenues declined. Lower ceilings imposed on ministries partway through the year squeezed nonwage operating costs. This resulted in cutbacks in some government services, with current expenditure (non-personnel) cut to T$63.5 million (down 17%). The major areas of expenditure cuts included maintenance and operations cut by T$3.4 million (33%); purchase of goods and services cut by T$2.3 million (9%); operational grants and transfers cut by T$1.3 million (6%); defense cut by T$0.1 million (90%); equity payment cut by T$0.8 million (41%); and capital expenditure cut by T$0.3 million (10%). 14. The government considered that the gap between estimated revenue and planned expenditure in FY2010 was too large to be bridged solely by expenditure cuts, and budget support was sought from development partners (footnote 4). General budget support through grant financing has helped Tonga to maintain its focus on priority budget expenditure. 15. The government sought to protect the most vulnerable members of society from the impacts of the global economic crisis as well as from the impacts of the resultant budget cuts. While Tonga’s strong culture and traditional sector provide a substantial buffer against economic shocks, growing population pressures driven by rising urbanization and migration to the country’s main island have meant that this system is no longer sufficient to help Tongans avoid hardship. Development partner assistance ensured that there was minimal disruption to the provision of essential social services, despite budget cuts (para. 13). Issues of vulnerability and social welfare rose to prominence and the cabinet considered a paper on vulnerable persons, which presented short- and medium-term options for providing assistance.

16. While the government was unable to afford stimulatory capital expenditure in FY2010 (domestically funded capital expenditure decreased by 68% from FY2009 to FY2010), it obtained a loan equivalent to T$81.07 million (30 November 2009 exchange rate) from the Export–Import Bank of China (China Eximbank) in January 2010 for the upgrading and maintenance of public roads over the next few years. Significant local participation and content is expected to provide fiscal stimulus to a weak economy. Through its adoption of financial ratios to guide overall budgetary settings, the government has committed to lifting capital expenditure to over 5% of the government’s own resources in the medium term, and capital expenditure was lifted by one percentage point in FY2011 over the FY2010 level (Table 1). Domestically funded capital expenditure has been increased by 60% from FY2010 to FY2011 budget estimates, albeit from a relatively low base. 17. The National Reserve Bank of Tonga (NRBT) has held a neutral monetary policy stance since June 2009. The effectiveness of monetary policy measures is lessened by weak transmission mechanisms and the pegged exchange rate, but has also been muted by the commercial banks’ continuing to tighten credit conditions and consolidate their balance sheets, following an overexpansion in lending in FY2008. Consequently, liquidity in the banking system remains at a high level, even with reserve requirements of just 5%. The level of foreign reserves has remained high over this period, above the equivalent of 6 months of import cover. Inflation also remains low, averaging 3% in 2010. These factors provide room for monetary easing. 18. During 2010, the government has continued to push vigorously a program of reform—in the areas of public enterprises, business environment, and PFM. These reforms should help

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strengthen economic growth in the medium term, once the recovery has commenced. This builds on a track record of reform since 2000, which has improved the performance of public enterprises and reduced the extent of the burden that regulations place on investment and business activity. Recent reforms have comprised a mix of legislative and regulatory reforms and actions to implement agreed reforms within specific public enterprises. This is noteworthy given the conflicting demands on limited government financial resources, the political capital that was expended in support of reforms, and the fact that this continued in the lead up to the November 2010 election—the first in which Tonga’s voters elected the majority of seats in the Legislative Assembly. 19. The government has made progress with a PFM reform agenda that should help underpin improvements in the use of public resources. In May 2010, Tonga’s second public expenditure and financial accountability (PEFA) assessment was completed. The assessment has helped Tonga identify areas of its PFM system that require strengthening, but more critically, it has provided the basis for the preparation of an overarching PFM reform plan. Ahead of this, specific initiatives have seen actions in the areas of internal audit, regular bank reconciliations, collation of a treasury manual, and more rigorous macroeconomic dialogue across government agencies. ADB is helping Tonga to put in place a framework for medium-term budgeting that will allow Tonga to make policy decisions and allocate resources more strategically. 5 C. ADB’s Development Experience in Tonga

20. Tonga has received $57.79 million in loans and $17.05 million in technical assistance (TA) since joining ADB in 1972. Two grant projects ($21.30 million) and three TA projects ($1.15 million) are currently active. Tonga has also benefited from ADB’s regional activities, most recently the Private Sector Development Initiative, Pacific Economic Management TA, and the services of the Pacific Infrastructure Advisory Centre.6 21. The Country Partnership Strategy, 2007–2012 for Tonga, approved in November 2007, defined as its main objectives: (i) the provision of infrastructure for the poor through urban development, (ii) financing of pro-poor policies through effective and prudent macroeconomic and fiscal management, and (iii) private sector development. 7 22. The national strategic vision aims for a higher standard of living for all Tongans. Progress toward achieving this objective has been slow. The outcome reflects past policy and governance environments that discouraged private sector investment, and the crowding-out effects of a relatively large public sector. Considerable effort by ADB and bilateral aid agencies to support reforms yielded disappointing results, which were attributed to a lack of political will. 23. Amid continued demand for effective reforms, in 2002, ADB approved the Economic and Public Sector Reform Program (EPSRP) and the program loan was completed by the end of 2003.8

5 ADB. 2009. Technical Assistance to the Kingdom of Tonga for Support for Economic and Strategic Management.

Manila. 6 ADB. 2006. Technical Assistance for the Private Sector Development Initiative. Manila (cofinanced by the

Government of Australia); ADB. 2009. Technical Assistance for Pacific Economic Management. Manila; ADB. 2009. Technical Assistance for the Establishment of the Pacific Infrastructure Advisory Center. Manila (financed by the Government of Australia).

7 ADB. 2007. Country Partnership Strategy: Tonga 2007–2012. Manila. 8 ADB. 2002. Report and Recommendation of the President to the Board of Directors: Proposed Loan and Technical

Assistance Grant to the Kingdom of Tonga for the Economic and Public Sector Reform Program. Manila.

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The completion report for the program concluded that it was partly successful.9 While a number of targets were achieved, they did not lead to a sustainable fiscal balance and improved public service delivery to the private sector and the public. However, the EPSRP was instrumental in supporting the prudent economic policy stance of the government in the context of challenging conditions characterized by the civil service strike in 2005 and the riot of 2006. This can be seen in (i) the role played by the foreign exchange reserves, in part supplied through the proceeds of the program loan; (ii) the reduction in pressure on the foreign exchange fluctuation as the NRBT moved to protect its reserves against volatility in the money supply; (iii) the alleviation of pressure on the budget when the government faced a large civil service redundancy payout in 2006; and (iv) the implementation of the reform initiatives that paved the way for improvements in the business environment, particularly tax reform that contributed to the aligning of the trade regime with Tonga’s obligations under various trade agreements. 24. Further to the reforms initiated under the EPSRP, ADB provided four phases of TA supporting the Rationalization of Public Enterprises. 10 Phases 3 and 4 directly supported the rationalization of selected public enterprises. Subsequently, the Private Sector Development Initiative consolidated the reforms by supporting legislative reforms to strengthen the oversight of public enterprises and improve the business environment (footnote 6).

25. The government’s focus on PFM reform has been growing, with the support of development partners. ADB is supporting economic and fiscal management through TA that will help to improve forecasting, implementation of a medium-term budget framework, and strengthen the budget-planning link (footnote 5). ADB’s regional TA resources have also provided support to Tonga, including the Ministry of Finance and National Planning (MOFNP) and NRBT (footnote 6), and to strengthen management for development results within executing agencies for ADB projects. 11 26. ADB also continues to support project-based development. Phase 1 of the ADB-supported Integrated Urban Development Project in Tonga is progressing well and preparation for the second phase is under way. 12 Preparatory work has also commenced on the Tonga–Fiji Submarine Cable Project. 13

9 ADB. 2005. Program Completion Report. Economic and Public Sector Reform Program (Tonga) (Loan 1904-

TON[SF]). Manila. 10 ADB. 2009. Technical Assistance to the Kingdom of Tonga for Reforming Public Enterprises. Manila; ADB. 2006

Technical Assistance to the Kingdom of Tonga for Rationalization of Public Enterprises, Phase III. Manila (financed by the Japan Special Fund); ADB. 2004. Small-Scale Technical Assistance to the Kingdom of Tonga for Rationalization of Public Enterprises (Phase 2). Manila; ADB. 2003. Technical Assistance to the Kingdom of Tonga for the Rationalization of Public Enterprises. Manila.

