Document of The World Bank FOR OFFICIAL USE ONLY INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED GRANT

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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT FOR A PROPOSED GRANT IN THE AMOUNT OF SDR 1.2 MILLION (US$1.8 MILLION EQUIVALENT) TO THE KINGDOM OF TONGA FOR A SECOND TONGA ECONOMIC RECOVERY OPERATION OCTOBER 15, 2012 Poverty Reduction and Economic Management Department Pacific Islands Country Department East Asia and Pacific Region Report No TO This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 Kingdom of Tonga GOVERNMENT FISCAL YEAR July 1 June 30 CURRENCY EQUIVALENTS (Exchange Rate Effective as of 28 September) Currency Unit US$1.00 Tongan Pa anga TOP$1.72 WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS ADB Asian Development Bank MOE Ministry of Education AusAID Australian Agency for International MOH Ministry of Health Development CAS Country Assistance Strategy MTEF Medium-Term Expenditure Framework CEDAW Convention on the Elimination of All NGO Non-Government Organization Forms of Discrimination Against Women CFAA Country Financial Accountability NRBT National Reserve Bank of Tonga Assessment CPIA Country Policy and Institutional Assessment NZ-IDG New Zealand Ministry of Foreign Affairs International Development Group DSA Debt Sustainability Analysis PEFA Public Expenditure and Financial Accountability EU European Union PFM Public Financial Management EXIM Export-Import Bank of China PER Public Expenditure Review GEC Global Economic Crisis PFTAC Pacific Financial Technical Assistance Centre GDP Gross Domestic Product PHRD Japan Policy and Human Resources Development Trust Fund GNP Gross National Product PIAC Pacific Infrastructure Advisory Center GOT Government of Tonga PRIF Pacific Regional Infrastructure Facility HIES Household Income and Expenditure Survey ROSC Report on the Observance of Standards and Codes HIPC Heavily Indebted Poor Countries SDR Special Drawing Rights IBRD International Bank for Reconstruction and SMEs Small and Medium Enterprises Development IDA International Development Association SOE State-Owned Enterprise IFC International Finance Corporation TERM Tonga Energy Roadmap IMF International Monetary Fund TERM-IU Tonga Energy Roadmap Implementation Unit IPP Independent Power Provider TPL Tonga Power Limited JSAN Joint Staff Advisory Note TSD Tourism Sector Diagnostic LDP Letter of Development Policy TSDF Tonga Strategic Development Framework MDGs Millennium Development Goals UNDP United Nations Development Program MFNP Ministry of Finance and National Planning Vice President : Country Director: Sector Director: Lead Economist: Task Team Leader: Pamela Cox Ulrich Zachau (Acting) Sudhir Shetty Vivek Suri Tobias Haque

3 KINGDOM OF TONGA SECOND TONGA ECONOMIC RECOVERY OPERATION TABLE OF CONTENTS GRANT AND PROGRAM SUMMARY... i I. INTRODUCTION... 1 II. COUNTRY CONTEXT... 4 RECENT ECONOMIC DEVELOPMENTS IN TONGA... 4 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY III. THE GOVERNMENT S PROGRAM AND PARTICIPATORY PROCESSES IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM LINK TO COUNTRY ASSISTANCE STRATEGY COLLABORATION WITH THE IMF AND OTHER DONORS RELATIONSHIP TO OTHER BANK OPERATIONS LESSONS LEARNED ANALYTICAL UNDERPINNINGS V. THE PROPOSED SECOND TONGA ECONOMIC RECOVERY OPERATION OPERATION DESCRIPTION POLICY AREAS VI. OPERATION IMPLEMENTATION POVERTY AND GENDER IMPACTS ENVIRONMENTAL ASPECTS IMPLEMENTATION, MONITORING AND EVALUATION FIDUCIARY ASPECTS DISBURSEMENT AND AUDITING RISKS AND RISK MITIGATION ANNEXES Annex 1 : LETTER OF DEVELOPMENT POLICY Annex 2 : SECOND TONGA ECONOMIC RECOVERY OPERATION POLICY MATRIX Annex 3 : IMF PUBLIC INFORMATION NOTICE Annex 4 : TECHNICAL ASSISTANCE SUPPORT TO PRIOR ACTIONS Annex 5 : GOVERNMENT OF TONGA MEDIUM-TERM REFORM MATRIX Annex 6 :COUNTRY AT A GLANCE TABLES IN TEXT Table 1: Fiscal and Economic Indicators FY2007-FY2012 (Millions of Pa anga)... 9 Table 2: Summary of Medium-Term Macroeconomic Outlook (FY2010-FY2017) Table 3: Poverty Incidence in Tonga by Region, 2001 and Table 4: Prior Actions and Evidence of Completion under Second Tonga Economic Recovery Operation Table 5: Progress in Completing Triggers Specified Under First Operation and New Prior Actions iii

4 FIGURES IN TEXT Figure 1: Change in Remittances (TOP) and Remittances as Percentage of GDP... 7 Figure 2: Real Revenue and Grants (FY2005-FY2012)... 8 Figure 3: Real GDP Growth and Real GDP Per Capita BOX IN TEXT Box 1: Good Practice Principles for Conditionality MAP The Second Tonga Economic Recovery Operation Grant was prepared by an IDA team consisting of: Tobias Haque (TTL), Economist, EASPR; Vivek Suri, Lead Economist, EASPR; Virginia Horscroft, Senior Economist, EASPR; Saia Faletau, Focal Officer, Tonga Liaison Office; Robert Jauncey, Senior Country Officer, EASPR; Isabella Drossos, Senior Counsel, LEGES; Roberto Aiello, Senior Energy Specialist, EASNS; Tendai Gregan; Energy Specialist, EASNS; Stephen Hartung, Financial Management Specialist, EAPFM; Patricia Hoyes, Senior Finance Officer, CTRLN; Samantha Evans, Team Assistant, EACNF. Peer Reviewers: Rob Taliercio, Lead Economist, EASPR; Francis Rowe, Senior Country Economist, SASEP; Rosa Terme, Senior Public Sector Specialist, EASPR. iv

5 GRANT AND PROGRAM SUMMARY KINGDOM OF TONGA SECOND TONGA ECONOMIC RECOVERY OPERATION Borrower Implementing Agency Financing Data Operation Type Main Policy Areas Key Outcome Indicators Program Development Objective(s) and Contribution to CAS Kingdom of Tonga MINISTRY OF FINANCE AND NATIONAL PLANNING IDA Grant Standard IDA Grant terms SDR 1.2 million (US$1.8 million equivalent) The proposed operation is the second in a series of two programmatic development policy operations. In addition to IDA financing, AusAID is expected to provide budget support of US$5.3 million for the same set of policy actions. The proposed operation will support actions in the following policy areas: (i) strengthening public financial management; (ii) strengthening fiscal policy; and (iii) promoting structural reforms relating to the business enabling environment. The key outcome indicators for the program over the medium term are: (i) budget credibility at the level of ministries; (ii) public access to key fiscal information; (iii) an effectively managed civil service wage bill; (iv) curtailment of growth in the cost of tax exemptions; (v) improvements in the financial reporting of SOEs; (vi) reduction in the cost of doing business; and (vii) energy prices that better reflect the costs of supply. The proposed operation will assist the Government of Tonga (GoT) to implement key aspects of its medium-term reform agenda, while providing a predictable flow of resources in a challenging fiscal environment. Over the last four years, Tonga s economy has been hit hard by a series of crises, which have caused a slowing of economic growth, a significant fiscal gap to emerge, and poverty to increase sharply. At the same time, Tonga has made the transition to a more democratic political system. The proposed operation provides the Bank with an opportunity to support key public sector and economic reforms at a critical juncture in Tonga s development process. The proposed operation contributes mainly to the first theme of the CAS, of supporting policy reform to strengthen economic growth i

6 Risks and Risk Mitigation Operation ID prospects and improve service delivery. The policy actions supported by the proposed operation will strengthen critical aspects of public financial management as well as key components of fiscal policy that underpin the delivery of services, including revenue effort. The policy actions also support essential structural reforms, including in the business regulatory environment. In addition, the policy actions and associated budget support will facilitate accumulation of cash reserves, contributing to the third theme of the CAS on building resilience against shocks. The main risks of the proposed operation and their associated mitigation strategies are: Severe capacity constraints in particular areas of Government and associated reliance on donor technical assistance may mean that the operation cannot be implemented as successfully or as quickly as expected, especially in the context of the current Government restructure. This risk is being mitigated through: i) selection of a limited number of key reform actions to prevent overspreading of scarce capacity; ii) strong dialogue with Government to ensure ownership of supported reforms; iii) the provision of technical assistance to support the Government restructure as well as other policy actions. Macroeconomic disruption arising under several feasible shock scenarios, including natural disasters, could distract available capacity and resources from implementation of actions supported by the program, as well as undermine the impact of these actions on growth and poverty-reduction. This risk is being mitigated through the government s accumulation of cash reserves and strong policy dialogue around the management of macroeconomic shocks and challenges, including with the IMF. Political uncertainty persists in the current challenging economic environment, and given the recent reform of political institutions. This risk is somewhat mitigated through extensive dialogue building strong ownership of proposed reforms across a broad range of policy-makers and officials. P ii

7 INTERNATIONAL DEVELOPMENT ASSOCIATION PROGRAM DOCUMENT SECOND TONGA ECONOMIC RECOVERY OPERATION GRANT TO THE KINGDOM OF TONGA I. INTRODUCTION 1. The proposed operation is the second in a programmatic series of two development policy operations. The operation will be financed by IDA resources of US$1.8 million and AusAID is expected to provide associated sector budget support of AUD 5.0 million (US$5.3 million) for the same policy actions and dependent on the Bank s operation being approved. The operation will help the Government of Tonga manage severe economic challenges that have coincided with historic political reforms. It supports a focussed program of Government reform priorities in public financial management, fiscal policy, and business environment reforms while providing a vital fiscal buffer in the context of sustained revenue contraction. The series of operations coincide with the term in office of Tonga s first Government to be selected by a majority-elected parliament and provide an opportunity for the Bank to support Tonga at a critical juncture in its development process. 2. Tonga faces many of the challenges typical of small island economies. Almost unique in the extent to which it is disadvantaged by smallness and isolation, Tonga has a very narrow production base and is vulnerable to economic shocks. The population of just 104,000 is spread over 36 islands which are extremely isolated from global centres of production and population. Lack of economies of scale and long distance to larger markets push up costs of production and erode opportunities for successful exporting. High levels of imports are financed by aid and remittances with remittances averaging 32 percent of GDP over the past decade. Dependence on imports means the economy is exposed to changes in the international prices of fuel and other commodities. Capacity constraints associated with a small public sector necessarily limit the achievable scope and pace of reform efforts. 3. Tonga s economy was in a vulnerable state prior to the Global Economic Crisis (GEC) and has witnessed a weak recovery. Despite achieving major progress over recent years against a broad program of public sector and structural reforms, Tonga was poorly placed to weather the GEC. Factors contributing to vulnerability included ongoing declines in remittances, falling agriculture exports, food and fuel price increases, rising levels of public debt, and a contraction in private sector credit following a domestic credit bubble. As remittances and tourism receipts declined further during the crisis, Tonga relied on grants and concessional loans to offset falling revenue and to finance fiscal stimulus through major capital projects. The economy is now showing some signs of recovery, with improvements in revenue performance, bottoming out of remittances, and a recent uptick in tourism receipts. 1

8 Recovery has been hampered, however, by a series of natural disasters and ongoing budget support assistance will be required to maintain service delivery standards and bolster broader recovery. 4. The programmatic series of Economic Recovery Operations focuses on three reform areas. Areas of focus reflect Government s concern to support short-term recovery and mitigate continuing impacts of the crisis on the poorest households while maintaining progress against longer-term structural reforms to deal with ongoing fiscal and economic challenges. Areas of focus include: i) strengthening public financial management; ii) strengthening fiscal policy; and iii) promoting structural reforms relating to the business regulatory environment. The first Tonga Economic Recovery Operation also supported reforms to strengthen social protection. 5. Significant progress was achieved under the First Economic Recovery Operation. To strengthen public financial management, the first operation supported the establishment of a system for in-year monitoring of budget execution and the reform of the budget calendar to make budget proposals available to the public when tabled in the legislative assembly. To strengthen the management of the wage bill, the first operation supported efforts to bring recruitment in all areas of the public service under centralized control. In promoting structural reform, the first operation supported policy decisions to reduce electricity costs for poor households and improve incentives for renewable energy generation through reform of the electricity tariff. In this area, the operation also supported the introduction of new petroleum pricing template to reduce the cost of petroleum products and increase the effectiveness of the regulatory framework, and the publication of audited accounts for economically significant public enterprises. To improve social protection, the operation supported the adoption of a community public works scheme to generate cash-earning opportunities for the poorest communities. 6. Progress has been made against specified triggers for a second operation. Reflecting the fluid economic context and the extent of capacity constraints across Government, progress against the individual triggers specified under the previous operation has been expectedly uneven. While some specific triggers for a second operation have not been met often due to factors beyond Government control others have been exceeded. More generally, Government continues to make progress against priority reforms within all of the areas of focus specified under the previous operation. The Bank has reviewed, with the authorities and development partners, the progress in the implementation of the reform program and, considering the areas of faster than expected progress as well as those with slower than expected progress, has found overall progress to be robust. The Bank expects that the reforms and policy implementation through the actions supported by both the first and the second operation will cumulatively help Tonga achieve the development objectives of its reform program supported by this series of operations. 2

9 7. The Second Tonga Economic Recovery Operation will build on the gains achieved to date. In the area of public financial management, priorities reflect the importance of embedding transparency and solid Public Financial Management (PFM) foundations following recent political reforms. Actions in this area include introduction of a Treasury Single Account, publication of in-year budget reports, and the tabling in Parliament of audited Annual Financial Statements of Government. Under fiscal policy, the agenda focuses on strengthening revenue effort to maintain delivery of public services following substantial revenue declines. Actions in this area include policy decisions to introduce small business and natural resource tax regimes and measures to increase transparency of the costs of tax exemptions. In relation to structural reform, the focus is on easing constraints to viable sources of private sector development, particularly in the tourism sector through introducing an improved business license regime. 8. Supported reforms will deliver improvements in living standards within inevitable and ongoing resource constraints. Current policy priorities are focussed on achievable improvements in the business environment while ensuring a sound macroeconomic environment and strengthening systems for improved accountability and service delivery. Such measures are intended to increase resilience to future shocks and improve living standards, even in the context of limited growth over the medium-term. Supported measures are not, on their own, expected to lead to any step-change in growth performance given the extent to which Tonga s economy remains constrained by smallness, distance to large markets, and exposure to a difficult international environment. Sustainability of Government finances is likely to remain reliant on budget support from development partners over the medium-term, given difficult economic conditions and weak revenue performance. 9. The proposed operation is the product of strong dialogue between the Government of Tonga, the Bank, and development partners. The Bank has worked with Government and development partners in coordinating the formulation of a joint policy reform matrix that outlines shared reform priorities. A subset of reforms included in the joint policy reform matrix are supported by the proposed operation, with AusAID also expected to provide budget support of AUD 5 million for the achievement of the same set of policy actions. The Asian Development Bank (ADB), the Pacific Financial Technical Assistance Facility (PFTAC), the European Union (EU), and the International Monetary Fund (IMF) have also been closely involved in policy discussions around the identification of reforms to be supported by budget support. PFTAC, International Finance Corporation (IFC) and ADB are providing technical assistance to the Government of Tonga in implementing included actions relating to business environment and revenue strengthening measures. ADB, AusAID, the New Zealand Ministry of Foreign Affairs International Development Group (NZ-IDG), and the EU may also provide budget support against the policy actions associated with any future World Bank operation developed through the joint-donor dialogue during FY2013/14. The multi-donor dialogue around budget support has played a key role in mobilizing political 3

10 attention, administrative effort, and technical assistance to implement reforms. The strong consensus achieved around policy actions reflects the extent to which Government and development partners are firmly committed to a harmonized approach to budget support and the medium-term goals of the Tonga Strategic Development Framework. 10. The proposed operation carries high risk due to capacity constraints within the public sector, exposure to external economic shocks and natural disasters, and the possibility of further change within Government. The proposed operation faces three main risks. Firstly, Tonga experiences the thin capacity typical of public sectors in very small states, with a small number of qualified public servants called upon to implement the many tasks of a central government. Severe capacity constraints in particular areas may mean that the operation cannot be implemented as successfully or as quickly as expected, especially in the context of the current Government restructure. Secondly, macroeconomic stability is dependent on successful fiscal consolidation, recovery of remittances, and continuing grant support from donors. Macroeconomic disruption arising under several feasible shock scenarios, including any substantial scaling back of external assistance, would distract available capacity and resources from implementation of actions supported by the program, as well as undermine the impact of these actions on growth and poverty-reduction. Finally, Tonga s political system has been recently reformed and political conditions could be subject to rapid change. While Government has remained stable over the length of the current term, political dynamics within the new system are poorly understood. Broader political changes remain a possibility in the current challenging economic environment, and represent a source of substantial uncertainty, given limited experience under new political institutions. II. COUNTRY CONTEXT RECENT ECONOMIC DEVELOPMENTS IN TONGA 11. Tonga is a small, remote economy that is highly vulnerable to external economic shocks and natural disasters. Tonga s population of 104,000 is dispersed across 36 of the 176 islands that make up the archipelago. Located in the South Pacific, Tonga is one of the most remote countries in the world, when measured by indicators of proximity to major markets. 1 Small size and remoteness combine to push up the cost of economic activity in Tonga, limiting competitiveness of its exports of goods and services in world markets. These same factors also push up the cost of providing public services. In addition, the openness of Tonga s economy and the lack of diversification of its sources of foreign exchange make Tonga highly vulnerable to external economic shocks, while its geographical characteristics make it highly vulnerable to natural disasters. 12. Supported by remittances, aid flows, and strong Government commitment to service delivery, social indicators remain among the strongest in the Pacific. The gross 1 See Gibson (2006) Are the Pacific Island Economies Growth Failures? Macmillan Brown Centre for Pacific Studies: Working Paper No. 3, Pasifika Interactions Project. 4

11 secondary enrolment rate is currently estimated at 106 percent, with no significant decline since the global economic crisis. Under-five mortality, at 16 per 1000, continues to decline. The child immunization rate for measles is 99 percent, while 98 percent of births are attended by skilled health staff. Life expectancy continues to improve, and recently reached 72 years. 100 percent of the population continues to have access to an improved water source. 13. Indicators paint a mixed picture regarding the position of women in society. The female enrolment rate is higher than the male enrolment rate for secondary and tertiary education. The female labour force participation rate, at around 50 percent, is higher than other Pacific countries at comparable levels of income (Samoa and Fiji). 30 percent of civil servants are women, but women remain underrepresented at senior levels of the bureaucracy. The maternal mortality ratio, which has been stable for the last 20 years, is 36.5 per 100,000 live births. The contraceptive use is at about 27% (2008) and the total fertility rate is 3.8 (2006). Recent political reforms opened the door for women s representation in parliament, but only one Member of Parliament is female. There is no legislation prohibiting domestic violence or sexual discrimination. Women are unable to own land and, because of incompatibility of its provisions with traditional land ownership models, Tonga has not ratified the United Nations Convention on the Elimination of All Forms of Discrimination Against Women (CEDAW) Like other small, remote economies, Tonga depends on a very limited number of sources for its foreign exchange earnings and has a relatively undiversified economic base. Remittances are Tonga s largest source of foreign exchange, averaging just under-32 percent of GDP over the last decade. Tourism receipts are Tonga s next largest source of foreign exchange, averaging about 6 percent of GDP over the last decade. Merchandise export receipts have averaged about 5 percent of GDP over the last decade and have declined substantially during this period. Tonga also receives significant development assistance, with cash grants averaging 3 percent of GDP over the last decade but 5.1 percent of GDP over the last five years. Tonga also receives significant in-kind grants, which amounted to some 3 6 percent of GDP in each of the last two years. The services sector dominates the economy, among which government services at about 15.5 percent of GDP are the largest component, closely followed by commerce, restaurants and hotels at about 14.5 percent of GDP. Commercial services are dominated by wholesale and retail trading activities, which largely distribute imported goods (imports are equivalent to about 40 percent of GDP). Due to its reliance on a small productive base, and heavy exposure to external conditions, Tonga s economic growth trajectory reflects the impact of various shocks rather than the dynamics of a business cycle. 15. Recent economic performance has been weak despite structural reforms. Since 2007, Tonga has progressed major tax policy and customs administration reforms, while strengthening the business regulatory environment and corporatizing and privatizing several 2 See Country Gender Profile: Kingdom of Tonga, JICA,

12 SOEs. Reflecting these reforms, Tonga s Country Policy and Institutional Assessment (CPIA) rating has increased from 2.9 to 3.5 over the last five years. The growth benefits of these reform efforts have been somewhat undermined, however, by geographical disadvantages and a range of shocks. GDP growth has averaged about 1.5 percent per annum over the past decade. While low compared to both other Pacific Island Countries and the broader East Asia Pacific region, recent analysis suggests that a large portion of Tonga s slower growth performance can be explained by these inherent geographical disadvantages of smallness and isolation. Recent economic growth has also been adversely impacted by several shocks, including the impact of blight on agricultural export performance, a prolonged civil service strike in response to sweeping civil service reform proposals, and major civil disturbances sparked by protests demanding political reform, which caused widespread damage to the capital, Nuku alofa. 16. The Tongan economy entered the global economic crisis in a vulnerable state. Remittance flows to Tonga peaked as a proportion of GDP in 2004/05, following which they declined substantially in the years prior to the GEC possibly reflecting the aging of emigrant stocks and weakening relationship links. With heavy reliance on imported food products and energy, the global food and fuel crisis led to inflation of 12 percent in Price hikes disproportionately impacted on poor, urban households highly reliant on cash incomes in the absence of subsistence opportunities and the current account deficit widened to 14.7 percent of GDP by Growth momentum was further weakened by a contraction of domestic credit following a poorly-judged lending surge on behalf of commercial banks in late 2007 and Non-performing loans peaked at 20 percent in mid-2009, with a 25 percent contraction in credit to the private sector between 2008/09 and FY2010/11, as banks became increasingly risk-averse. The Government contracted a large loan for reconstruction of Nuku alofa in 2007 from the China EXIM bank, reducing capacity for sustainable additional borrowing. 17. The global economic crisis had a severe impact on remittances and exports. With economic slowdown in key remittance sending countries the US (where over 50 percent of Tonga s remittances originate), New Zealand and Australia the decline in remittances accelerated. From 31.1 percent of GDP in FY2007/08, remittance receipts fell by 13.6 percent and 10.1 percent over the next two years, to reach 22.5 percent of GDP in FY2009/10. At the same time, with New Zealand, Australia, and the United States also being Tonga s largest tourist markets, Tonga s tourist receipts declined by 13.3 percent in FY2009/10. Led by falls in agricultural and fish exports, merchandise exports also continued their declining trend in FY2008/09 and FY2009/10. 3 Two-thirds of food consumed in Tonga is imported. All grid-supplied electricity (which accounts for 98 percent of total electricity consumption) is generated using imported diesel. 6

13 Figure 1: Change in Remittances (TOP) and Remittances as Percentage of GDP 50% 40% 30% 20% 10% 0% -10% 2002/ / / / / / / / / /12-20% -30% Change in Remittances (%) Remmitances as % GDP Source: IMF (Estimate for FY2011/12). 18. The crisis had a major impact on Government revenues. In FY2008/09 and FY2009/10, tax revenue fell 6.4 and 11.3 percent in nominal terms. Falling remittances fed through into declining imports, and consequent reductions in consumption tax, import duty and excise revenue. While revenue policy settings remain appropriate and in line with regional comparators, the revenue impacts of remittance declines have generated pressure to consolidate expenditure and identify alternative financing sources Economic and poverty impacts of the crisis were ameliorated by donor-financed fiscal stimulus and major capital projects. Despite sharply contracting revenues, the Government of Tonga was able to substantially increase expenditure through donor support. An extraordinary grant from China supported a seven-fold increase in capital expenditure in 2008/09 for road investments, which supported an increase of total Government expenditure and net lending of 28.8 percent. In FY2009/10, an inflow of project aid and capital expenditure and on-lending associated with loans from China s EXIM Bank more than compensated for the scaling back of Government capital expenditure, while ADB budget support of 9.5 million pa anga allowed recurrent expenditure to be maintained. Despite the magnitude of the economic shocks facing Tonga up to and during the economic crisis, fiscal 4 The pace of revenue declines was exacerbated by the simultaneous implementation of the second phase of an ambitious tax reform program designed to shift the burden of taxation away from trade taxes by reducing import tariffs, raising excises and introducing a consumption tax. The tax reforms were revenue-neutral, overall, but were divided into two sets. The first set was implemented partway through FY2004/05 and had an overall positive impact on revenue receipts. The second set, implemented during FY2007/08, had an offsetting negative impact on revenue receipts which unfortunately coincided with the initial impacts of the crisis. A 2011 PFTAC review concluded that Tonga s revenue settings remain appropriate and found limited scope for increases in tax rates without negative poverty and growth impacts. See the Analytical Underpinnings section for a detailed discussion of this review. 7

14 Real FY2005 USD stimulus and major capital projects prevented a major economic contraction, with growth of zero percent in 2008/09, and 1.9 percent during FY2009/10. Figure 2: Real Revenue and Grants (FY2005-FY2012) FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 Real Revenue Real Grants Source: IMF and World Bank Calculations (Forecast for FY2011/12). 20. Tonga s recovery from the GEC remains partial, fragile, and reliant on donor support. In FY2010/11 and FY2011/12, remittances continued to decline as a proportion of GDP, to reach their lowest level since FY2001/02. Tourism receipts have shown a recent uptick, but merchandise exports have remained sluggish, reflecting continued lacklustre performance of the agricultural sector. Despite these constraints, the economy of Tonga has continued to expand since the GEC, with growth of 1.4 percent in FY2010/11, and 1.6 percent in FY2011/12. This growth has been largely driven by grant and debt-financed stimulus as development partners and the Government responded to the immediate need for supporting aggregate demand. Total spending grew by 7.7 percent in FY2010/11, as capital investment and on-lending from China EXIM Bank loans offset small declines in recurrent expenditure. Budget support of 22.8 million pa anga (13.2 percent of the government-funded budget) played a key role in maintaining recurrent expenditure. Total expenditure declined slightly in FY2011/12, as the pace of development project implementation slowed and recurrent expenditure was restrained to support the accumulation of cash reserves. As grant- and debtfinanced expenditure falls from the historically high levels seen over recent years, maintaining growth, sustaining public service delivery, and avoiding further increases in poverty represent major challenges in the context of still-uncertain international conditions. 21. Monetary conditions have remained accommodative over the past two years, but private credit growth remains constrained. Increases in international reserves and limited sterilization led to large accumulation of banks excess reserves. But private sector credit growth has remained negative due to the weak economic outlook and the application of tighter lending standards by now-risk-averse banks, constraining private sector development 8

15 and job creation. The banking system is adequately capitalized but non-performing loans remain high. Table 1: Fiscal and Economic Indicators FY2007-FY2012 (Millions of Pa anga) Source: World Bank and IMF. 2008/ / / / /13 Total Revenue and Grants Total Revenue Current Revenue Tax Revenue Taxes on incomes/profits Sales and consumption tax Trade taxes Non-tax revenue Capital Revenue Grants Project grants Budget support Total Expenditure and Net Lending Total Expenditure Govt. Current Expenditure Wages and Salaries China EXIM Bank Loans Current Balance (excl. project grants) Overall Balance (incl. grants) Overall Balance (excl. China EXIM Bank loans) Primary Balance (incl. grants) Money and Credit (% change) Money supply (M2) Private sector credit Gross official foreign reserves In millions of USD In months of imports (goods and services) External debt in % GDP External debt Debt service ratio Exchange rates P'anga per USD (period average) Nominal effective exchange rate (1990=100) Real effective exchange rate (1990=100) Natural disasters continue to impede Tonga s recovery from the global economic crisis. In September 2009, Tonga was buffeted by a tsunami, causing loss of life and significant material damage, particularly in the outlying Niuas island group. In February 2010, a cyclone affected the whole of the archipelago, with the worst impact in the Vava u island group, causing widespread material damage. In February 2011, a cyclone hit the Ha apai island group, causing significant damage to infrastructure and housing. In February 2012, 9