11 ADB. 2008. Technical Assistance for Results-Based Project Management for Pacific Developing Member Countries. Manila (financed by the Japan Special Fund).

12 ADB. 2008. Report and Recommendation of the President to the Board of Directors: Proposed Asian Development Fund Grant and Technical Assistance Grant to the Kingdom of Tonga for the Integrated Urban Development Sector Project. Manila.

13 ADB. 2010. Technical Assistance for Preparing the Tonga–Fiji Submarine Cable. Manila.

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III. STATUS OF SECOND TRANCHE POLICY ACTIONS

27. The program supports the government in carrying out policy reforms in the following areas: (i) budget support to protect services to the vulnerable, (ii) maintenance of fiscal responsibility, (iii) structural and governance improvements, (iv) support for the vulnerable through targeted actions, and (v) communication and ownership of economic and fiscal management initiatives. The second tranche release conditions comprise 18 policy actions. The government is judged to be compliant with 17 second tranche conditions and partly compliant with one second tranche condition. Details of compliance are set out below. Appendix 1 presents the detailed status of the government’s provision of documents evidencing compliance with these policy actions. A. Maintenance of Fiscal Responsibility

Condition 2.1 (complied with). The recipient, through the MOFNP, shall have completed the second PEFA.

28. Tonga completed its second PEFA assessment in May 2010, 14 the first being undertaken in September 2007. 15 This allowed for the tracking of progress in PFM performance based on the implementation of reforms by the Government of Tonga. The assessment will also assist development partners to prioritize future support to Tonga. The PEFA is publicly available through the government website and a link on the PEFA website. 16 29. The PEFA rating suggests that about two-thirds of Tonga’s PFM system is performing at an average level or better when compared to international best practice. Measured against the six core PFM objectives examined, it is clear that most parts of the system work reasonably well. Of the 28 PEFA indicators, Tonga had improved on 2007 ratings in 11 of these, maintained performance in 15, and fallen back against two indicators (PI-19 competition, value for money and controls in procurement, and PI-27 legislative scrutiny of the annual budget law).

Condition 2.2 (complied with). The recipient, through the MOFNP, shall have operationalized the improved processes for macroeconomic and revenue forecasting in which (a) credible models for macroeconomic and revenue forecasting are in use; (b) the macroeconomic technical committee meets quarterly and submits reports against its terms of reference; and (c) 3-year macroeconomic and revenue forecasts are presented in the budget for FY2011.

30. Revenue projections used in the FY2010 budget estimates were overly optimistic—proving to be 20% higher than actual outturn. Overestimation of revenue is particularly problematic. Monitoring of revenues identified the likelihood of overestimation of revenue early in the financial year; the revenue estimate was adjusted within that budget year and noted in At A Glance. 17

14 Government of Tonga. 2010. Public Expenditure and Financial Accountability—Public Financial Management

Performance Report: Kingdom of Tonga. Nuku’alofa. http://www.finance.gov.to/publications/others 15 Government of Tonga. 2007. Public Expenditure and Financial Accountability—Public Financial Management

Performance Report: Kingdom of Tonga. Nuku’alofa. 16 Public Expenditure and Financial Accountability. http://www.pefa.org 17 Ministry of Finance. 2009. At A Glance October 2009. Nuku’alofa. http://www.finance.gov.to/publications/at-a-

glance.

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31. The MOFNP has in place a credible spreadsheet-based model for macroeconomic and revenue forecasting, guided by a forecasting handbook. 18 In practice, forecasts were largely developed within the MOFNP without the active participation of technically skilled stakeholders such as the Prime Minister’s Office, National Statistics Office, and the NRBT. Thus there was not necessarily wide understanding of the forecasting process or a broad base of support for the forecasts. Further, a trend had developed of the MOFNP forecasts subsequently being adjusted to reflect aspirational targets and desired expenditure levels before inclusion in the budget. The existing model and guidance provided by the forecasting handbook were used in September 2009 to provide revised forecasts for FY2010, which resulted in a revenue projection 18.6% below that in the budget estimates. Subsequently, during 2010, both ADB and the Pacific Financial Technical Assistance Centre have provided support for strengthening of forecasting processes and techniques. 32. To ensure that forecasts used in the budget are robust, Tonga has reactivated the Macroeconomic Technical Committee, which monitors macroeconomic developments and prepares macroeconomic forecasts. Membership of the committee comprises the Ministry of Finance (Policy and Planning, Budget and Statistics Departments), the Prime Minister’s Office, the Bureau of Statistics, and the NRBT. The membership of the committee allows for technically sound consideration of forecasting assumptions and risks, and robust discussion of resultant forecasts. At times, external technical support (including from ADB and the Pacific Financial Technical Assistance Centre) has been invited to join the committee’s discussions. The formalization of the committee’s functions, through specific terms of reference, and the formal recording of decisions taken at its regular meetings makes its work more systematic and transparent. The estimates approved by the Macroeconomic Technical Committee are taken to the Expenditure Review Committee of the cabinet by the minister for finance, who is better equipped by the Macroeconomic Technical Committee’s discussion to defend the forecasts at Expenditure Review Committee meetings. The 3-year GDP, consumer price index, and revenue forecasts used in the FY2011 budget were developed through this system. 33. The robust nature of FY2011 budget forecasts are exemplified by the fact that the revenue received in the first 6 months of FY2011 represents 52% of estimated annual total revenue.

Condition 2.3 (partly complied with). The recipient, through the MOFNP, shall have met the financial ratios in the program budget guidelines for FY2011.

34. The Expenditure Review Committee approved financial ratios in December 2009 to promote fiscal sustainability over the medium term, as had been committed to by the Government under tranche 1. These were included in the budget preparation guidelines for FY2011, providing broad guidance to budget development. These ratios set ceilings or minimum shares of government funds to be directed to capital expenditure and maintenance, public debt servicing, government personnel costs, and other (non-personnel) operating costs, as well as the level of government debt as a percentage of GDP. 35. The government decided to adopt largely medium-term targets for the financial ratios to accrue sustained improvements over time. This avoided the risk that subsequent governments may not regularly update easily achievable short-term targets. As a result, projections show that, while the government will move toward its own targets in FY2011, it will only fully meet these over the medium term (Table 1). ADB supports the government in its decision to set medium-

18 B. Taplin. 2008. Tongan Forecasting Handbook – 2008. Nuku’alofa.

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term financial ratios as targets that will be achieved in a stepwise fashion. This was a sound decision, which gave due regard to the fluid political and difficult economic environment being experienced at the time the decision was made. 36. Capital expenditure has typically been a small component of government-funded expenditure—largely supported by development partner funding. The government targeted not falling below the FY2010 baseline (1.7%). Projections in table 1 show capital expenditure will not fall below the baseline and there is stepwise movement to the medium-term target of 5% which is anticipated to be surpassed in FY2013. In setting a medium-term capital expenditure target of 5% of total government funds, the government recognized the need to take greater control of this portion of expenditure, which is directly supportive of future growth.