16 cyclone Jasmine caused widespread flooding in Nuku alofa and associated damage to property and businesses. Aside from the private costs of the natural disasters, these events cause a periodic diversion of public resources away from implementing the development program of the Government and towards immediate reconstruction needs. MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY 23. Macroeconomic conditions are expected to improve over the short-term. Inflation fell to 4.6 percent in FY2011/12, down from 6.1 percent in FY2010/11, and is expected to remain at around 4.5 percent during FY2012/13. This reflects a stabilization of import prices and exchange rate appreciation. Inflation of around six percent is expected over the mediumterm, consistent with historical averages, as private sector credit returns to positive growth in response to the accommodative monetary policy adopted by the National Reserve Bank of Tonga (NRBT), and fuel prices strengthen. The current account is expected to widen to 6.1 percent of GDP during FY2011/12, reflecting imports for major capital projects, but then narrow to less than two percent of GDP in the medium-term as tourism receipts strengthen and remittance-financed imports of consumption goods while recovering remain below pre-crisis levels. Despite the widening current account, donor inflows have allowed the continued build-up of foreign reserves now equivalent to 5.9 months of import cover but pressure is expected to build on the foreign exchange position as donor flows slow over the medium-term. According to the IMF, the currency remains broadly in line with fundamentals. With inflation forecast to decline over the short-term, the exchange rate is expected to remain broadly stable against the currency basket. 24. Growth is expected to remain at modest levels through 2012/13 and dependent on grant support. As fiscal stimulus is gradually removed, the pace of growth is expected to further slow from 1.6 percent in 2011/12 to 1.2 percent in 2012/13, with the balance of risks tilted to the downside. Consumption growth is expected to pick-up as remittances increase slightly, driven by recovery in the United States and New Zealand, but remain well below precrisis levels. The recent uptick in tourism is expected to continue, similarly driven by improved global economic conditions. The growth outlook remains heavily contingent on ongoing grant support from donors, with grants expected to reach record highs of 12.4 percent of GDP in 2012/13. Modest growth over the medium term is projected to occur in the context of ongoing population growth and slowing emigration. GDP per capita is not expected to return to 2005 levels until around

17 Real GDP Growth GDP Per Capita (2002 USD) Figure 3: Real GDP Growth and Real GDP Per Capita Real Growth GDP Per Capita (2002 USD) Source: IMF and World Bank Calculations. 25. The Government remains reliant on budget support to overcome current fiscal challenges. The overall fiscal deficit declined to 2.7 percent of GDP in 2011/12, and a small surplus of around 0.6 percent of GDP is expected in FY2012/13 as fiscal consolidation continues. This outcome depends on ongoing budget support grants, continued efforts to improve tax and customs performance, and careful expenditure management. The tax policy framework is considered generally sound, but planned tightening of exemptions and deductions has the potential to yield increases in revenue of around 0.5 percent of GDP per year over the next two years. On the expenditure side, the Government s medium-term fiscal framework shows substantial reductions in recurrent spending of 3.5 percent of GDP by FY2016/17, supported by improved control in payroll expenditure. Allocations in the FY2012/13 budget (excluding China EXIM Bank financed expenditure and donor projects) represent a real decline in recurrent expenditure. With government revenues continuing to fall short of expenditure, budget support will play a key role in maintaining acceptable standards of service delivery. 5 5 In FY2011/12, Tonga received nearly 40 million pa'anga in budget support grants (15.1 million from the Bank, 12.8 million from the EC, 8.9 million from AusAID). This was equivalent to 23.3 percent of government-funded expenditure, and reduced the overall budget deficit from 6.6 percent of GDP to 1.7 percent of GDP. 11

18 Table 2: Summary of Medium-Term Macroeconomic Outlook (FY2010-FY2017) 2009/ / / / / / / /2017 Output and Prices Annual percentage change Real GDP Consumer Prices (period average) Central government finance Percentage of GDP Total revenue and grants Total domestic revenue Grants Total expenditure and net lending Govt. Current Overall Balance (incl. grants) Balance of Payments Millions of U.S. Dollars Exports, f.o.b Imports, f.o.b Services and investment income (net) Transfers (net) Of which: remittances Current account balance Overall balance Gross international reserves (end period) In million of U.S. dollars In months of imports (goods and services) External debt Public sector external debt Percentage of GDP Debt service ratio Memorandum items Private transfers (net, in millions of US dollars) Nominal GDP (millions of TOP) Source: World Bank and IMF. 26. Tonga faces challenges in achieving more robust economic growth over the medium-term. Due to inherently higher cost structures associated with geographical isolation and smallness, growth opportunities are concentrated in areas where economic rents can be generated as from natural resources such as tourism and fisheries. Tonga s tourism sector has considerable untapped potential, which continued business environment reform and targeted donor assistance may help to unlock. Tonga s agricultural exports could receive a boost from new heat treatment and fumigation facilities, helping Tonga overcome non-tariff barriers in nearby large markets. Improving the efficiency of the public enterprises that provide infrastructure services could also benefit households and businesses, as could further efforts to reprioritise government expenditure towards higher priority areas such as agriculture and infrastructure ministries. Development of fisheries resources represents an additional area of opportunity, which Tonga is seeking to pursue with World Bank technical assistance. Further expanding access to international labour markets represents one of the most promising sources of supporting living standards over the longer-term, through remittances, tourism (from returning migrant families), and skills and knowledge transfers. 6 While credit growth is forecast, continued risk aversion on behalf of commercial banks is likely to continue to somewhat constrain access to credit. 6 The Ministry of Tourism estimates that returning Tongan families constitute 70 percent of current visitor arrivals. 12

19 27. Prospects for achieving a step-change in growth performance are limited. While much could be done to facilitate growth from the sources listed above, their potential to affect major changes in economy-wide output should not be overstated. It is not clear that any set of policy measures could be relied on to deliver sustained and substantial improvements in economic growth due to inherent disadvantages faced by Tonga arising from its small size and geographical isolation. While making the most of potential growth opportunities is vital, policy priorities for Government also reflect the seriousness of geographical constraints to growth. Current policy priorities are focussed on achievable improvements in the business environment, ensuring macroeconomic stability and strengthening systems for improved accountability and service delivery. Such measures are intended to increase resilience to future shocks and improve living standards without any major step-up on the current growth trajectory. 28. Tonga s remains at high risk of debt distress. The latest joint Bank-Fund Debt Sustainability Analysis (DSA) for Tonga reports the present value of external debt at 33 percent of GDP in FY2011/12, as against a policy-dependent threshold of 30 percent. The large majority of debt relates to the two large China EXIM Bank loans contracted for reconstruction of Nuku alofa in 2007 and road infrastructure in Under the baseline scenario, the present value of debt remains above the policy threshold until 2014/15, before declining to 15 percent of GDP by 2016/17. Tonga s debt and debt servicing also breach the relevant debt-to-export and debt service-to-export ratios for prolonged periods. When remittances are taken into account, breaches are shorter and less severe but still occur. The baseline scenario presented in the DSA assumes continuation of the recent tourism uptick, remittance recovery, recurrent expenditure restraint including wage control, maintenance of grant support at current nominal levels, and successful implementation of revenue reforms. Stress tests indicate Tonga s vulnerability if progress against these objectives is not achieved. Key medium-term vulnerabilities include lower GDP growth, external shocks impacting on tourism or exchange rate, or incomplete implementation of revenue and expenditure reforms, all of which would see larger and more sustained breaches of policy thresholds. 7 The DSA concludes that, taking into account the cushion provided by remittances, Tonga s projected debt profile is consistent with manageable if high risk debt dynamics The Government is committed to returning its debt to sustainable levels and managing the challenges associated with increased debt servicing obligations. The Government has maintained a policy of avoiding any new debt, even on concessional terms, over the past year, in order to regain the fiscal space needed to respond to future shocks. It has also introduced and implemented a policy of using domestic borrowing only for the purposes of in-year cash management. As grace periods on loans expire over coming years, the debt servicing profile will present a major challenge to fiscal sustainability, with substantial 7 Medium-term vulnerabilities indicated in by the DSA include lower GDP growth, currency mismatches, credit risks on government s balance sheet, and new borrowing on less concessional terms. 8 Despite the rise in total debt, the Government has continued to reduce its domestic debt level to an estimated 5.4 percent of GDP as at April 2012, relative to about 20 percent of GDP at the beginning of the last decade. 13

20 reprioritization of resources and successful management of wage bill pressures necessary to avoid either a failure to meet debt obligations or potentially significant declines in the provision of public services. The Government is committed to implementing such reprioritization measures and has been working closely with the World Bank to identify expenditure options consistent with maintenance of service delivery and reallocation of public investment towards priority sectors. 30. The current macroeconomic policy stance is satisfactory and sustainable over the medium-term, but outcomes remain subject to uncertainty and reliant on ongoing international assistance. A sharper than expected rise in global commodity prices would exacerbate inflation and threaten the incipient economic recovery in Tonga. The global fallout of possible developments in the European debt crisis and in the US economy could yield a further shock for Tonga s remittance flows, which poses a threat both to growth and fiscal stability. The macroeconomic policy framework also depends on the continued availability of grants from development partners over the medium term, given Tonga s high risk of debt distress and hence the inadvisability of borrowing to fund fiscal deficits. The FY2012/13 budget has been developed with projected budget support receipts of TOP$22 million. If the committed level of donor support does not materialize or if there are significant delays in its provision, fiscal stability would be threatened. Budget support assistance is likely to remain necessary to avoid a damaging contraction in Government recurrent expenditure and an associated deterioration in service delivery. The upcoming remuneration review presents a potential additional risk with any large increases in the civil service wage bill likely to cause a widening of the deficit or substantial disruptions to service delivery through cash shortages and the squeezing out of non-payroll expenditure. Finally, Tonga remains vulnerable to a variety of natural disasters, including tsunamis, cyclones, and flooding. III. THE GOVERNMENT S PROGRAM AND PARTICIPATORY PROCESSES 31. Tonga s national development strategy is set out in the Tonga Strategic Development Framework, (TSDF), which was endorsed by the current government in May The extensive consultation process underpinning the TSDF began under the previous government. Individual line ministries worked interactively with their stakeholders, including both civil society groups and private sector entities, over a period of at least one year, in preparing their strategies for contribution to the TSDF process. The Ministry of Finance and National Planning (MFNP) then led the coordination process within government, whereby line ministries worked together to integrate their sector-specific strategies into a single national development strategy. The TSDF was approved by Cabinet at a special meeting convened for the purpose in May The vision guiding the TSDF is to develop and promote a just, equitable and progressive society in which the people of Tonga enjoy good health, peace, harmony and prosperity, in meeting their aspirations in life. To achieve the vision of the TSDF, the Government aims to deliver on nine strategic objectives. 14

21 33. The first objective is to build strong, inclusive communities by engaging locallevel groups in meeting their service needs and ensuring the equitable distribution of development benefits across and within communities. Protection and support is to be provided to vulnerable communities and vulnerable groups within communities including women, the elderly and youth especially unemployed youth. Rural and outer-island communities are to be supported through community-specific development programs that are implemented in conjunction with the communities themselves. 34. The second and third objectives concern the role of a dynamic public and private sector partnership in driving economic growth, and the importance of adequate infrastructure for business activity and household wellbeing. Under the second objective, the Government will work to ensure that public sector policies and services create an enabling environment in which the private sector can flourish, including through the maintenance of macroeconomic stability. Emphasis is placed on the key industries of tourism, agriculture, fisheries and temporary labour abroad. Under the third objective, the Government is committed to implementing its National Infrastructure Investment Plan, which is a mediumterm plan for energy, telecommunications, water, solid waste management and transport infrastructure. This plan provides a valuable framework for prioritizing between infrastructure investment projects and is expected to improve coordination on project selection between Government and development partners. 35. The fourth, fifth and sixth objectives focus on key aspects of human development. Under the fourth objective, the Government aims to strengthen educational standards, particularly by improving the quality of the universal basic education it provides. Under the fifth objective, the Government aims to improve the technical and vocational education and training available to Tongans, to enable them to take advantage of employment opportunities both in the domestic labour market and in labour markets abroad. Under the sixth objective, the Government is committed to the provision of quality, effective and sustainable health services, with a particular focus on health promotion and on tackling the growing incidence of non-communicable diseases. 36. The seventh, eighth and ninth objectives concern governance. Under the seventh objectives, the Government aims to integrate cross-cutting concerns relating to Tonga s distinctive culture, fragile environment and vulnerability to natural disasters and the impacts of climate change, into all government programs. Under the eighth objective, the Government is committed to adhering to the principles of good governance, accountability, transparency and the rule of law, in order to improve the governance of Tonga at this critical juncture in its political history. Under the ninth objective, the Government aims to strengthen the operation of the judiciary and to maintain law and order to ensure a safe, secure and stable society. 37. The delivery of these objectives is to be facilitated by four enabling themes on the public sector, macroeconomic framework, public enterprises and development assistance. The efficiency and effectiveness of the public sector is to be improved, by 15

22 focusing on core functions, optimising the use of resources, improving service delivery and improving coordination. On the macroeconomic framework, the TSDF emphasises the importance of good fiscal management, including effective revenue collection and sound public expenditure management. On public enterprises, further reforms are planned to improve their accountability and sustainability and to accelerate the privatisation agenda. On development assistance, the TSDF stresses the value of a coordinated approach to Tonga s relationship with development partners. Each enabling theme in the TSDF is underpinned by a set of specific strategies, which are themselves allocated to particular ministries to implement. 38. The proposed operation will support the objectives and enabling themes of the TSDF. The public financial management reforms in the proposed operation will support the objective of good governance, particularly with respect to accountability and transparency, as well as the enabling theme on good fiscal management. The fiscal policy reforms will bolster the enabling themes on good fiscal management and the efficiency and effectiveness of government. The structural reforms will support the private sector and infrastructure objectives, as well as the enabling theme on public enterprises. 39. The operation has been developed through a process of detailed consultation with all relevant authorities and stakeholders, both within the central government and at the sector-specific level. The proposed operation was developed through dialogue mechanisms established to support the previous economic recovery operation. The Government has established a Budget Support Management Committee to facilitate discussion and monitoring of progress around actions under the Government reform program to be supported by the operation. The MFNP provides secretarial support to the committee and it includes representatives from various agencies involved in all key areas of the reform program, including the Ministry of Public Enterprises, the Ministry of Labour, Commerce and Industry, Revenue Services, and, recently, Tonga Power Limited and the Tonga Energy Roadmap Implementation Unit. The operation design reflects dialogue with the Civil Society Forum of Tonga, an umbrella NGO, regarding the social and poverty impacts of recent economic shocks. 40. Relevance of the actions supported by the proposed operation was reaffirmed during a major economic dialogue in March Hosted by the NRBT and attended by a broad range of Government, NGO, private sector, and donor representatives including the Bank, this dialogue highlighted broad consensus around many of the reforms being supported through the proposed program. Key messages arising from the dialogue included 1) the need for careful management of debt and improved expenditure allocation in the context of upcoming increases in debt-servicing obligations, 2) the need to focus economic reform in areas of potential advantage, especially in tourism, and 3) the importance of business-enabling environment reforms, including improvements in regulatory processes and economic infrastructure to support private sector development. 16

23 IV. BANK SUPPORT TO THE GOVERNMENT S PROGRAM LINK TO COUNTRY ASSISTANCE STRATEGY 41. The World Bank Group s Country Assistance Strategy for the Kingdom of Tonga, FY (CAS) is built around three themes of reform, integration and resilience. The first theme is supporting policy reform to strengthen economic growth prospects and to improve service delivery. The second theme is generating opportunities through greater global and regional integration. The third theme is building resilience against shocks. The proposed multi-year programmatic series of operations contributes mainly to the first theme of engaging with the Government on policy reforms to strengthen growth and improve service delivery. It supports policy actions aimed at strengthening critical aspects of public financial management as well as key components of fiscal policy that underpin the delivery of services, including revenue effort, expenditure quality and control of the civil service wage bill. The actions also support essential structural reforms, including in the vital energy sector, in public enterprise reform and in private sector development. 42. The CAS provides scope for a multi-year programmatic series of operations to respond to the aftermath of recent economic shocks and to underpin an agreed program of reforms. The CAS envisages that the provision of budget support will depend on the new government s commitment to continue work to strengthen public financial management, improve revenue collection and expenditure prioritisation, and pursue structural reform. These goals are reflected in the TSDF and the policy actions supported by the proposed operation. COLLABORATION WITH THE IMF AND OTHER DONORS 43. The World Bank and the IMF have worked closely in Tonga and reached shared perspectives on key macroeconomic and structural reform issues. The Bank has participated in the last four Article IV missions, facilitating the discussions on fiscal policy and structural reform in particular. The Bank and the Fund jointly prepare the DSA each year for Tonga. Based on this cooperation, the Bank and the Fund share a common view about Tonga s macroeconomic and structural reform priorities. 44. The Bank has led efforts to coordinate development partners in the provision of budget support to Tonga. The World Bank represents all donors providing budget support on the Budget Support Management Committee, which is the primary mechanism for formal dialogue regarding selection of and monitoring progress against policy actions. AusAID budget support of AUD 5 million is expected to be mobilized for the same policy actions. A single point of contact between donors and Government reduces strains of coordination on Government, and World Bank co-ordination of this process reflects the strength of the dialogue between the Bank and the Government on economic policy as well as within the energy sector. ADB, AusAID, EC, PFTAC and NZ-IDG are all providing assistance to the 17

24 achievement of the proposed program of policy reforms through varying combinations of budget support and technical assistance. 45. The Bank cooperates closely with key development partners in the provision of analytical work and technical assistance to Tonga. ADB and PFTAC staff informally peerreviewed the Bank s macro-fiscal analysis in late PFTAC staff participated in Bank informal review processes for the Bank s technical assistance on the medium-term expenditure mapping. This work has been informed by, and is tightly integrated with, the ADB s technical assistance on a medium-term budget framework and PFTAC s technical assistance on a tax policy and administration review. Bank and ADB staff participated in the PFTAC-led tax review. RELATIONSHIP TO OTHER BANK OPERATIONS 46. The proposed program provides a key mechanism for strengthening policy engagement as analytical and financial support is scaled up. Total IDA and Trust Fund commitments to Tonga over the past three years amount to almost US$73 million, compared to $30 million between 1985 when Tonga became a member and FY10. All assistance has been provided on 100 percent grant terms. Bank leadership of the joint donor budget support process has played an important role in facilitating this expansion through strengthened policy dialogue around major infrastructure investments, including: i) a broadband cable, cofinanced with ADB (US$17.2 million); ii) transport sector reform, with Pacific Regional Infrastructure Facility (PRIF) and AusAID financing (US$14.7 million); and iii) aviation sector support (US$27.2 million). 47. The proposed operation builds on the previous economic recovery operation and the Bank s Energy Sector Development Policy Operation, undertaken in late The proposed operation represents a direct continuation of support to policy reforms identified during the first economic recovery operation, including through continued focus on public financial management reforms, fiscal policy, and structural reform. The proposed program also builds on the earlier energy-sector budget support operation, which helped the critical energy sector reform program to remain front and centre of the policy agenda in Tonga during the transition to a new government. The proposed operation will help to take the previous operation forward, by supporting the Government as it undertakes the next key policy actions needed to implement the TERM. LESSONS LEARNED 48. The proposed operation reflects key lessons learned from the four development policy operations that the Bank has undertaken in the Pacific Islands. The proposed operation draws lessons from the First Tonga Economic Recovery Operation, Samoa Economic Crisis Recovery Support Credit in mid-2010, and the Tonga Energy Sector Development Policy Operation in late

25 49. Development policy operations can be mobilised relatively quickly and achieve good results in the context of strong government ownership of a reform agenda. In both the Tongan and Samoan operations, budget support needed to be mobilised relatively quickly, with the Bank s ability to respond facilitated by strong government ownership of a reform agenda and an existing base of analytical work. In the case of Samoa, the reform agenda was broad, and substantive and realistic policy actions that could be supported within short timeframes were readily identifiable. In the case of Tonga, the government had a deep commitment to a sector-specific reform agenda, which formed a ready foundation for the operation. In both cases, the Bank s engagement provided momentum at a time when the reform agendas could have gone off-track due to the multiple challenges then facing the governments. For the proposed operation, the Government has a strong commitment to a broad reform agenda. Bank engagement has assisted the Government to clarify and sequence its reform program, and will provide momentum to implement the reforms in a challenging fiscal context. 50. Project-level engagement can assist in identifying key priorities to be supported through policy-based operations. Both the Tongan and Samoan operations demonstrated how prior project engagement can provide a vital foundation for identifying key policy reforms that can drive further progress in important sectors, assisting the implementation of the reforms, and tracking progress closely with relatively little additional monitoring effort. The leveraging of project and technical assistance engagements for policy-based operations is being repeated in the proposed operation in respect of the energy sector and public enterprise actions. 51. Close coordination and engagement with other development partners in the identification of policy priorities is useful in sectors where the Bank has limited knowledge and engagement. The Tongan and Samoan operations reflected the general context of Bank engagement in the Pacific Islands, with the Bank having insufficient presence to maintain in-depth knowledge of all sectors across all countries. In key sectors where the Bank did not have active project or policy engagement, task teams drew selectively on analytical work and advice from other development partners to quickly build knowledge and make judgments regarding policy priorities across a broad range of sectors. In the proposed operation, the task team worked very closely with other development partners to help identify possible reform areas and to gather background information and experience to judge potential actions, particularly from the ADB and IFC in the area of public enterprise reform and PFTAC in relation to revenue reforms. 52. Coordinated management of international aid flows, in the context of prudent fiscal policy, can provide vital support in mitigating the impacts of external shocks in the Pacific Islands. Without the aid flows provided to Tonga and Samoa to help them respond to the shocks they were facing, the impacts of these shocks would have been more extensive and prolonged. Development assistance played a vital role in financing essential government services, while maintaining macroeconomic stability. These operations demonstrated the 19

26 importance of coordination between macroeconomic policy and international aid flows in managing economic shocks, a lesson that is equally applicable to the proposed operation in Tonga, given the continuing effects of the shocks Tonga has experienced in recent years. ANALYTICAL UNDERPINNINGS Growth Prospects and Priorities 53. Recent analytical work highlights the importance of geographical constraints to growth in the Pacific. Under the Pacific Futures label, the Bank has worked with other development partners in analysing, discussing, and communicating the constraints of geography faced by small Pacific Island Countries, including during a seminar to discuss these issues, held in Suva, Fiji in November of All small countries face constraints to private sector development and the delivery of public services due to the absence of scale. Small markets undermine economies of scale in production, preventing specialization, while the fixed costs of Government must be met by smaller populations with narrower tax bases. Capacity constraints are also more severe than in larger countries, with a limited pool of individuals in various specialized fields required to fulfil all of the tasks of Government. Other, less remote, small countries have been able to somewhat mitigate the costs of smallness through trade integration, specializing in production of a small range of exports to finance high import reliance. Options for adopting such strategies are limited in Pacific Island Countries due to very severe geographical isolation, with high transport costs undermining the competitiveness of exports and pushing up the costs of imported inputs. Analysis has shown that such disadvantages are sufficiently severe to explain lower rates of growth in the region over recent decades. Reflecting inherent geographical constraints, small Pacific Island Countries have typically relied on labour mobility, natural resource industries (that can attract investment despite higher cost structures), and aid flows to support standards of living. Public Financial Management Reform 54. Performance indicators of public financial management in Tonga have shown an improvement in recent years. In the 2007 Public Expenditure and Financial Accountability (PEFA) assessment, Tonga received 16 ratings of C or better out of the 27 applicable indicators. In the 2010 PEFA assessment, the number indicators that Tonga scored C or better increased to 20, with further improvements observed against some indicators where performance was already strong. Reflecting tax policy and administration reforms, marked improvements were noted on the transparency of taxpayer obligations and liabilities, and the effectiveness of measures for taxpayer registration and tax assessment. Improvements were also noted for orderliness and participation in the annual budget process, the effectiveness of controls on payroll and non-salary expenditure, and the timeliness of accounts reconciliation. 55. The 2010 PEFA highlighted several weaknesses in PFM, which will be tackled over the course of the proposed multi-year programmatic series of operations. The 20

27 coverage of in-year budget reports was identified as an area for improvement, because the existing reports could not be used to compare actual and forecast revenues and expenditures, weakening control of budget execution. Public access to key fiscal information was found to be limited, in part because the budget proposal is made public only when it is approved, not when initially submitted to the legislature, and in-year budget reports are not made public. The process for legislative scrutiny of the budget was also found to be inadequate. Budget credibility was found to be weak at a disaggregated level, with significant variances in the composition of the outturn resulting from the shifting of resources between ministries during the year through the Contingency Fund. Significant weaknesses were found in the external audit process, in the scope, nature and follow-up of the external audit, and in legislative scrutiny of audit reports. Weaknesses were also identified in the chart of accounts, arrears collection, and timeliness of submissions of the annual financial statements. 56. A PFM assessment by PFTAC in 2010 provides further clarity on weaknesses and guidance on the appropriate sequencing of PFM reforms. In the assessment, PFTAC lays out the PFM building blocks that need strengthening in Tonga as a foundation for the planned introduction of a medium-term budget framework (MTBF). These include consolidating bank accounts, automating bank reconciliations and moving towards a Treasury Single Account (TSA), as well as improving the clarity and uniformity of application of the chart of accounts. Improved revenue, expenditure and cash flow forecasting is recommended, along with better monitoring of budget execution and more frequent consultations on execution with ministries. PFTAC also identifies the pressing need to strengthen planning processes in line ministries and the links between plans and the budget, and to control the use of the Contingency Fund. 57. The findings and recommendations of these reviews are closely reflected in the reform measures being supported by this program. Further improvements to quarterly budget reporting and the tabling of Government Financial Statements are expected to improve transparency and contribute, over time, to increased credibility. The establishment of a Single Treasury Account is also being supported through the proposed program. The first Economic Recovery Operation supported changes to the budget process in order to allow public release of the budget proposal, which occurred for the first time during the FY2012/13 budget process. Fiscal Policy Reform 58. The Bank s macro-fiscal analysis provided a foundation of knowledge for appropriate revenue and expenditure reforms in Tonga. The World Bank s macro-fiscal analysis, completed in 2011, showed how recent declines in tax revenue were driven by the adverse impact of the global economic crisis on remittances and the end of the domestic credit bubble on corporate taxes, as well as the coincidental timing of the completion of Tonga s tax reforms. This analysis provided a solid basis for the revenue policy and administration review carried out by PFTAC in The analysis also showed how expenditure restraint has 21