Table 1: Performance Against Financial Ratios (%)

Ratio Target Level FY2010 (Base) FY2011 FY2012 FY2013

Capital expenditure

Maintain at no less than FY2010 capital expenditure share – with medium-term target of 5% of total government funds

1.7 2.7 3.8 7.4

Government personnel costs

Capped at FY2010 levels – 45% of total government expenditure with a view to increase the relative proportion spent on service delivery

45.0 51.1 52.4 49.1

Other (non-personnel) operating costs

Gradually increase from FY2010 levels to 35% of total government funds

33.3 28.5 25.5 26.5

Debt servicing Maintain at less than 15% of government funds

16.4 12.1 16.1 21.4

Public debt Maintain at less than 40% of GDP 41.6 44.1 43.7 41.6

FY = fiscal year, GDP = gross domestic product. Source: Government of Tonga. 2010. Budget Paper No. 2. Data supplied by the Ministry of Finance and National Planning. 37. The financial ratios relating to personnel and other (non-personnel) operating costs reflect the largest shares of government expenditure, and table 1 indicates these have not been fully met in FY2011. Despite the increase in the personnel cost ratio, the absolute change in personnel costs between FY2010 and FY2011 is a decline of T$3.3 million; the change in ratio is being driven by the decline in expected Government funds. Comparability across years has been complicated by two factors. The first is that ongoing improvements in budget processes have already seen some revision of expenditure items into the appropriate expenditure group—e.g., in FY2010 some contract staff and labor were included in operating costs (non-personnel) but these expenditures (totaling T$1.2 million) were reclassified in FY2011. The second, and more significant, is the government’s budget support forecasting practice. Budget support, which is treated as the government’s own funds, was relatively high in FY2010 and largely served to support operating costs (non-personnel), in effect pushing down the share of personnel costs to an artificially low base. However, budget estimates for FY2011 only include confirmed budget support (T$9.4 million, a small proportion of budget support of T$32.9 million which the government indicated it was expecting) and forward years do not include any amounts of budget

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support, causing a point of disconnect in the data between FY2010 and subsequent years. In assessing the likelihood of tracking towards these targets in the medium term, reliance has been placed on general trends in expenditure and evidence such as planned programs, which would directly impact specific expenditure areas, and so cause the ratios to track towards target levels. 38. The FY2011–FY2013 share of government expenditure is overestimated for personnel costs because of the lack of inclusion of budget support, which would allow a greater share of expenditure for other (non-personnel) operating costs. The government has also proposed a number of actions to reduce personnel costs, such as revising public service policies with the effect of reducing staff entitlements, rationalization of the public service, review of the activities of line ministries, and contracting out of services. The impact of such programs has not been included in forward estimates of the financial ratios. Internal assessment by MOFNP, undertaken after the release of the budget, estimates this financial ratio will be met in FY2015, with budget support potentially bringing this forward. 39. Similarly, the share of government expenditure is underestimated for operating (non-personnel) costs from FY2011 onwards, due to the exclusion of budget support. Budget support will be expected to raise non-personnel expenditures. Thus, the government is considered to be on target to meet both these financial ratios in the medium term. Attention should be given to improved means of forecasting expected future ratios, to improve cross-year comparability and so support financial ratios as a means to guide budget allocation. 40. Debt servicing as a share of government funds remains below the ceiling of 15% of government funds in FY2011, at an estimated 12.1%. In FY2011 this financial ratio has been achieved. Debt servicing levels reflect historical patterns of debt, and managing the level of debt servicing requires actions such as debt consolidation and forgiveness. In practice, this ratio is hard to impact, and as such restricts flexibility in meeting other ratios. Nonetheless, budget forward estimates indicate an expectation that this target will be significantly exceeded from FY2012 because external loan servicing will begin on the first of the two loans from China Eximbank, with repayments on the second beginning in FY2013. However, this ratio will then plateau, before falling off again in FY2016. 41. Out-year forecasts for public debt show that the government expects to reduce this from FY2010 and be below the ceiling of 40% of GDP in FY2014. The government records debt at the point it is drawn down from a loan, not at loan signing or effectiveness. The drawdown of the China Eximbank Roads Improvement Project loan explains why the debt:GDP ratio continues to increase through FY2011 before falling away and moving below the ceiling in FY2014. Government has stated it has no plan to enter into new loans and the intent is to draw on loan funds judiciously. The government has a time-bound and viable action plan to meet this target. 42. As two of the financial ratio targets have been met but not the others and given the existence of credible and viable plans to meet all of the remaining three targets within acceptable time periods it is considered that Tonga has partly complied with condition 2.3.

Condition 2.4 (complied with). The recipient shall have operationalized the cabinet-approved debt risk management and mitigation policy and strategy, which shall include: (a) processes and responsibilities for the analysis and approval of proposed new guarantees and debt; (b) processes for prioritizing and scheduling debt repayment; and (c) a schedule of timely and standardized reporting on the debt portfolio of the recipient.

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43. Government approval of a debt risk management and mitigation policy and strategy in December 2009 was one of the first tranche policy actions and included a Sustainable Debt Policy for Tongan Sovereign Debt approved by the cabinet in May 2009, and a requirement for analysis of any new borrowings and consideration of the impact on the current loan portfolio. This was an important step as the IMF noted in 2009 that “any additional external borrowing should be strictly limited.” 19 The IMF reiterated this position in 2010, noting that Tonga was in the range of “high risk of debt distress,” so further borrowing by the government, even on concessional terms, should be avoided. 20 44. Given the impact of the global economic crisis and the resultant need for economic stimulus, when considering the Roads Improvement Project loan funded by the China Eximbank, the government chose to invoke the clause in Tonga’s Sustainable Debt Policy which states:

The constraining of debt to specific targets is necessary to ensure that debt is sustainable…This policy, however, recognizes that in times of extreme economic conditions there may be periods when the Government is required to incur further debt and operate outside these targets for short periods of time to provide a fiscal stimulus to the economy. The size and duration of the periods of departure from this policy will need to be determined on a case by case basis… 21

45. The intention with the road loan is similar to that used in Chinese funded projects in 2007 and 2009, which used a significant amount of local contractors and local labor, thus stimulating the domestic economy at a time when many households are suffering from the decline in remittances. Another significant component of this project will involve procurement of coral rock from local quarries, with other materials also being sourced locally. 46. Tonga continues to meet all of its debt obligations, indicating that the processing and prioritization procedure adopted is operational. The government debt monthly status report and quarterly report provide a schedule of timely and standardized reporting on government debt for the finance minister and cabinet, and were assessed under the PEFA framework to be clear and comprehensive. These reports track the debt sustainability analysis indicators against the targets and analyze movements. A summary of this information is available to the public in At A Glance. 22 As noted in para. 41, the government intends to reduce its debt level and expects to be below the public debt–GDP threshold by FY2014. 47. Continued implementation of the debt strategy and close monitoring of debt obligations is essential as Tonga’s external debt servicing commitments will increase significantly from $6.3 million in FY2013 to $11.2 million in FY2014.

Condition 2.5 (complied with). The Privy Council shall have approved the regulations for public procurement under the Public Financial Management Act.

48. The Public Financial Management Act, 2002 (Public Procurement Regulation 2010) was formally approved by the cabinet and the decision included in the Government Gazette on 1 November 2010. Regulations do not need privy council approval and publication in the gazette makes the regulations effective as of that date. In developing the regulations, Tonga sought and incorporated the views of procurement specialists from both ADB and the World Bank.

19 IMF. 2009. Tonga: 2009 Article IV Consultation—Staff Report. Washington, DC (IMF Country Report No. 09/292). 20 IMF. 2010. Tonga: 2010 Article IV Consultation – Staff Report. Washington, DC (IMF Country Report No. 10/12). 21 Government of Tonga. 2009. Sustainable Debt Policy. Nuku’alofa. para. 61. 22 Ministry of Finance. Various years. At A Glance. Nuku’alofa. http://www.finance.gov.to/publications/at-a-glance.

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Significant advances include the detailed inclusion of planning procurements, bidder eligibility, procedures for evaluating bids, announcing outcomes, and assessing complaints and dealing with appeals. 49. Procurement was one of the two areas of the August 2010 PEFA where Tonga was assessed to have slipped back on 2007 performance. Prior to gazettal of the regulations, procurement was guided by the seven-page government procurement instructions, dating from 2005.

Condition 2.6 (complied with). The recipient, through MOFNP, shall have (a) completed treasury instructions; (b) completed a treasury manual; and (c) made a commitment to establish an internal audit unit within MOFNP to strengthen financial management.

50. Under the Public Finance Management Act, 2002, the minister for finance and national planning is empowered to issue the Treasury Instructions setting out detailed procedures and requirements consistent with the act. The aim is to enforce compliance with all fiscal prudency, budgeting, revenue, and expenditure management strategies and policies. Treasury Instructions 2010 were completed and released on 10 September 2010. This was the first time that comprehensive instructions have been developed, and the intent is to update them annually for release on each 30 June.

51. The Treasury Manuals provide a comprehensive account of the business processes of the Treasury Division of MOFNP, enabling verification of the correct process steps to be followed for relevant business procedures. 23 The manuals are vital to the effective and lawful operation of the Treasury Division. They are also expected to provide the starting point for a thorough review, with the intent of strengthening Treasury processes. The government completed the Treasury Manuals and circulated these to all Treasury staff in October 2010.

52. An Internal Audit Division commenced operations in January 2010 within MOFNP, with an initial two staff members, increasing to four staff members during 2010. Prior to this, the internal audit function had not been staffed since 2005. A strategic plan for the unit, as well as a charter and resource manuals, have been prepared. 24 Training has been provided to staff. A pilot audit on the payroll system was conducted and a further pilot audit is planned. This unit is expected to provide the opportunity for consideration of any systemic issues that impact on PFM systems. The government program of decentralizing the finance function into line ministries will inevitably place greater emphasis on the internal audit function of MOFNP because of additional risks associated with decentralization. B. Structural and Governance Improvements

Condition 3.1 (complied with). The recipient, through the Ministry of Public Enterprises, shall have restructured at least five additional public enterprise boards to no longer include ministers, members of the Legislative Assembly, or civil servants as directors.

53. The government, through the Ministry of Public Enterprises, has restructured a further five public enterprise boards to comply with the requirement of the Public Enterprises Act that ministers, members of the Legislative Assembly, or civil servants should not serve as public

23 Ministry of Finance. 2011. Treasury Manuals. Nuku’alofa. http://www.finance.gov.to/publications/treasury-manuals. 24 Some of this has been done with the support of ADB TA through ADB. 2008. Technical Assistance for Strengthening

Public Financial Management in Pacific Developing Countries. Manila.

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enterprise directors. These public enterprises are Tongatapu Market, Tonga Communications Corporation, Tonga Timber, Tonga Airports, and Tonga Power. 54. Board members (including chairs) who were not compliant with the conditions of the act because of their employment background, resigned or had their appointments ended. With elections scheduled in November 2010, the government was constrained in its choice of new directors, as potential candidates were unable to be appointed. Thus, board restructuring took place in several stages—the first was removal of ministers, members of the Legislative Assembly, and civil servants as public enterprise directors, with a limited number of private sector appointments:

(i) Tonga Airports. Three of the six board members ended their terms of appointment on 31 August 2010. The remaining board members are not ministers, members of the Legislative Assembly, or civil servants.

(ii) Tonga Power. Two of the original six board members resigned (both from the government) and one new appointment was made from the business sector. The Board comprises five persons and they are not ministers, members of the Legislative Assembly, or civil servants.

(iii) Tonga Timber. One government board member’s appointment ended on 31 August 2010 and one new appointment was made from the business sector. The board comprises four persons and they are not ministers, members of the Legislative Assembly, or civil servants.

(iv) Tongatapu Market. The one government representative resigned as of 31 December 2009. The board comprises two persons and they are not ministers, members of the Legislative Assembly, or civil servants.

(v) Tonga Communications Corporation. One government board member’s appointment was terminated on 31 April 2010, another resigned on 31 December 2009. The board comprises four persons and they are not ministers, members of the Legislative Assembly, or civil servants.

Subsequent to the elections, three additional directors compliant with the Public Enterprise Amendment Act have been appointed to the Tongatapu Market board.

Condition 3.2 (complied with). The recipient shall have submitted the Public Enterprise Amendment Bill to the Legislative Assembly, which (a) enhances the commercial governance practices of public enterprises; (b) strengthens the monitoring framework for public enterprises; (c) formalizes the decision that politicians should not serve as public enterprise directors; (d) establishes a principle objective for all public enterprises to operate as a successful business; (e) clarifies the rules and processes associated with the approval of community service obligations; (f) establishes clear guidelines on the selection and appointment of directors; and (g) clarifies director accountabilities.

55. The Tongan Legislative Assembly passed the Public Enterprise Amendment Bill into law on 21 September 2010. The Public Enterprise Amendment Act significantly strengthens the manner in which public enterprises are governed and managed. It puts in place legal rules that enhance the commercial governance practices of public enterprises, strengthens the monitoring framework for public enterprises, formalizes the government’s decision that politicians should not serve as public enterprise directors, clarifies the rules and processes associated with the approval of community service obligations, establishes clear guidelines on the selection and appointment of directors, and clarifies director accountabilities.

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Condition 3.3 (complied with). The recipient shall have submitted the Personal Property Securities Bill to the Legislative Assembly, which facilitates the use of chattels as collateral for loans.

56. In Tonga, market-based transfer of land titles is constrained by the traditional land ownership system, hence the ability to use land as a form of security against a loan is lessened. Creating an alternative set of assets that can be used as collateral is an important factor in promoting an active financial sector and in facilitating private sector investment and development. Such alternative assets can include buildings, goods, timber, minerals, leased goods, in fact any tangible or intangible personal property. 57. In order to address this, the Government submitted the Personal Property Securities Bill to the Legislative Assembly on 1 September 2010. The Legislative Assembly passed the Personal Property Securities Act 2010 on 2 September 2010. The Act is intended to promote business and consumer’s access to credit, by facilitating the use of personal property as collateral or security for loans and other financial obligations. It creates a comprehensive set of rules on the creation, attachment, and enforcement of security interests in personal property. It also establishes an electronic personal property securities registry to receive, store, and disseminate notices of security interests and other rights in personal property.

Condition 3.4 (complied with). The recipient through the Ministry of Labour, Commerce and Industries, shall have operationalized the new companies’ registry to make the process of company registration simple and fast in accordance with the Companies Amendment Act.

58. The companies’ registry was operationalized to make the process of company registration simple and fast, in line with the Companies Amendment Act. From 1 December 2009, applications for company registration were processed electronically. The searchable electronic registry is available to the public 24 hours a day, 7 days a week. 25 59. With the transfer to an electronic registry, all Tongan domestic and overseas companies were required to re-register under the new electronic system before 31 May 2010. Out of the 1,366 companies registered prior to 1 December 2009, 620 companies had electronically re-registered by the cutoff date, and a further 57 new companies had been registered.

Condition 3.5 (complied with). The recipient shall have ensured that (a) the Companies Amendment Act receives the Royal Assent, and (b) the implementing regulations of the Companies Amendment Act are made effective.

60. The Companies Amendment Act—to clarify the law and simplify procedures for incorporation—received Royal Assent on 28 October 2009. Regulations were included in the Government Gazette on 22 October 2009. The regulations provide guidance on the operation of the electronic companies registry. The act came into force on 1 December 2009, the date on which the electronic companies’ registry it created was launched.

25 The companies register is accessed through the Tongan Companies Office website http://www.companies.gov.to.

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Condition 3.6 (complied with). The cabinet shall have approved the prioritized medium- to long-term infrastructure plan of the recipient.

61. The cabinet approved the Tonga National Infrastructure Investment Plan (NIIP) on 22 October 2010, and has made it publicly available. 26 The NIIP sets out medium- to long-term (5–10 years) economic infrastructure investment priorities, bringing together and prioritizing projects in the energy, telecommunications, water, solid waste management, and transport sectors. It includes both projects within the core public service (valued at T$359 million through 2015) and projects planned by public enterprises (valued at a further T$170 million). The NIIP provides for efficiencies in infrastructure planning and financing, as well as promoting greater attention to strategic asset management and consideration of life cycle costs. It is planned to update the NIIP regularly.