28 impacted on service delivery, with controls on discretionary expenditure in the context of wage bill expansion undermining expenditure quality and threatening higher future costs. These conclusions provided a basis for the detailed expenditure mapping work in FY2011/ A review of revenue policy and administration was carried out by PFTAC in 2011, and broadly confirmed the appropriateness of current tax policy settings. The review identified drivers of the sharp declines in revenue during 2008/09 and FY2009/10 as: (i) falling trade tax revenues due to planned reductions in trade tax rates and increased exemptions and non-compliance; (ii) falling income tax revenues due to reduced tax rates in the context of falling incomes and the global economic crisis; (iii) a substantial decline in consumption tax revenues, due to a decline in consumption of items with a large domestic value added component due to lower remittances and declines in the post-duty value of imported goods due to the reduction in trade taxes; (iv) various problems with exemptions and compliance. The review concluded that Tonga s current tax rates and structure are similar to many other countries and that overall tax performance is in the mid-range. The review recommended reforms to exemption and concession processes to improve transparency and reduce revenue loss, while also rationalizing, and making less severe, the existing penalty and interest regime for late payments and non-compliance. Over the medium-term, the review recommended the introduction of a presumptive tax for SMEs to reduce the administrative burden on the Revenue Service and new tax regimes for natural resources and land rentals. In the longer-term, the review recommended applying income tax to pensions to remove existing distortions and strengthen revenue. Reforms supported by this operation relating to the publication of tax expenditure information, the introduction of a presumptive tax, and the introduction of a natural resource revenue regime are all informed by this review. 60. The World Bank s expenditure mapping work has highlighted the need for careful expenditure reprioritization. This work was undertaken collaboratively with the MFNP during FY2011/2012, and assessed the scope for meeting expenditure needs in priority sectors in the context of continued fiscal constraint and upcoming debt-servicing pressures. The analysis shows that it is possible for Tonga to increase spending in priority areas over the medium term, but that this will require not only higher levels of tax collections and/or budget support but also wage restraint, such that the wage bill declines somewhat in real terms over the medium term - particularly in non-priority sectors. The analysis also highlighted problems with budget execution and identified the need for improved expenditure control, including through: i) placing more limits on discretion of line ministries to transfer resources in-year, which has typically occurred at the cost of priority areas and critical inputs; and ii) improving the definition and scope of programs and sub-programs to better reflect ministry activities and allow greater linkages between policy, planning, and budgeting. 61. PFTAC provided assistance to Tonga in strengthening its debt-management framework in late With debt servicing obligations due to expand rapidly over coming years, a PFTAC team worked with the Tongan authorities to identify and address system weaknesses and capacity gaps in debt management. The review recommended several steps 22

29 for strengthening the debt management framework, including: (i) establishing a clear policy for contracting all new debt, including evaluations against the objectives of the debt management strategy and ensuring consistency with the risk management objectives; (ii) developing a formal debt management strategy that identifies and quantifies the existing risks in the portfolio and determines a portfolio composition and borrowing strategy that is consistent with fiscal and monetary policies and realises the government s costs and risk objectives; (iii) forming an effective high-level policy committee to provide policy direction, oversight, and cross-government coordination to debt management operations; (iv) improving debt reporting practices, including producing a regular public report with complete debt information; and (v) strengthening key technical capacities of staff working in the debt management unit of the MFNP. The World Bank is currently planning to provide technical assistance to implement certain elements of recommended reforms. Structural Reform 62. The Tonga Energy Road Map (TERM) lays out a strategy to reduce Tonga s vulnerability to oil price shocks and achieve an increase in quality access to modern energy services in a financially and environmentally sustainable manner. The related analytical work traces the implications of oil price volatility for electricity prices, and the implications of rising oil prices and energy demand for the viability of renewable energy sources for the grid. The analysis demonstrates the need for a comprehensive reform of the legislative, regulatory and institutional framework applying to the energy sector including updating the regulatory framework for the electricity supplier to ensure its incentives are aligned to those of consumers in least cost energy sources. 63. Two studies by the Bank on the petroleum sector identify existing weaknesses in the regulatory structure and supply chain for petroleum, and lay out a series of reforms to remedy these weaknesses. 9 The studies show that around 90 percent of Tonga s energy needs come from imported petroleum products. Fluctuations in underlying fuel prices impose the biggest cost, with transport and storage costs imposing additional, but more limited, costs. The overarching recommendation is to prioritise reforms to strengthen the petroleum regulatory regime, improve the competitive environment and increase energy security. Several phases of reforms are recommended, in order to ensure that Tonga is better protected from volatility in world oil prices and that fuel costs in Tonga reflect efficient costs of supply, storage and distribution. In addition, reforms to the regulatory regimes for petroleum are recommended, to enable the benefits of these reforms to be passed on to consumers 64. The IFC has recently undertaken a comprehensive review of constraints to tourism development in Tonga. During April 2010, IFC Advisory Services (Pacific) worked with the Tongan Ministry of Tourism to identify constraints to tourism development through 9 The first study, The Regulation of Tonga s Petroleum Sector, was completed by the Bank in June The second study, Tonga Oil & Gas Supply Chain Efficiency & Price Stabilisation, was completed by the Portland Group for the Bank, also in June

30 the application of IFC s Tourism Sector Diagnostic (TSD) Tool. The primary objective of the diagnostic study was to identify and measure sector constraints, in order to propose and mobilise appropriate solutions. Key constraints to sustainable tourism development identified through the analysis included: (i) a lack of coordination and leadership in the tourism sector, with a need for clearer identification of priorities within the sector and closer collaboration between government agencies and the private sector in achieving these priorities; (ii) a lack of institutional capacity and resources within the tourism bureau, with a need for improved enabling legislation to support increased investor confidence and greater role clarity; and (iii) an outdated and cumbersome regulatory environment, with processes for foreign investment approval, establishing clear land titles, and the granting of business licensing needing to be streamlined. The diagnostic study also identified lack of a substantial accommodation product at a suitable price as a constraint on tourism sector development, with the absence of a large, high quality hotel impeding broader volume-based development of the industry, including the emergence of wholesale businesses in the tourism sector. Reforms to the business license regime supported by this operation are likely to contribute to improvements in the regulatory environment for tourism investment. Further improvements may be achieved through reforms to foreign investment legislation, identified as a potential area of focus for possible future operations. 65. The ADB has played the lead role among development partners on analytical work and technical assistance on public enterprise reform in Tonga. Tonga s portfolio of 14 public enterprises currently includes 8 infrastructure service providers and 6 enterprises engaged in commercial activities, with a combined asset value the equivalent of about 40 percent of GDP (in FY2008/09). The ADB s latest benchmarking study of the performance of public enterprises in the Pacific, Finding Balance, shows that Tonga s public enterprises outperform those of the other Pacific Islands in the study, with an average return on equity between FY2001/02 and FY2008/09 of 6 percent and an average return on assets of 3.6 percent. Tonga has also set the pace for public enterprise reform, including through legislative reforms, strengthened governance frameworks, restructuring of boards, and the rationalisation and privatisation of public enterprises. Public enterprise reforms have slowed in the last year, due to the difficulty involved in the next phase of reforms, which requires the consolidation of existing reforms and further progress on the rationalisation and privatisation agenda. 66. Analytical work by the IFC and the ADB has highlighted areas of Tonga s business licensing system that are in need of reform. The IFC, in its 2009 study Reviewing the Business Licence in Tonga, reviews and provides recommendations on the reform of the general business licence process and the nine activity-specific business licences that operate in Tonga. The extent of the reform needed for the different licences vary, but one general finding is that administrative resources are unduly focused on issuing licences, at the cost of enforcing compliance with the terms of licences. Licensing is frequently used as an enforcement tool for performance and compliance, when other means could be more cost effective and less burdensome to the majority of businesses. The ADB s recent Private Sector 24

31 Assessment reinforces the message about the need to reform business licensing. This need will be addressed through the business license reforms supported by this operation. Poverty Analysis 67. The Social Protection Issues Paper prepared for the MFNP by the ADB shows that basic needs poverty in Tonga has risen over the last decade, and that there are significant gaps in Tonga s social protection framework. The paper analyses the results of the 2009 Household Income and Expenditure Survey (HIES), to show the increase in basic needs poverty since the 2001 HIES (see Table 3). The analysis shows poverty to be highest outside Nuku alofa on the main island, Tongatapu, but to have risen most sharply on Tonga s other islands. While the proportion of women with expenditure below the basic needs poverty line is quite similar to the population averages in each region, the incidence of poverty among children is notably higher. The paper highlights that a significant portion of the population lives just above the basic needs poverty line, thus a small event could push many more households below the poverty threshold. The paper shows that the Government provides good access to basic education and health and gives annual grants to a number of non-government organisations that provide social services to the disadvantaged. Table 3: Poverty Incidence in Tonga by Region, 2001 and 2009 Percentage of Households/Population With Expenditure Below the Basic Needs Poverty Line Households Population Disaggregation (2009) Women Children National Average Nuku alofa Rest of Tongatapu Other Islands Source: Ministry of Finance and National Planning (Tonga Department of Statistics and 2009 HIES). V. THE PROPOSED SECOND TONGA ECONOMIC RECOVERY OPERATION OPERATION DESCRIPTION 68. The Second Tonga Economic Recovery operation is the second in a programmatic series of two operations. The operation will be financed by IDA resources of $1.8 million and AusAID is expected to provide associated sector budget support of AUD 5.0 million (US$5.3 million) for the same policy actions and dependent on the Bank s operation being approved. The multi-year programmatic series of operations is designed to support the Government of Tonga in implementing key aspects of its medium-term reform agenda, while providing a predictable flow of resources in a challenging fiscal environment. The operations are being implemented to help meet a clear need for budget support in the context of lingering 25

32 impacts of the GEC and the weak global recovery, including rising poverty, falling remittance flows, a large contraction in tax revenues, and poor export performance. The operations support the reform agenda of Tonga s first majority-elected parliament at a critical juncture in Tonga s development process. 69. The operation is timed to prevent the erosion of Tonga s limited cash reserves and avoid the need for disruptive cash-rationing. Government total cash balances were TOP$25 million at the start of FY2012/13. The Budget for FY2012/13 is balanced on a cash basis, based on projected budget support grants of TOP$22.5 million. Budget support provided by donors is already likely to fall below budgeted levels by as much as TOP$10 million an amount equivalent to 40 percent of current cash reserves. A delay in receipt of budget support would place further pressure on cash resources, and see cash reserves fall to around TOP$8 million (or around 2 weeks of recurrent expenditure) by the end of the third quarter of the fiscal year, assuming no further external disruptions to revenue and no unforeseen variance in expenditure. This would leave the Government of Tonga highly vulnerable to any shocks, such as the unexpected continuation of declines in remittances during the first months of the current fiscal year. While the Government of Tonga may have some capacity to smooth cash-flows during the year through the issuing of Treasury bills, this mechanism has not been recently utilized. A quickly-implemented bond issue would place additional strain on already-overstretched treasury staff. 70. The programmatic series of Tonga Economic Recovery Operations supports three key elements of Tonga s development agenda. These are: i) strengthening public financial management; ii) strengthening fiscal policy; and iii) promoting structural reforms relating to the business regulatory environment. The Second Tonga Economic Recovery Operation builds on progress achieved through the previous operation, and maintains focus on further key reforms in three of these areas of the Government s reform agenda. In the area of public financial management, priorities include strengthening PFM building blocks, strengthening execution of the budget and increasing transparency of key budget processes. Under fiscal policy, the agenda focuses on strengthening revenue effort in the context of recent revenue declines. In relation to structural reform, the operation will support private sector development through an improved business regulatory environment. The prior actions supported by the program and the evidence provided of their completion are listed in the table below. 26

33 Table 4: Prior Actions and Evidence of Completion under Second Tonga Economic Recovery Operation Prior Actions and Evidence of Completion POLICY AREA 1: STRENGTHENING PUBLIC FINANCIAL MANAGEMENT 1. A Treasury Single Account has been implemented for all Government-funded operations, as evidenced by letter No. 69/7/2/238 from the Minister of Finance, dated September 11, 2012 received by the Association. 2. Quarterly reports have been made available on the Ministry of Finance and National Planning website on a timely basis (within 45 days of the end of the reporting period), as evidenced by the publication on August 10, 2012 of same for the period ending on June The Recipient s Cabinet has approved the submission to Parliament of the audited Financial Statements of Government up to FY2010/11 as evidenced by the Cabinet minutes No 813 and the Cabinet minutes No 814, both dated September 18, POLICY AREA 2: STRENGTHENING FISCAL POLICY 4. Details regarding the cost by category of tax expenditure during the previous year have been published in the annual Budget Statement for FY2012/13, as evidenced by the Budget Statement dated June 2012 received by the Association. 5. The Recipient s Cabinet has approved the introduction of a presumptive tax for SMEs, consistent with the recommendations of the PFTAC Tax Review, as evidenced by the Cabinet minutes No 781, dated September 14, The Recipient s Cabinet has approved the introduction of a natural resource revenue regime, consistent with the recommendations of the PFTAC Tax Review, as evidenced by the Cabinet minutes No. 781 dated September 14, POLICY AREA 3: PROMOTING STRUCTURAL REFORM 7. The Recipient s Cabinet has approved the submission to Parliament of legislative changes to reduce the number of business license classes and extend license duration, as evidenced by the Cabinet minutes No.810, dated September 14, Continuation of the series through a second operation is appropriate given progress achieved to date and continued need for budget support assistance. While some triggers specified under the first operation have been missed, the Government of Tonga has made substantial progress under all areas of the reform agenda. Delays in progress in the electricity sector clearly reflect implementation problems, rather than a lack of Government commitment to reform. Broader progress in both the petroleum and electricity sector has been achieved. Progress against specified actions is considered sufficient to achieve the development objectives of the program. At the same time, ongoing macroeconomic challenges have elicited renewed commitment to key economic and fiscal reforms, including key reforms in areas supported by the Bank program, while necessitating ongoing budget support. With remittance flows continuing to decline, loan-financed construction projects coming to an end, consumption remaining sluggish, and large debt repayment obligations coming due, grant support needs to be maintained at levels seen over previous years to avoid either an unsustainable deterioration of the macroeconomic framework or substantial declines in declines in delivery of vital services. 27

34 72. Technical assistance is being provided to support the achievement of several policy actions. Reflecting the extent and seriousness of capacity constraints in key areas of reform, technical assistance from various donors is being provided to assist in the implementation of several policy actions (Annex 4). Provision of this technical assistance is likely to contribute to capacity building in key reform areas, although the extent to which sustainable capacity building can be achieved will be limited by small staff numbers and high staff turnover, typical of Pacific contexts. It is therefore likely that continued technical assistance will remain critical to support reforms under any possible future operations. 73. Consistent with the approach proposed during the first operation, the decision to proceed with a second operation has been based on an assessment of overall progress across reform areas. Substantial progress has been achieved in all policy areas supported by the Bank through the previous operation. Some specific triggers have not been met due to delays, often beyond the control of the Government of Tonga, or changes in policy focus within a fluid economic and political context. In other cases, targets established as triggers have already been met or exceeded. Accordingly, there have been changes between the prior actions used for the Second Tonga Economic Recovery Operation and those specified as triggers under the first operation. Reasons for changes from the triggers are provided in Table Policy actions have been updated to reflect the extent of progress. In relation to public financial management, DPO II prior actions relating to publication of quarterly reports and publication by gazette of the financial statements of Government have been adjusted from DPO I triggers, and a new action relating to the introduction of a Treasury Single Account has been added, to reflect faster-than-expected progress against previously-identified triggers. In relation to structural reform, DPO I triggers relating to the introduction of a revised electricity tariff and the privatization of the Dateline Hotel have been dropped, due to slower-thanexpected progress to date. An additional DPO II prior action, relating to business license reform, has been added, reflecting the extent of progress in other areas of the Government s structural reform agenda. The DPO I trigger relating to the community public works scheme has not been included. Given that policy decisions regarding implementation of the community public works scheme have now been made, implementation is considered to be best pursued through project-level engagement. The Bank has reviewed, with the authorities and development partners, the progress in the implementation of the reform program and, considering the areas of faster than expected progress as well as those with slower than expected progress, has found overall progress to be robust (see Table 5). The Bank expects that the reforms and policy implementation through the actions supported by both the first and the second operation will cumulatively help Tonga achieve the development objectives of its reform program supported by this series of operations. 28

35 Table 5: Progress in Completing Triggers Specified Under First Operation and New Prior Actions FIRST OPERATION TRIGGER / SECOND OPERATION PRIOR ACTION New prior action for Second Operation: 1) A Treasury Single Account has been implemented for all Government-funded operations. Trigger identified in First Operation: Make the quarterly budget reports available to the public, to improve the transparency of budget execution. Prior action for Second Operation: 2) Quarterly reports have been made available on the Ministry of Finance and National Planning website on a timely basis (within 45 days of the end of the reporting period). Trigger identified in First Operation: Table the outstanding annual reports from the Auditor-General in Parliament, to improve the transparency of the audit process Prior action for Second Operation: 3) The Recipient s Cabinet has approved the submission to Parliament of the audited Financial Statements of Government up to FY2010/11. Trigger identified in First Operation: Implement reforms recommended by the tax policy and administration review, in order to improve revenue collections over the medium term. EXPLANATION Progress towards implementation of a Treasury Single Account has been part of the policy dialogue with the government since the last operation. This action has since been prioritized by the government and Tonga now fully meets the definition of a Treasury Single Account for government operations. Progress has been achieved in making quarterly reports available to the public, but often with a significant delay. The change to the action ensures that the potential transparency gains from publication are maximized by requiring publication within 45 days of the end of a reporting period. Annual reports of the Auditor General have now been brought up-to-date, but these reports have omitted the annual financial statement of Government on the grounds that they have not been submitted by the Minister of Finance. This has somewhat undermined the transparency gains of formal compliance with the previously specified trigger, and this has been rectified with the revised action. Specific recommendations of the tax policy and administration review are included as individual policy actions 4-6. Prior Actions for Second Operation: 4) Details regarding the cost by category of tax expenditure during the previous year have been published in the annual Budget Statement for FY2012/13; 5) The Recipient s Cabinet has approved the introduction of a presumptive tax for SMEs, consistent with the recommendations of the PFTAC Tax Review; and 6) The Recipient s Cabinet has approved the introduction of a natural resource revenue regime, consistent with the recommendations of the PFTAC Tax Review. 29

36 Trigger identified in First Operation: Implement a new electricity tariff that, inter alia, provides for full cost recovery, establishes financial incentives to generate and distribute electricity efficiently, and institutes a lifeline tariff. Partially completed: Not a prior action for Second Operation. A tariff review was required to inform the development of a new electricity tariff. Cabinet agreement to that review was included as a prior action under the first economic recovery operation. Due to implementation delays, including in the mobilization of required technical assistance from development partners, the review is now likely to be completed only in third quarter of 2012 too late for the implementation of a new tariff within timeframes for this operation. Trigger identified in First Operation: Amend the regulatory framework for the petroleum sector to, inter alia, define the regulated assets of petroleum suppliers, institute systems to independently value and inspect the regulated assets of petroleum suppliers, and establish a system of shared supplier shipping among petroleum suppliers. Delayed: Not a prior action for Second Operation. New prior action for Second Operation: 7) The Recipient s Cabinet has approved the submission to Parliament of legislative changes to reduce the number of business license classes and extend license duration. Trigger identified in First Operation: Bring the International Dateline Hotel to the point of transaction, as recommended by an internationallyreputable transaction adviser. Partially completed: Not a prior action for Second Operation. Trigger identified in First Operation: Complete the pilot of the community public works program, and take into account lessons learned for scaling up the program. Progress in implementing planned regulatory reforms in the petroleum sector has been slower than expected, due to continuing capacity constraints within the TERM Implementation Unit and the Ministry of Commerce, Labour and Industry, and a shift in Government s petroleum sector policy priorities towards the purchase and refurbishment of storage and distribution assets. Government, following extensive dialogue with donors and the private sector on private sector development, is now taking action on the business environment agenda, and has sent legislation to Parliament to simplify the business license regime. Progress against this action has been slower than expected due to changes in Government policy regarding the appropriate scope of private participation. The Government, with IFC support, remains committed to some form of public-private partnership. This action is, however, unlikely to be completed for this operation given the time required for full consideration of options and due diligence requirements. Given that policy decisions regarding implementation of the community public works scheme have now been made, implementation is considered to be best pursued through project-level engagement. No longer relevant: Not a prior action for Second Operation. 30

37 75. As during the previous operation, the Bank has coordinated dialogue between Government and development partners to produce a joint policy matrix. The Bank has worked with Government and development partners in coordinating the formulation of a joint policy matrix (see Annex 5). AusAID is providing budget support for actions included in the joint matrix, while the ADB, PFTAC, EU, and the IMF have also been closely involved in the policy discussion. PFTAC and ADB are providing technical assistance to the Government of Tonga in implementing included actions. Coordinated dialogue has brought benefits in terms of ensuring strong Government ownership but also required flexibility on the behalf of development partners in agreeing detailed content of reform actions that aligns with Government priorities. 76. Decisions regarding future budget support will be made in light of country developments and dialogue with Government and development partners. The nature and scope of any possible program underpinning future Bank budget support remains to be determined. A possible future program of support from the Bank could be tightly aligned with an extension of reforms supported through the current operation (including energy sector reforms and the Dateline hotel). However, program content will remain flexible and fluid, given Tonga s evolving economic and political context. Any final decisions regarding future program design will reflect ongoing dialogue with Government and other development partners through existing joint-donor dialogue processes. ADB, AusAID, and the EU are likely to be providing budget support during Box 1: Good Practice Principles for Conditionality Principle 1: Reinforce Ownership Policy actions are aligned with the priorities of the TSDF as explained in the section on Government s program and participatory processes. Prior actions reflect broader consultation with the private sector, through the Tonga Economic Dialogue. The Tongan Cabinet has been consistently involved in the development of the joint policy matrix and has approved the content of the matrix at key stages. Joint donor budget support has been provided to Tonga for several years, and the recent track record of success in implementing agreed prior actions and broader policy reforms demonstrates ownership and commitment to reform progress (see Annex 5). Extensive analytical work underpins the selection of policy actions as explained in the section on analytical underpinnings. Principle 2: Agree upfront with Government and other financial partners on a coordinated accountability framework The Bank has worked to coordinate between Government and donors in developing a joint policy matrix providing coordinated accountability for the current operation and the previous operation. Bank and AusAID financing is being mobilized to support a harmonized set of actions included in the joint policy matrix in FY13. The joint policy matrix has now been accepted by development partners as a joint basis for budget support in FY14 and future years. The joint policy matrix is included as Annex 5. Principle 3: Customize the accountability framework and modalities of Bank support to country circumstances The modality and timing of support is well suited to country needs as described in the country context section and the operation description section. Largely due to exogenous economic shocks, Tonga faces a need for immediate budget support assistance to offset revenue declines and avoid deterioration in the provision of vital services and an associated reduction in living standards. The timing of the operation reflects the need to avoid an undesirable depletion of fiscal buffers in the context of ongoing global economic uncertainty. Identified policy actions are intended to support implementation of Government reform priorities while providing a much-needed flow of fiscal resources at a critical juncture in Tonga s development trajectory. Principle 4: Choose only actions critical for achieving results as conditions for disbursement Policy 31

38 actions have been subject to extensive consultation with Government and donors. These consultations have been undertaken with an explicit objective of minimizing the number of supported reforms while ensuring the achievement of program development objectives. The choice of a limited set of seven high-impact policy actions reflects both the importance of these actions to the achievement of improved fiscal sustainability, strengthened economic development, and greater transparency in Government operations, while also taking account of the extent of capacity and resource constraints facing Government in implementing policy reforms. Principle 5: Conduct transparent progress reviews conducive to predictable and performance-based financial support The joint policy matrix process has been developed to a regular cycle that aligns with the Government s budget process and provides for disbursement in accordance with cash-flow needs. Bank and AusAID monitoring and evaluation processes are entirely aligned and the joint donor process is intended to achieve predictability in budget support. Within inevitable data constraints, reviews are focused on results achieved, based on the Bank s operation policy matrix. POLICY AREAS Strengthening Public Financial Management (i) First Tonga Economic Recovery Operation 77. To strengthen budget execution, the First Tonga Economic Recovery Operation supported the introduction of an in-year budget reporting system that tracks key budget information on a monthly and quarterly basis. Prior to the implementation of this system at the beginning of FY2011/12, the Government lacked an adequate analytical tool for identifying major in-year deviations from the approved budget. Cash forecasts and actual expenditure reports were prepared separately, and were produced infrequently and seldom in a timely manner. With World Bank technical assistance, the Government built consensus around the appropriate format for monthly and quarterly monitoring reports and developed the capacity to sustain the ongoing production of these reports. 78. Implementation of the new reporting system has exceeded expectations. Reports have been consistently produced on a monthly basis. As well as information on revenues, expenditure, and balances, reports also identify problems with budget execution within ministries, track use of the contingency fund, and monitor unbudgeted expenditure. Reports have been used extensively by the budget team in interactions with Ministers, with quarterly reports used as the basis for the mid-year budget review report and presentation to Cabinet. All monthly reports are also presented to Cabinet, contributing to increased awareness of expenditure constraints in the current environment, and supporting improvements in overall fiscal management, such as the recent successes in reducing the extent of inappropriate drawdowns from the Contingency Fund. 79. To strengthen budget transparency, the First Tonga Economic Recovery Operation supported reform of the budget calendar so as to make budget proposals available to the public when tabled in the Legislative Assembly. Prior to these reforms, the budget was only made public after it had been approved by the Legislative Assembly. In the 32

39 absence of access to the budget proposal, the public and civil society groups were not able to engage in debate regarding its contents and it was impossible to identify stages at which key changes to the budget were introduced. Reforms were effective not only in supporting increased transparency, but also encouraging greater Cabinet engagement in the development of the budget proposal. Increased Cabinet ownership of the budget has supported greater consideration of the detrimental impacts of unplanned in-year transfers across ministries, and strengthened the credibility of the budget. (ii) Second Tonga Economic Recovery Operation 80. To improve the management of cash flows, a Treasury Single Account has been implemented for all Government operations. Government has maintained momentum over several years in closing redundant bank accounts and retiring various revolving funds that undermined the clarity of budget data and documentation. Progress in this regard has allowed Government to substantially improve its capacity to monitor and control cash-flows and facilitated the streamlining of regular bank reconciliations. During March, 2012, 45 bank accounts were closed or consolidated into the Government s five main accounts (an operating account, a government development account, a national emergency fund account, a National Reserve Bank account, and a development fund account for donor funds). Following substantial consolidation of accounts over recent years, this action is considered to bring Tonga into compliance with best-practice criteria for a Treasury Single Account, with a unified structure of accounts that enables consolidation and better utilization of government cash balances. While development partners continue to require the maintenance of several separate project accounts, cash resources under Government control are now fully fungible across various resourcing needs, with complete cash balance information across Government accounts provided to the MFNP on a daily basis. 81. To strengthen budget execution and transparency, quarterly reports have been made available on the MFNP website on a timely basis (within 45 days of the end of the reporting period). While monthly and quarterly reports have been prepared reliably, and to a high quality standard, there have previously been substantial delays between the end of a reporting period and the publication of the relevant report. This has somewhat limited the usefulness of the reports in informing immediate budgeting decisions and reduced transparency of deviations from the budget over the short-term. Under the Second Economic Recovery Operation, the MFNP has made quarterly reports available on the MFNP website within 45 days of the end of the relevant reporting period. This action has required delays to be reduced in the time taken for the MFNP to collate the required data and prepare the report, the time taken for Cabinet to clear the report for publication, and the time taken by the MFNP to place the report on the website. The transparency and accountability yielded by this action will help further strengthen budget execution, including through reinforcing incipient demand for budget execution information from NGOs and civil society. Government is already planning training for Cabinet Ministers and senior public servants in the use and interpretation 33

40 of published reports, with such training intended to be provided to civil society groups and NGOs over the next year, leveraging additional transparency and accountability benefits. 82. To further strengthen transparency, the Recipient s Cabinet has approved the submission to Parliament of the audited Financial Statements of Government up to FY2010/11. Annual Financial Statements of Government were omitted from the coverage of the Auditor General s Annual Report during FY2009/10 and FY2010/11. Auditing of the FY2009/10 Annual Financial Statements was delayed by a special Parliamentary Committee enquiry into misuse of ministry-administered bank accounts. With the enquiry now complete, rapid progress has been achieved. Annual Financial Statements for both FY2009/10 and FY2010/11 have been completed and audited, and Cabinet has approved the submission of the Audited Financial Statements of Government to Parliament during its next sitting. This establishes a new precedent for compliance with basic transparency and accountability standards through the audit process and will help embed increased accountability under the new political system. 83. Supported reforms have occurred in the context of broader efforts to strengthen budget execution and transparency. The Government has successfully improved aggregate budget execution and realized a cash surplus of around TOP$20 million in FY2011/12. While also reflecting improvements in revenue performance and higher-than expected budget support grants, this result has been supported by greater discipline in the use of the Contingency Fund. The amount allocated to the fund was reduced to TOP$3.2 million in FY2011/12 (from $6.7 million in FY2010/11), and only $2.1 million of this amount was accessed during the year. The Government has also made substantial progress in budget transparency. The budget proposal, as submitted by Cabinet to Parliament, was publically released on the MFNP for the first time during the FY2012/13 budget process. The MFNP is currently preparing a series of information sessions on interpretation of budget documentation and upcoming expenditure management challenges. The audience will initially be restricted to Cabinet Ministers and Chief Executives of Ministries, with additional sessions for civil society organizations and NGOs planned for next year. These training sessions are expected to leverage the accountability benefits of progress in publishing quarterly budget reports, quarterly debt reports, the annual budget statement, and the approved estimates on the MFNP website. (iii) Possible subsequent operations and expected outcomes 84. To improve budget execution, any possible subsequent operation could support the revision of the chart of accounts to provide improved control and greater transparency in resource allocation decisions. The Government is implementing a major public service restructuring for the 2012/13 fiscal year. This restructuring will include the separation and combination of several ministries, and accompanying changes to ministry roles and responsibilities. The Bank and ADB are currently providing a range of technical assistance to the Public Service Commission and the MFNP to support the restructuring, 34