C. Support the Vulnerable through Targeted Actions

Condition 4.1 (complied with). The recipient, through the Ministry of Health and the Ministry of Education, shall have commissioned the public expenditure tracking system for health and education sectors.

62. The government, through the Ministry of Education and the Ministry of Health (MOH), and with the support of the Australian Agency for International Development, commissioned public expenditure reviews (PERs) in January 2010. They were completed in June 2010 (education PER) and September 2010 (health PER). The PERs highlighted weaknesses in the quality and efficiency of the education and health budgets, and proposed a number of options on policy, systems, and processes to help the government address these weaknesses. 63. The education PER included a recommendation that the budget for education and training should be raised gradually from 15% to 20% of government spending based on firm plans to improve ministry and school-level efficiency and effectiveness. Currently, there is very limited room for maneuver in the government-funded education budget given that, in the 5 years since the public sector wage settlement, the wage and salary bill has been above 80% of the budget. Donor-funded education expenditures are typically heavily focused on capital projects, leaving the government-funded budget to focus on current expenditure. Given that the government-funded budget consists only of wage and salary expenditure and other current expenditure, other current expenditure has necessarily been lower in FY2004 to FY2008, when the wage bill has been higher. In FY2009 and FY2010, the wage bill was held flat, largely through a fall in staff numbers (about 15% from June 2008 to June 2010) and the resulting more youthful staff profile. The PER made specific recommendations as to options for savings and for priorities for allocation of any additional expenditure. 64. The health PER included a recommendation that the MOH recurrent budget should rise from under 12% to 15% of the government’s total recurrent spending over the medium term. Health shows an expenditure pattern similar to that of education for the government-funded budget, with wages comprising about 70% of the government-funded health budget. Specific recommendations were made regarding the treatment of off-budget development programs and areas for efficiency savings, which could be redirected to curative care budgets.

26 Government of Tonga. 2011. National Infrastructure Investment Plan. Nuku’alofa.

http://www.theprif.org/sites/theprif.org/files/Final%20Tonga%20NIIP%20Report%20-%20for%20website.pd

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Condition 4.2 (complied with). The recipient, through the Ministry of Health, shall have adopted the action plan to implement the recommendations of the review of outer island districts and community health center services.

65. In Tonga, community health centers and nurse clinics on the outer islands play a vital frontline role in health care. Those living on the outer islands are some of the most dependent on remittances. As remittances contracted during the global economic crisis, the vulnerabilities of this group were heightened. In an effort to strengthen primary health outreach activities, the government, through the MOH, undertakes an annual review of outer island districts and community health center services. The most recent was completed in August 2010. The review assessed the available staff, equipment, and facilities in each community health center and nurse clinic and the services provided, making recommendations on future needs. 66. Subsequent to the review, the MOH adopted an action plan to implement the review recommendations on 17 August 2010. A report detailing progress in the implementation of the review’s recommendations, as well as future objectives, was completed on 27 August 2010. It noted that all facilities were fully staffed and a medical officer had been made responsible for oversight of the clinical activities of the community health centers. Future actions under the Tonga Health Systems and Australian-supported Partnership Program are expected to continue to support the revitalization of community health.

Condition 4.3 (complied with). The cabinet shall have reviewed the issues paper on vulnerable persons which shall (a) identify vulnerable groups; (b) consider the adequacy of existing social safety net systems; and (c) provide options for enhanced social protection policies.

67. The cabinet approved, on 20 October 2010, a social protection issues paper that included the identification of vulnerable groups, the adequacy of existing social safety net systems, and options for enhanced social protection policies. 27 The paper provided a range of policy options for consideration. In the short term, assistance such as targeted education and utility subsidies to the poor or disadvantaged households (particularly for those with children), increasing access to finance for women, and support for people with disabilities could be considered. In the long run, social policy and legislation reforms, establishing a contributory pension scheme, increasing coverage of health insurance and workers’ compensation, and increased support to informal social protection providers (nongovernment organizations, churches, community-based groups) would strengthen social inclusion and reduce risks for the vulnerable groups. ADB is supporting the government in trialing elements of these policies. 28 D. Communication and Ownership of Economic and Fiscal Management Initiatives

Condition 5.1 (complied with). The recipient, through the Ministry of Finance and National Planning, shall have commenced the rolling out of the communication and engagement strategy.

68. The government, through the MOFNP, has implemented a communication and engagement strategy to generate widespread understanding of the economic situation of Tonga and government policy responses to promote economic recovery. Awareness of Tonga’s

27 Government of Tonga. 2010. Social Protection Issues Paper. http://www.finance.gov.to/publications/others. 28 ADB. 2010. Proposed Grant Assistance for Social Protection of the Vulnerable in the Pacific (Cook Islands, Marshall

Islands, and Tonga). Manila (financed by the Japan Fund for Poverty Reduction).

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macroeconomic and fiscal situation was increased through monthly At a Glance reports (produced by MOFNP) available on the internet, and TV appearances by the minister for finance, which explained how and where the economic crisis was impacting on Tonga’s economy, and outlined the government’s response.

Condition 5.2 (complied with). The recipient, through the Ministry of Public Enterprises, shall have published enterprise-level performance data for the public enterprises for FY2009 following the tabling of the respective annual reports in the Legislative Assembly.

69. The government, through the Ministry of Public Enterprises, published enterprise-level FY2009 performance data for the 13 public enterprises in local newspapers in the Tongan and English languages on 10 December 2010. This provided an opportunity to highlight publicly efforts on public enterprise reform—it was noted that during 2010 a number of boards were restructured and politicians and public servants were replaced by private sector directors; and balance sheets were restructured, tidying up historic issues such as overvalued assets. 70. The published data show a mixed performance by public enterprises and allow for comparison of the performance of each enterprise in FY2008 and FY2009. While the government has set a target for public enterprises to earn at least a 10% return on equity, only one public enterprise (Tonga Development Bank) came close with a 9.4% return on equity in FY2009. The worsening economic environment was also reflected in a decline in average net profit after tax from FY2009 to FY2010.

71. The government prioritized making public enterprise performance data widely available. The information placed in the media achieves compliance with the condition. While the condition asked for publication of FY2009 performance data “following the tabling of the respective annual reports in the Legislative Assembly,” delays in the audit process meant in some cases only unaudited accounts were available by December 2010. Unaudited accounts were used for the data of five of the 13 public enterprises. As of the end of February 2011, five of the eight public enterprises’ audited FY2009 annual reports had been submitted to the Legislative Assembly.

Condition 5.3 (complied with). The recipient, through the MOFNP, shall have released publicly the PEFA.

72. The 2010 PEFA (para. 28) is publicly available through the government website and the PEFA website (footnote 16).

IV. MAINTENANCE OF TRANCHE 1 CONDITIONS AND COVENANTS

73. The first tranche release conditions comprised 16 policy actions in all areas of the program. In many instances, policy actions in tranche 1 are built on and reinforced by related policy actions in tranche 2. In these cases, achievement of tranche 2 actions demonstrates maintenance of tranche 1 policy actions (Table 2). 74. The remaining seven tranche 1 conditions have been maintained by the government as summarized below. 75. Under tranche 1 output 1.1, the government committed to the following principles in managing its FY2010 budget expenditure in light of reduced growth and revenue forecasts:

(i) essential social services (including primary education and basic health services) will not be cut; and

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Table 2: Status of Tranche 1 Conditions

Tranche 1 Condition Status 2.2 The Government through the ERC will have made a commitment

to complete the second PEFA by June 2010. Maintenance confirmed by completion of tranche 2 action 2.1 (para. 28)

2.3 The Government through the MOFNP will have created a standing Macroeconomic Technical Committee: • to include Secretary for Finance (Chair), representative from

the Reserve Bank, Government Statistician and representatives of Prime Minister's Office, and Policy and Planning (Secretariat) as member in order to more effectively utilize the strengths available within these various agencies;

• with a terms of reference including responsibility for monitoring the macroeconomic environment; developing macroeconomic forecasts; development, use and maintenance of an improved macroeconomic and revenue forecasting model; and advising the Minister for Finance on the above;

• which meets at least quarterly; and • which has the overarching objectives of improving the quality

of economic forecasts and macroeconomic analysis being supplied to ERC and hence used in the budget development process.

Maintenance confirmed by completion of tranche 2 action 2.2 (para. 32)

2.4 The Government through the ERC will have made a commitment to develop financial ratios by the end of December 2009, to promote fiscal sustainability over the medium term, in relation to measures of:

• capital expenditure and maintenance; • public debt; • government personnel costs; and • other (non-personnel) operating costs.


2.5 The Cabinet will have approved the development of a debt risk management and mitigation policy and strategy, with the intent of ensuring debt is kept to sustainable levels, and which shall include: • processes and responsibilities for the analysis and approval of

proposed new guarantees and debt; • processes for prioritizing and scheduling debt repayment; and • a schedule of timely and standardized reporting on

Government’s debt portfolio.

Maintenance confirmed by completion of tranche 2 action 2.4 (paras.43 and 46)

3.4 The Legislative Assembly will have approved the Companies Amendment Bill, which: • clarifies the law; and • simplifies procedures for incorporation.


4.3 The Government through the Ministry of Health will have made a commitment to undertake, by December 2009, a review of existing facilities and equipment to ensure these support the provision of services in the outer islands and districts and community health centers.


5.1 The Cabinet will have endorsed a communications and engagement strategy which explains Government’s programmatic response to the economic crisis


5.2 The Government through the Ministry of Public Enterprises will have published aggregated public enterprise performance data (using the most recent financial information available where

As per release of tranche 1 conditions, this information was published in the local

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Tranche 1 Condition Status FY2009 is not available) in a local newspaper in Tongan and English, comparing it with prior year results and explaining major trends.

media in January 2010. It therefore remains publicly available.

5.3 The Government through the MOFNP will have released publicly the 2009 IMF Article IV Staff Report.

Both 2009 and 2010 IMF Article IV Staff Reports [footnotes 19 and 20] released.

ERC = Expenditure Review Committee, FY = financial year, IMF = International Monetary Fund, MOFNP = Ministry of Finance and National Planning, PEFA = public expenditure and financial accountability. Source: ADB. 2009. Report and Recommendation of the President to the Board of Directors: Proposed Asian Development Fund Grant to Tonga for the Economic Support Program. Manila (Grant 0185-TON).

(ii) savings will be made through a planned and strategic reduction, such as in low-value-added current expenditure.

76. The FY2010 recurrent budget outturn was 5.4% below the original recurrent budget estimates. Cuts were not made evenly across the board—the MOH recurrent budget outturn was only 2.6% below estimate, while the Ministry of Education, Women’s Affairs and Culture saw an increase of 2.0% on recurrent estimates. This demonstrates the government’s efforts to protect these areas of basic social services and focus its deeper cuts elsewhere. Furthermore, the development budget outturn indicates an influx of development assistance to the areas of health and education, which offset government cuts. The government’s prioritization of these two areas for development assistance is a further reflection of the intent to protect provision of these basic social services. Appendix 2 examines this data in more detail. 77. Cost-cutting has been maintained into FY2011, with the government noting the need to be strictly disciplined in managing its finances and to be proactive in trying to save money and not to incur unbudgeted items. Sale of government assets, such as excess vehicles and government quarters, is being considered to generate more revenue and reduce operational costs. Ministries are reviewing office rental charges to determine whether savings could be made by consolidating staff or sharing facilities with other ministries and divisions. Extensive overseas travel is discouraged unless it is fully funded by external sponsors. 78. Under tranche 1 output 2.1, the government committed to the implementation of specific PFM reforms in response to the 2007 PEFA. These reforms have been followed through:

(i) the FY2011 budget was prepared using a medium-term budget framework (Budget Paper 2, Table 2, provides forward estimates for FY2012 and FY2013 as a first step);

(ii) a budget calendar (Letter ref. 15/11/2/118 of 21 April 2010 from minister to each line ministries, and again on 30 April, ref. 15/11/2/136, on the Budget Allocation for FY2011) was adhered to in the preparation of the FY2011 budget;

(iii) the public accounts for FY2010 were completed by 31 December 2010; (iv) bank reconciliations are completed on a monthly basis; (v) a medium- to long-term infrastructure investment plan has been put in place (para.

61) and will be used to guide the government’s capital works program, as well as development partner financing in support of infrastructure development; and

(vi) the establishment of a specialized debt collection team implementing a new debt recovery initiative saw nearly T$10 million in tax debts recovered in FY2009, and T$8.8 million in FY2010. There has also been improvement in pay-as-you-earn collections.

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79. Under tranche 1, there were some notable achievements in public enterprise reform, which have been maintained. Leiola Duty Free continues as a successful example of a privatized public enterprise (tranche 1 output 3.1). The boards of Tonga Development Bank, Tonga Post, Tonga Print, Shipping Corporation of Polynesia, and Waste Authority remain compliant with the government decision that politicians (i.e. ministers and members of parliament) as well as civil servants should not serve as public enterprise directors (tranche 1 output 3.2). 80. Under tranche 1 output 3.3, rationalization strategies were accepted for the Waste Authority, Tonga Water Board, and Tonga Power. Implementation of these has been slower than hoped, despite some positive moves such as the twinning of Tonga Water Board with the Manukau Authority from New Zealand. 81. Cabinet adopted the community development program design document and committed to pilot test the structure and systems of a community development program in two districts (tranche 1 outputs 4.1 and 4.2). A progress report supplied by the government noted that each of the seven districts of Tongatapu now has a fully equipped office for the district officer, supported by a clerk, with an intention to replicate this at a later date in the outer islands. District officers, with the assistance of a district development committee (inclusive of community leaders) coordinate community development in the district, including through supporting the government’s community development activities and implementing self- and externally funded development activities. District officers meet together on a 3-monthly basis under the auspices of the Prime Minister’s Office. The intent has been to devolve decision making and responsibilities in local and regional development, so as to address community needs more effectively, promote self-reliance, and enhance service delivery.

V. CONCLUSIONS

82. The government has demonstrated its ownership of the program. The four agencies concerned—the MOFNP; Prime Minister’s Office; Ministry of Labor, Commerce and Industries and Ministry of Public Enterprises—have made sustained efforts in implementing the agreed reform measures. This is particularly noteworthy as these actions took place during a time of considerable political and constitutional change in the lead-up to Tonga’s first fully democratic national election. 83. The program has showed clear results, and its key development objectives were substantially achieved, as evidenced by the following.

(i) The overall macroeconomic policy environment is improving, albeit slower than hoped. There was a contraction in GDP of 1.2% in FY2010 but the outlook for FY2011 is substantially stronger, with an expectation of growth of 0.5% of GDP, building to 1.8% in FY2012.

(ii) The World Bank and International Finance Corporation’s country ranking of the cost of doing business shows improvement, with Tonga moving up five places between 2006 and 2011. 29

(iii) Cabinet consideration of social welfare issues, the undertaking of PERs in the education and health sectors, and actioning of recommendations on community health centers, all demonstrate the intent to ensure access to basic services by the vulnerable.

29 The World Bank and the International Finance Corporation. 2010. Cost of Doing Business 2011: Tonga—Making a

Difference for Entrepreneurs. Washington, DC.

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84. The ESP has been closely coordinated with Tonga’s other development partners. Development partners eased the call made on government resources by agreeing to work together, sharing analysis and focusing on a core set of priority policy issues in dialogue with the government. The European Union is using the ESP second tranche conditions as the basis for release of T$14.1 million in budget support under the V-Flex facility. Continued coordination of development partners, and dialogue with government, around ESP issues is envisioned.