41 including work to ensure that: i) new ministry structures, roles and responsibilities are accurately represented in corporate plans; and ii) the outputs of ministries specified in corporate plans align to ministry programs and sub-programs resourced through the budget, with resources commensurate to delivery of clearly-defined outputs being provided. Progress in this direction would represent a major improvement in the transparency and control of resource allocation decisions over the current budget framework, under which ministries are granted discretion over the movement of money within a very small number of often-large and inadequately defined programs that do not align to service delivery responsibilities articulated in corporate plans. 85. Broader public financial management reforms are planned. The Government of Tonga engaged technical assistance from PFTAC and the ADB during 2012 to develop a PFM reform roadmap, based on the most recent PEFA assessment. The roadmap will outline a prioritized and sequenced program of PFM reforms supporting a gradual movement towards policy-based budgeting within a sustainable medium-term framework and with clear links between the budget and various planning documents to address the greatest current challenges to macroeconomic management and improved service delivery. Implementation of key elements of the roadmap could be supported through possible future budget support from the Bank or other development partners. 86. Over the medium term, the supported reforms are expected to improve the credibility of the budget and increase public access to key fiscal information. On budget credibility, the measure chosen as a monitoring indicator is the composition of the expenditure outturn relative to the approved budget (PEFA Indicator 2). In conjunction with the wider PFM reforms being undertaken by the Government, improving budget monitoring through the in-year reporting system is expected to strengthen budget execution and bring actual outturns closer to the approved budget. Over the last decade, the Government s performance on PEFA Indicator 2 has been a 0 5 percent deviation in four years, a 5 10 percent deviation in three years, and a percent deviation in three years (equivalent to a C ). The medium term target is to reduce deviation to 0 5 percent in most years (a B ). On public access to key fiscal information, PEFA Indicator 10 has been chosen as a monitoring indicator. To date, the public has had timely access to only one of the six specified key budget documents comprising the indicator (equivalent to a C ). The medium term target is to increase this to three documents (a B ). Strengthening Fiscal Policy (i) First Tonga Economic Recovery Operation 87. To improve the management of the public sector wage bill, the First Tonga Economic Recovery Operation supported measures to bring recruitment in all parts of the public service under centralized control, and applied a partial hiring freeze. Tonga has historically faced major challenges in the management of its wage bill. In the context of 35

42 revenue pressure and expenditure control measures, inadequate control over the wage bill contributed to a squeeze on non-wage expenditure. Between FY2008/09 and FY2010/11, the wage bill as a proportion of government-funded expenditure (excluding debt service) rose from 41.6 percent to 58.0 percent. While wage increases played a major part in driving expenditure increases, inadequate central-agency control over recruitment by some agencies also led to unchecked expansion in the number of civil service positions. 88. Control measures have proven largely successful. A Treasury Circular was issued in the third quarter of 2011, specifying that: i) the MFNP must confirm availability of funds before any new recruitment or filling of existing positions could take place, with PSC providing advice on the need for the new position; and ii) recruitment to existing vacant positions was to only proceed if the position was at a technical level and vital to service delivery, and if options for internal redeployment had been exhausted. While some ministries have filled vacant positions that are not in accordance with the Treasury Circular, they have generally done so after the MFNP has provided confirmation of the availability of funds. Centralized control over new recruitments has been generally maintained, although a small number of new positions have been created through the year in Ministries of Health, Agriculture, Police, and Foreign Affairs without MFNP approval. The FY2012/13 Budget Circular includes a statement of Government policy to reduce the wage bill to 45 percent of recurrent expenditure. FY2012/13 Budget allocations reflect this policy, with wage-bill allocations declining as a share of total recurrent expenditure. The hiring freeze remains in place as the Government moves to consolidate the restructure of ministries implemented at the beginning of the fiscal year, with hiring only to resume once resourcing needs under the new structure have been carefully considered by the MFNP and the Public Service Commission. (ii) Second Tonga Economic Recovery Operation 89. To further strengthen fiscal policy, the Recipient s Cabinet has implemented or approved various reforms recommended by the recent tax policy and administration review. As an outcome of dialogue around budget support, development partners agreed to support Government in undertaking a major review of tax policy and administration during FY2011/12. This review was completed in late 2011, and consistent with DPO I triggers DPO II will support as prior actions implementation of several reforms recommended by this review. 90. To improve processes and transparency in the granting of exemptions, details regarding the cost by category of tax expenditure during the previous year have been published in the annual Budget Statement for FY2012/13. The total cost of various tax exemptions was estimated at TOP$44.6 million for the period July 2009 to August 2011 (equivalent to 17 percent of total recurrent expenditure in FY2011/12). The current exemptions regime includes some measures that serve a legitimate policy purpose, but the Government considers that there remains significant scope to reduce the costs of exemptions through improved processes and transparency. Under the Second Economic Recovery 36

43 Operation, the total costs of tax expenditure were published in the annual budget statement, disaggregated by the exemption classification. With World Bank Technical Assistance, the Budget Unit provided an explanation of current costs and recent trends in relation to specific tax expenditure items. Inclusion of this information in the Budget Statement will continue in subsequent years. This level of transparency is expected to ensure greater rigor and consistency with policy in the granting of exemptions, while providing information by which the public can assess the benefits of such exemptions against their costs. 91. To encourage tax compliance and reduce administrative burdens on Tonga Revenue Services, the Recipient s Cabinet has approved the introduction of a presumptive tax for SMEs, consistent with the recommendations of the PFTAC Tax Review. The existing tax regime for small and medium enterprises is onerous in Tonga. All businesses, regardless of size are required to keep the same records and prepare the same accounts. Compliance costs are high for businesses, discouraging registration and compliance, and for Revenue Services, which diverts scarce capacity into processing small business taxes, at the expense of improved surveillance over large tax-payers. To address this, Cabinet has approved introduction of a presumptive tax for SMEs. The presumptive tax will apply a lump sum tax for businesses with turnover less than a low specified level, and a low percent tax on gross turnover for small businesses with turnover above this level. Small businesses will retain the ability to opt into the standard income tax, but would be required to stay in the regime for an extended period of time and would have to adhere to the income tax record keeping requirements. The new tax regime will impose a roughly equivalent liability on SMEs as under the current system, but substantially reduce associated compliance costs. The Government is committed to the implementation of these reforms by mid-2014, following the provision of necessary technical assistance on specific design issues, and a suitable program of consultation and communication. The next step is Cabinet agreement to specific rates and levels for the new tax, scheduled for March, To ensure that benefits of prospective natural resource investments are maximized, the Recipient s Cabinet has approved the introduction of a natural resource revenue regime. Tonga has significant natural resource endowments, including forestry (mainly sandalwood) and fisheries. To date, the absence of a clear natural resource tax framework has prevented Tonga from maximizing returns from associated extractive industries. With recent World Bank and IMF analysis emphasizing the likely continuing importance of natural resource industries to Tonga s economic development, and current prospecting underway for undersea mineral deposits, government has identified the need to introduce an appropriate natural resource revenue regime. Accordingly, Government has approved the introduction of an international best-practice framework, consisting of: i) an ad valorem royalty, with a rate in the range of 2 to 4 percent for minerals and around 10 percent for oil, applied to the freight on board export price of the minerals; the corporate income tax (CIT); and a resource rent tax (RRT) with a tax rate in the range of 20 to 35 percent, and an accumulation rate in the range of 15 to 25 percent. Cabinet has also approved a timetable for 37

44 the implementation of the natural resource tax regime, with legislation expected to be enacted late in Ensuring the existence of a transparent and appropriate revenue regime will help attract much-needed investment in prospective natural resource industries while ensuring a fair share of natural resource wealth is retained by the people of Tonga. While offshore mining prospects remain uncertain, regional experience indicates the importance of establishing revenue frameworks prior to natural resource investments, in order to avoid arbitrary and ad hoc arrangements around individual investments. The Government is committed to this reform, based on strong support from the Ministry of Labor, Commerce and Industry and industry groups, and the high priority accorded to this work in the recent PFTAC review. 93. DPO II prior actions have occurred in the context of broader efforts to improve fiscal policy. Cabinet has agreed to a number of measures to control expenditure growth and better prioritize resources. These measures are informed by the recently-completed expenditure analysis work by the MFNP with World Bank technical assistance. 10 On the expenditure side, several measures to improve the quality of expenditure are included in the 2012/13 budget guidance including: i) the maintenance of the current hiring freeze until the completion of the Government restructure; ii) the establishment of a process for ensuring appropriate reallocation of staff under the restructure; iii) the continued commitment to a policy target to reduce payroll costs to 45 percent of recurrent expenditure; and iv) a requirement that all new spending proposals are aligned with priorities identified in ministry corporate plans. Accordingly, the FY2012/13 Budget included several positive expenditure measures, including a reduction in the proportion of recurrent expenditure dedicated to wages and salaries, a further reduction in appropriation to the Contingency Fund (to TOP$2.0 million from TOP$3.2 million in FY2011/12), and a general rebalancing of expenditure towards health and education. On the revenue side, recent additional reform measures include: i) a Cabinet decision to review existing exemptions with a view to terminating them in order to increase revenues and remove distortions ; and ii) plans to reinstate a exemptions committee staffed by senior officials, including the Secretary of Finance to advise the Cabinet Economic Development Committee on the eligibility of exemption applications under existing legislative provisions. (iii) Possible subsequent operations and expected outcomes 94. Possible subsequent operations may support additional key steps towards the introduction of a presumptive tax for SMEs and the introduction of an appropriate natural resource revenue regime. Agreed changes to the SME regime and the development of a natural resource revenue regime will take time, and possible subsequent operations could support additional steps towards the end of legal implementation. Such steps could include the completion of required consultation and communication processes, the drafting of legislative changes, or the presentation of revised legislation to parliament. 10 Findings of this work are summarized in the Analytical Underpinnings section. 38

45 95. Over the medium term, the reforms supported by the current multi-year programmatic series of operations are expected to enable the Government to keep its actual wage bill in line with the budget and to reduce the cost of exemptions as a proportion of consumption tax and import duty revenues. With respect to the wage bill, the monitoring indicator chosen is the variation between the actual wage bill and the budget. Over the last decade, this has averaged approximately 3.7 percent (excluding the year of the civil service strike and major wage settlement). The medium term target is to reduce this variation to below 2.5 percent. This target was achieved in FY2011/12, with recurrent Government wage expenditure within 1 percent of budget allocations. A new indicator has been added under the Second Tonga Economic Recovery Operation to take account of the new emphasis on revenue reforms. The monitoring indicator for tax changes is cost of exemptions as a proportion of total consumption tax and duty revenues. The medium-term target is no further increases from a FY2010/11 baseline of 30 percent. Promoting Structural Reform (i) First Tonga Economic Recovery Operation 96. The First Tonga Economic Recovery Operation supported the approval of guiding principles for reforming the electricity tariff structure, aimed at a financially sustainable and efficient electricity sector, taking into account the planned shift to renewable energy, with adequate protection for the poorest consumers. The Bank has been heavily engaged in the Tongan energy sector and the implementation of the Tonga Energy Roadmap, and is supporting reforms in the electricity and petroleum sectors. The design of the existing electricity tariff presents obstacles to achieving Tonga s energy policy objectives. Under the current tariff design, the utility Tonga Power Limited can fully recoup its diesel costs through electricity tariffs and therefore lacks a strong incentive to buy electricity from cost-effective renewable suppliers. Incentives to minimize the cost of its petroleum imports or use diesel inputs more efficiently could be strengthened. In addition, the existing electricity tariff does not provide any protection to the least-well off electricity consumers, in the form of a lifeline tariff or similar fully-funded community service obligation. The absence of any protection for the poor contributes to political resistance to oil price rises being passed on in electricity tariffs, particularly in times of hardship. Given that TPL is a wholly state-owned enterprise, this places a significant financial risk on the Government. The First Tonga Economic Recovery Operation supported a decision by Government to review the tariff according to guiding principles that would see the introduction of strengthened incentives for cost-effective renewable generation and a life-line tariff to protect the poorest electricity consumers. Explicit Cabinet agreement to the review was obtained in the second quarter of