VI. THE PRESIDENT’S RECOMMENDATION

85. In view of the substantial progress made in the implementation of the Economic Support Program in Tonga, as evidenced by the compliance with 17 second tranche conditions and partial compliance with one second tranche condition, the President recommends that the Board approve, on a no-objection basis:

(i) the waiver of full compliance with one tranche release condition, which has been partially complied with; and

(ii) the release of the second tranche in the amount of $5,000,000 for the Economic Support Program in Tonga.

Haruhiko Kuroda President

10 May 2011

Appendix 1

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STATUS OF COMPLIANCE WITH SECOND TRANCHE RELEASE CONDITIONS

Output Area Second Tranche Condition Status of Compliance and Supporting Documentation Output 2: Maintenance of fiscal responsibility

2.1 The Government through Ministry of Finance and National Planning will have completed the second PEFA.

Complied with. Documents: PEFA available at http://finance.gov.to/publications/tonga-2010-pefa-report and http://www.pefa.org. Also, certified in letter of 8 October 2010 signed by Acting Secretary, MOFNP.

2.2 The Government through the Ministry of Finance and National Planning will have operationalized improved processes for macroeconomic and revenue forecasting in which: • credible model for macroeconomic

and revenue forecasting in use • the Macroeconomic Technical

Committee meets quarterly and report against their terms of reference.

• 3-year macroeconomic and revenue forecasts presented in FY2011 Budget

Complied with. Documents: Forecasting Handbook 2008 provided. Forecasting rigor subject of discussion by Macroeconomic Technical Committee (see below). Minutes, agenda, and participants of Macroeconomic Technical Committee for meetings of 5 March 2010, 14 May 2010, and 28 May 2010. Tonga’s FY2011 Budget Paper No. 1 Review of the Tongan Economy and Outlook 2010/11, Table 1, p. 8 provides 3-year GDP forecasts; table 2, page 9 provides consumer price index forecast for 3 years. Annex C Table 17 Full GFS Presentation of the Government Operations Account 2008/09–2012/13 provides 3-year revenue forecasts.

2.3 The Government, through the Ministry of Finance and National Planning, will have met financial ratios set out in the Program Budget Guidelines for FY2011.

Partly complied with. Documents: MOFNP. Budget Preparation Guidelines 2010/2011 to 2012/2013. Table 2, p. 5, sets out the financial expenditure targets [financial ratios]. Tonga’s FY2011 Budget Paper No. 2 Fiscal Analysis and Outlook. Table 4: Financial Expenditure Target and Projected Performance, p.32.

2.4 The Government will have operationalized Cabinet-approved debt risk management and mitigation policy and strategy, which include: • processes and responsibilities for

the analysis and approval of proposed new guarantees and debt;

• processes for prioritizing and scheduling debt repayment; and

• a schedule of timely and standardized reporting on Government’s debt portfolio.

Complied with. Documents: Internal memorandum from the secretary for finance and national planning to the minister of finance and national planning, which sets out actions to keep debt at a sustainable level. Cabinet Paper, 8 May 2009, setting out the debt strategy, which was agreed by Cabinet under tranche 1. Letter to the regional director of the SPSO from the minister of finance and national planning dated 15 September 2010 (setting out implementation of debt strategy) and follow-up letter dated 17 November 2010 (providing further details of implementation of debt strategy) Government debt monthly status report (31 March 2010) and quarterly report (30 June 2010). A summary is available in At A Glance via the Ministry of Finance website. http://finance.gov.to/publications/at-a-glance

Output Area Second Tranche Condition Status of Compliance and Supporting Documentation 2.5 The Privy Council will have

approved the regulations for public procurement under the Public Financial Management Act.

Complied with. Documents: Tonga Government Gazette Supplement Extraordinary, No. 28 Monday 1 November 2010, issuing Public Procurement Regulations 2010. Regulations do not need privy council approval and gazettal makes the regulations operational.

2.6 The Government, through the Ministry of Finance and National Planning (MOFNP), will have: • completed Treasury Instruction; • completed Treasury Manual; and • committed to establish an internal

audit unit within MOFNP to strengthen financial management.

Complied with. Documents: Treasury Instructions disseminated 10 September 2010, under Circular 15/23/778. Treasury Manual, MOFNP, October 2010 circulated under Internal Memorandum, MOFNP, 25 October 2010 directing its use by all Treasury Staff. Technical Assistance Consultant’s Reports for TA 6507-REG Strengthening Public Financial Management in Pacific Developing Member Countries.

Output 3: Structural and governance improvements

3.1 The Government, through the Ministry of Public Enterprises, will have restructured five additional public enterprise boards to comply with the decision that Ministers, Members of the Legislative Assembly or civil servants should not serve as public enterprise directors.

Complied with. Documents: Memorandum (Savingram), Ministry of Public Enterprises, 21 October 2010. Provided status of board members of all five boards and their backgrounds. Copies of correspondence making changes to boards.

3.2 The Government will have submitted to the Legislative Assembly the Public Enterprise Amendment Bill which: • enhances the commercial

governance practices of public enterprises;

• strengthens the monitoring framework for public enterprises;

• formalizes the Government’s decision that politicians should not serve as public enterprise directors;

• establishes a principle objective for all public enterprises to operate as a successful business;

• clarifies the rules and processes associated with the approval of community service obligations;

Complied with. Document: Tonga Government Gazette Extraordinary, No. 25 Wednesday 13 October 2010, noting “The following Acts were passed at the 2010 Session of the Legislative Assembly of Tonga and are issued with this Gazette: … 2. Public Enterprises (Amendment) Act 2010.” Public Enterprises (Amendment) Act 2010, Act 40 of 2010. ADB confirmed Public Enterprises (Amendment) Bill is "fit for purpose."

22 A

ppendix 1


Appendix 1

23

Output Area Second Tranche Condition Status of Compliance and Supporting Documentation • establishes clear guidelines on the

selection and appointment of directors; and

• clarifies director accountabilities. 3.3 The Government will have

submitted to the Legislative Assembly the Personal Property Securities Bill which facilitates the use of chattels as collateral for loans.

Complied with. Documents: Letter from Clerk of the House, Legislative Assembly of Tonga dated 3 September 2010 attaching a copy of Resolution 78/10 (2 September 2010) of the Legislative Assembly, which passed the Personal Property Securities Bill.

3.4 The Government, through the Ministry of Labour, Commerce and Industries, will have operationalized the new Companies' Registry to make the process of company registration simple and fast, in line with the Companies Amendment Act.

Complied with. Documents: Letter dated 18 July 2010 to ADB from the minister for labor, commerce, and industry which provided a copy of the first month report (January 2010) of the Tongan Companies Office (dated February 2010)—indicating activities of the office, demonstrating the Companies Registry is operational.

3.5 The Government will ensure that Companies Amendment Act will have received Royal Assent and made effective the implementing regulations of the Act.

Complied with. Documents: Letter dated 18 July 2010 to ADB from the minister for labor, commerce, and industry which provided copy of the Companies (Amendment) Act 2009—noting that it received Royal Assent on 28 October 2009, and providing a copy of the Companies (Amendment) Regulations.

3.6 The Cabinet will have approved the Government’s prioritized medium to long term infrastructure investment plan.

Complied with. Documents: Letter dated 22 October 2010 from the chief secretary and secretary to cabinet to the regional director of the SPSO, confirming Cabinet Decision 1034 that “Tongan NIIP, with amendments be approved.” Copy of the cabinet-approved NIIP. Also available on MOFNP website: http://finance.gov.to

Output 4: Support the vulnerable through targeted actions

4.1 The Government, through the Ministry of Health and Ministry of Education, will have commissioned the public expenditure tracking system for health and education sectors.

Complied with. Documents: Copy of education PER (June 2010) and copy of health PER (September 2010) provided.

4.2 The Government, through the Ministry of Health, will have adopted the action plan to implement recommendations of review of outer island districts and community health center services.

Complied with. Documents: A memorandum (savingram) from the director of health to the secretary for finance and national planning dated 27 August 2010 entitled “Provision of Services in the Island Districts & Community Health Centers, per December 2009 Review” sets out progress in the Ministry of Health’s implementation of recommendations of the review of health services in outer island districts and community health centers.

Output Area Second Tranche Condition Status of Compliance and Supporting Documentation 4.3 The Cabinet will have reviewed a

Vulnerable Persons Issues Paper, which will include: • the identification of the vulnerable

groups; • the adequacy of existing social

safety net systems; and • the options for enhanced social

protection policies.

Complied with. Documents: Letter dated 21 October 2010 from the chief secretary and secretary to cabinet to the regional director of the SPSO certifies that cabinet approved the Social Protection Issues Paper (CD 1017) on 20 October 2010 and directed it be made available to the public. It is available on the MOFNP website: http://finance.gov.to

Output 5: Communication and ownership of economic and fiscal management initiatives

5.1 The Government, through the MOFNP, will have commenced the rolling out of the communication and engagement strategy.

Complied with. Documents: The Government’s monthly At a Glance economic reports (http://www.finance.gov.to/publications/at-a-glance) and ministerial TV appearances (DVD provided) explained the government’s response to the economic crisis.

5.2 The Government, through the Ministry of Public Enterprises, will have published enterprise level performance data for the public enterprises for FY2009 following the tabling of the respective annual reports in the Legislative Assembly.

Complied with. Documents: MOFNP provided a copy of the media advertisement that met ADB requirements, which was placed in Taimi ‘o Tonga (daily newspaper) on 22 December 2010.

5.3 The Government, through the MOFNP, will have released publicly the PEFA.

Complied with. Documents: PEFA available at http://finance.gov.to/publications/tonga-2010-pefa-report and http://www.pefa.org

ADB = Asian Development Bank, FY = financial year, GDP = gross domestic product, GFS = government financial statistics, MOFNP = Ministry of Finance and National Planning, NIIP = national infrastructure investment plan, PEFA = public expenditure and financial accountability, PER = public expenditure review, SPSO = Pacific Subregional Office.

24 A

ppendix 1

Appendix 2 25

EXPENDITURE ON BASIC HEALTH AND EDUCATION FY2010

1. The government committed that in managing its FY2010 budget expenditure, in light of reduced growth and revenue forecasts, essential social services (including primary education and basic health services) will not be cut (tranche 1 output 1.1). The FY2010 budget outturn was 5.4% below the original budget estimates. However, reflecting the commitment under the Economic Support Program, cuts were not made evenly across the board. The degree to which the protection of expenditure on an output or outcome basis can be monitored is limited by the available breakdown and classification of government expenditure. 2. The MOH budget outturn for FY2010 was only 2.6% below the estimate, while the Ministry of Education, Women’s Affairs and Culture saw an increase of 2.0% on estimates. This demonstrates government efforts to protect basic social services and focus cuts elsewhere. 3. Health expenditure had a strong shift between the budget estimate and outturn away from purchase of goods and services (cut 11.7%) and maintenance and operations costs (down 58.4%) to bolster staff and travel and communications expenditure, which had been underestimated (Table A2.1). Maintenance costs were overestimated in the budget as a standard annual allocation of $3.0 million (of which $1.5 million was the government contribution) was made for hospital maintenance, despite the hospital’s near-new status. It is notable that there was a decrease in staff numbers across FY2010 – from 828 (July 2009) to 771 (June 2010). Development partner support to the health sector was significant—T$800,000 on salaries, just under T$500,000 on new equipment, T$2 million on medical supplies, and T$5.7 million on new building or plant. Development partner support for the purchase of goods and services (T$2.5 million) offset the decline in the government’s own expenditure.

Table A2.1: Health Expenditure by Standard Expenditure Group

Standard Expenditure Group Original Budget FY2010

(T$) Actual as of June 2010

(T$) Variance

(%) Established staff and others 13,482,861 15,144,786 12.3 Unestablished staff 199,600 487,285 144.1a Travel and communications 213,000 411,850 93.4 Maintenance and operations 3,565,534 1,484,017 (58.4) Purchase of goods and services 5,631,905 4,972,896 (11.7) Operational grants and transfers 1,100 0 (100.0) Total 23,094,000 22,500,834 (2.6) ( ) = negative. a This increase in part reflects “cleaning” of the standard expenditure groups, with some of the final costs of

unestablished staff having initially been included with supporting projects under maintenance and operations. Source: Ministry of Finance and National Planning. 4. Within the Ministry of Education, Women’s Affairs and Culture budget, cuts were made in operational grants and transfers (down 28.4%) and maintenance and operations costs (cut 26.4%) (Table A2.2). Funds were redirected toward staff, purchase of goods and services, and travel and communications expenditure. Development assistance supplemented the government’s own resources; T$800,000 was provided for salaries, T$500,000 on renovations, T$336,000 on new building and plant, and T$175,000 on new equipment. 5. Examining health and education expenditure from an output perspective allows the costs of management, policy advice, and administration to be excluded from consideration (Table A2.3). These data demonstrate that expenditure on basic social services—through schools and culture, curative healthcare, and nursing services—was maintained.

26 Appendix 2

Table A2.2: Education, Women’s Affairs, and Culture Expenditure by Standard Expenditure Group

Standard Expenditure Group Original Budget FY2010

(T$) Actual as of June 2010

(T$) Variance

(%) Established staff and others 20,058,170 21,799,162 8.7 Unestablished staff 22,013 402,398 1,728.0a Travel and communications 316,161 345,081 9.1 Maintenance and operations 153,733 165,660 7.8 Purchase of goods and services 1,992,881 1,467,268 (26.4) Operational grants and transfers 3,854,542 2,758,908 (28.4) Total 26,400,000 26,938,478 2.0 ( ) = negative. a This increase in part reflects “cleaning” of the standard expenditure groups, with some of the final costs of

unestablished staff having initially been included with supporting projects under maintenance and operations. Source: Ministry of Finance and National Planning.

Table A2.3: Selected Expenditures by Outputs

Expenditure item Budget Estimate

FY2010 ($) Actual FY2010

($) Variance

T$ % Department of Education 26,272,386 24,341,809 538,479 2.0 Leadership and policy advice 1,734,378 1,703,091 (31,287) (1.8) Administration 5,201,217 3,114,738 (2,086,479) (40.1) Quality assurance 532,336 900,565 368,229 69.2 Schools and culture 18,204,847 17,184,652 (1,020,195) (5.6) Established staff 15,504,046 14,765,263 (738,783) (4.8) Unestablished staff 16,033 357,269 341,236 2,128.3 Travel and communications 41,954 124,262 82,308 196.2 Maintenance and operations 59,654 81,125 21,471 36.0 Purchase of goods and services 180,669 261,362 80,693 44.7 Operational grants and transfers 2,400,000 1,595,391 (804,609) (33.5) Capital expenditure 2,500 0 (2,500) (100.0) Post-secondary 599,608 1,438,763 839,155 140.0 Ministry of Health 23,094,000 22,500,834 593,166 (2.6) Leadership and policy advice 5,665,626 6,025,034 359,408 6.3 Preventive health care 3,181,109 1,632,516 (1,548,593) (48.7) Curative health care 7,704,971 7,866,130 161,159 2.1 Dental services 887,191 874,180 (13,011) (1.5) Nursing services 5,281,354 5,786,009 504,655 9.6 Health planning and information 373,749 316,965 56,784 (15.2) ( ) = negative. Source: Ministry of Finance and National Planning. 6. It appears efforts have been made to avoid, or at best limit, cuts to the provision of basic health and education services in FY2010. Beneath the line item data there are different explanations for changing budgets within the social sector ministries. Ministry of Health is making successful efforts to operate smarter—for example better procurement processes and practices have reduced the cost of medicines, and priority has been placed upon making front line health staff more available. Donor assistance to the Department of Education (which appears in the development budget not recurrent budget) has been typically for operational items, for example text books, and this has impacted on where Government spends its own funds in education. It should be noted that the rigor of this assessment is constrained by data limitations.

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