46 97. Progress with implementing the review has been slower than expected due to capacity-constraints within Government, delays in the provision of technical assistance, and growing ambition for broader reforms. Implementation of a new tariff was specified as an indicative trigger for the Second Economic Recovery operation. The TERM Implementation Unit (TERM-IU), as directed by Government, has worked closely with the World Bank and Pacific Infrastructure Advisory Center (PIAC) over the past year to mobilize technical assistance to support a review of the existing electricity tariff, as a precondition for tariff reform. Terms of reference for the review have now been finalized and a team of consultants have begun analysis. The delay in implementing the review reflects: i) administrative difficulties faced by donor agencies in identifying consultants considered appropriate by all parties and determining contracting arrangements for the current technical assistance; ii) postponement of the initial review mission due to the threat of a no-confidence motion against Government; and iii) some overstretching of TERM-IU s very limited capacity (TERM-IU had a total of less than three full-time-equivalent staff for most of the Calendar year), given competing demands for work to determine and secure Cabinet agreement to its institutional status and responsibilities. Government remains committed to implementing the findings of the current review as soon as feasible, and has also committed to a broader review of current institutional and regulatory arrangements for the Tongan electricity sector to feed into renegotiation of the current Tonga Power Limited (TPL) contract. 98. The First Tonga Economic Recovery Operation supported amending the petroleum pricing templates to ensure that consumer prices are an accurate reflection of existing costs. As part of its broader support to the TERM, the Bank has conducted two major studies of the petroleum sector. 11 The Government has formulated and approved an action plan to guide the implementation of the recommendations of the studies over the medium term. These studies recommended independent reviews of the LPG and petroleum pricing templates, to increase the transparency of the templates and provide a basis for adjusting the templates to ensure that consumer prices are an accurate reflection of existing cost structures. The previous operation supported amendments to the template based on these reviews, which delivered significant benefits to consumers. The retailers margin had been set on a percentage basis, which had imposed a significant penalty on consumers during periods of high oil prices. It is now set on a per liter basis. 99. The First Tonga Economic Recovery Operation supported the publication of the audited accounts of designated major public enterprises. In recent years, the Government has made progress with public enterprise reforms geared at moving public enterprises onto a more commercial footing. 12 A critical aspect of the Government s reforms to date has been strengthening the regulatory framework for public enterprises. In late 2010, the Public Enterprise Act was amended to assign a commercial objective to public enterprises, enhance corporate governance, strengthen the monitoring framework for public enterprises, clarify the 11 See Analytical Underpinnings. 12 For the financial status of Tonga s public enterprises, see the Analytical Underpinnings section. 40

47 rules and processes associated with the approval of community service obligations, establish clear guidelines on the selection and appointment of directors, and clarify director accountabilities. The Government has also been restructuring public enterprises, with a view to privatising those for which a strong rationale for public ownership does not exist. The First Tonga Economic Recovery Operation supported the publication of audited financial reports from six major public enterprises, following substantial preliminary work in bringing accounts up to date and mobilizing the required auditing expertise. The six major public enterprises whose accounts have now been published are Tonga Power Limited, the Tonga Water Board, Tonga Airports Limited, the Ports Authority of Tonga, Tonga Post Limited and the Tonga Development Bank. These six major public enterprises now serve as examples of financial transparency for the smaller enterprises in the portfolio. This was the first time that the audited accounts of public enterprises were made publicly available, in line with a new requirement enacted as part of the recent legislative reforms Introduction of private participation in the operation of the Dateline Hotel has been delayed to allow more careful consideration of policy options. The poor performance of the International Dateline Hotel under an earlier joint-venture arrangement has held back the development of the tourism sector in Tonga. The Dateline is the largest hotel in Nuku alofa and, if adequate quality standards were achieved, the business could play a strategic role in the broader development of the tourism industry by providing a hub for ancillary tourism businesses and wholesalers. Bringing the Dateline Hotel to the point of transaction was specified as a trigger for the current operation, on the assumption that the hotel would be fully privatized. Government, however, is now considering a broader range of options for private participation, including the introduction of a management contract. The Government remains committed to increasing the value Tonga derives from the Dateline hotel through a return to private management, but wishes to ensure that the most suitable ownership arrangements are in place. A liquidator was engaged in 2011 to conclude the previous jointventure arrangement, and clear the way for the Government to pursue privatization. Legal issues surrounding the prior joint venture arrangements significantly delayed this process, and Government s sole ownership of the asset has only recently been confirmed. Given these delays, full consideration of policy options and implementation of a transaction was not achievable within the timeframes of the current operation. The IFC is now working with the Ministry of Public Enterprises to consider appropriate private participation models. IFC will also help Government in developing and testing the financial viability of investment requirements, and undertaking due diligence on potential investors. (ii) Second Tonga Economic Recovery Operation 101. The Recipient s Cabinet has approved the submission to Parliament of legislative changes to reduce the number of business license classes and extend license duration. Existing business licensing arrangements in Tonga are onerous and discourage private sector development and foreign investment. Licenses are issued for activities rather than for 41

48 businesses, and with more than 100 activities listed in regulations, nearly all businesses are required to obtain multiple licenses. The duration of business licenses is typically restricted to one or two years, creating additional compliance costs and uncertainty for investors through the requirement for regular re-application. To address this situation, Cabinet has approved submission to Parliament of legislative revisions to allow businesses to: i) hold a single license for all activities, with a single application fee and process; and ii) be granted licenses in perpetuity. These measures will represent a substantial reduction in compliance costs faced by businesses in Tonga and contribute to reducing investor uncertainty and enhancing Tonga s reputation as a place to do business Progress on other fronts continues in the energy sector. While specified triggers in the energy sector have not been met, Government remains committed to reform in this area, and progress is occurring. TERM-IU now has a full complement of staff, following the appointment of a new, permanent, Director in August to replace the departing Interim Director. World Bank technical assistance has been accessed to assist in the development of a petroleum sector review, and a least-cost energy development plan, building on the tariff review that is already underway. Work has also begun on the development of a new Energy Act and established a technical committee to facilitate cooperation and consistency in approach with TPL, the national utility. In accordance with Government policy, TERM-IU has overseen regulatory arrangements for Tonga s first major solar Independent Power Provider (IPP) project (a 1MW photovoltaic system developed by New Zealand firm, Meridian) and developed a pipeline for further renewable IPP projects Broader SOE and business climate reforms are also underway. DPO II prior actions form only a small component of the Government s current structural reform agenda. SOE reform is proceeding with extensive ADB assistance across a broad portfolio. Recent examples of progress include: i) the recent re-advertisement for sale of the state-owned fisheries company, Seastar, as a going concern or the lease of its assets; ii) improved commercial performance of Tonga Post following recent restructuring; iii) improved commercial performance of Tonga Forest Products under revised SOE legislative and policy framework; and iv) ongoing policy work to support private participation in Tonga Print and Tonga Investments Limited. The Government is also working closely with the ADB to improve a range of aspects of the regulatory business environment. Recent advances in this area include: i) the planned presentation to Parliament by the end of the year of a revised law for personal insolvency, to fill important gaps in the current legal framework; and ii) the initiation of policy consultations regarding a planned revision of the foreign investment act to reduce compliance costs and increase certainty for investors. 42

49 (iii) Possible subsequent operations and expected outcomes 104. Any possible subsequent operation may support the implementation of a new electricity tariff that, inter alia, provides for full cost recovery, establishes financial incentives to generate and distribute electricity efficiently, and institutes a lifeline tariff. As discussed above, progress in carrying out the planned review of the electricity tariff has been slower than expected, due to the diversion of the small number of staff within TERM-IU towards obtaining Cabinet agreement to the unit s formal role and function, delays in identifying and engaging appropriate consultants, and Government s shift in policy focus towards a more wide-ranging review of institutional arrangements within the electricity sector (which is to include a review the broader regulatory framework within which the utility operates, rather than just the design of the tariff within the existing framework). With the tariff review now underway, and reform of the existing tariff design still integral to broader reform direction, the implementation of a new tariff consistent with the objectives previously specified by cabinet could be supported under any possible subsequent operation The authorities are prioritizing further reforms in the energy sector. Government, in the Letter of Development Policy, has indicated its intention to pursue key reform steps in the energy sector over the coming 18 months that could form part of any subsequent budget support operations undertaken by the Bank or other development partners. These include: i) Cabinet approval of recommendations arising from a petroleum sector review undertaken by TERM-IU, potentially including significant changes to the current regulatory and legislative framework for petroleum supply and distribution; ii) Cabinet approval of a least-cost energy plan to guide the development of generation capacity; iii) achievement of specified renewable energy generation targets of up to 15 percent of total energy supplied to the grid; and iv) key steps towards the implementation of a new Energy Act, which will establish a broad legislative framework for achievement of TERM targets and objectives Further steps towards private participation in the management of the Dateline Hotel could also be supported in possible future operations. While progress has been delayed by recent legal processes, Government remains committed to strengthening the management of the Dateline Hotel through some form of private participation. This commitment has been reiterated in the Letter of Development Policy. Any possible subsequent operation could support the implementation of private participation arrangements following Government s full consideration of policy options and due diligence processes with IFC assistance Government approval of policy principals and process for revising the Foreign Investment Act is also on the reform agenda. The improvements to business licensing arrangements supported under the previous operation will achieve maximum impact if combined with reforms of existing foreign investment rules. Substantial transaction costs and uncertainty will continue to exist for foreign investors under the improved business licensing 43

50 regime, given existing requirements for investors to gain separate clearances, involving multiple processes and high a degree of ministerial discretion, under the Foreign Investment Act. The Government is committed to reforming foreign investment legislation and consultations on a revised Act are due to commence in the third quarter of Any possible subsequent operation could support Government agreements to a process and guiding principles for the review and subsequent presentation of revised legislation to Parliament. Given the need for extensive consultation and legislative drafting, the passing of revised legislation is unlikely to be achievable until early Reforms in relation to public enterprises and the business license regime are expected to deliver sustained improvements in the financial accountability of SOEs and a reduction in the time taken to open a business. Business license reforms are expected to yield an improvement in the ease of entry for new businesses, as reflected in a reduction in the time taken to start a business in the next Doing Business Survey results from a baseline of 16 days. The program of public enterprise reforms is expected to deliver continued compliance with financial reporting requirements on behalf of designated major public enterprises. Improving Social Protection 109. The First Tonga Economic Recovery Operation supported adoption of a community public works program targeted to poor and vulnerable communities. In order to arrest further increases in poverty and protect the integrity of traditional systems, the First Tonga Economic Recovery Operation supported the adoption of a community public works scheme targeted to poor and vulnerable communities. With technical assistance from the Bank, the Government approved a community public works program to provide grant funds to communities for labor-intensive public works projects they propose. The project design contains wage-labor components, to enable the participation of the poorest individuals and provide them with a temporary income support cash injection Progress in implementing the Community Public Works Scheme has been delayed. Implementation of the community public works program was included as a trigger for the Second Tonga Economic Recovery Operation. Substantial progress has been achieved towards implementation of the project, including recent Cabinet approval of detailed design features and targeting and the selection of NGO groups to oversee implementation. However, there have been delays in securing the financing to support the implementation of the scheme. In the coming months, the World Bank will continue to work with Government to further progress with the implementation of the program. The Government of Tonga remains committed to improving social protection systems, with the recent introduction of a Social Benefit Scheme providing direct payments to the elderly and ongoing work with the ADB and the EU to implement additional social protection programs to protect marginalized communities and the disabled. 44

51 VI. OPERATION IMPLEMENTATION POVERTY AND GENDER IMPACTS 111. Poverty is a growing problem in Tonga. Tonga is one of the few countries in the Asia-Pacific region where the incidence of poverty is increasing with the proportion of people living below the basic needs poverty line increasing by over one-third between 2001 and 2009 (from 16.2 percent to 22.5 percent). Poverty is concentrated in Tongatapu, and especially in areas outside Nuku alofa. While traditional systems of support have typically provided some protection to poor and vulnerable households, the prolonged and severe contraction in remittances over recent years have put pressure on these informal risk-sharing mechanisms The operation will provide vital grant support to the budget, in a very challenging fiscal environment. Maintenance of public services is vital to the living standards of the poor. Budget support will help the Government to maintain the provision of core services to the public, and to build up its cash balances in order to avoid the impediment to effective budget execution imposed by cash rationing that have tended to disrupt service delivery in the past Reforms supported by the operation will help reduce poverty. Budget execution will be further strengthened by the PFM reforms supported by the operation, leading to more effective service provision as resources are utilised as scheduled and as budgeted. Over the medium- and long-term, improvements in budget transparency and the governance of public enterprises will improve accountability and efficiency in the use of public resources, contributing to greater equity of public resource use following recent democratizing reforms. Improvements in the business license regime are aimed to contribute to faster private sector development with the potential for additional job creation. Energy sector reforms are expected to have a substantial impact on poor households over time by improving access to electricity, reducing the cost of electricity and oil products, and contributing to reduced exposure to volatility in energy prices. Increased access to electricity is likely to reduce the time and cost faced by poor households in accessing alternative forms of energy for cooking and lighting. Lower and more stable energy prices are likely to reduce the share of household incomes required for energy needs, allowing increased consumption of other basic needs, and reducing exposure to severe hardship during periods of high imported energy prices The reforms to strengthen public service wage bill management are not expected to have an adverse impact on poverty in Tonga. While the reforms can be expected to lead to a reduction in recruitment in FY2012/13, they will not lead to any lay-offs (reductions in staff numbers will only be due to attrition). Recruitment will continue for essential personnel, preserving some new labour market opportunities in the public sector and ensuring that the provision of core public services will not be interrupted. In addition, the Government s main 45

52 rationale for improving its management of the wage bill is to protect non-wage expenditures from being further squeezed in the flat budget environment, which will also make a contribution to core service delivery through the availability of the necessary inputs Measures by the Government to strengthen its revenue effort will not have an adverse impact on poverty. None of the supported revenue reform measures include substantial changes in tax rates. The publication of exemptions information in the Government budget may lead to some reduction in the number of exemptions granted. Existing exemptions are considered to have a strongly regressive impact, predominantly benefiting large businesses and wealthier households. Introduction of a presumptive tax for SMEs will not impact on the effective tax rates for SMEs, as presumptive tax rates will be deliberately set to achieve consistency between the presumptive and assessed tax regimes Policy actions supported by the operation are expected to have a positive impact on women. Business environment reforms supported by this operation are expected to deliver direct benefits to women. Reforms to the business license regime are expected to address some of the regulatory constraints cited as barriers to business development by women in Tonga in a recent IFC study, where accessing business licenses was considered an especially onerous process. The current burdensome and opaque licensing regime is likely to disproportionately disadvantage women because women may: i) have less time available to deal with business license processes because they spend a disproportionate amount of time engaged in unpaid work within the household; ii) be more likely to suffer from harassment from regulatory officials; iii) have less exposure to and confidence in dealing with officialdom and less sophisticated networks for obtaining permits and licenses; and iv) have less access to information about permits and licenses than their male counterparts 13. Budget transparency reforms will, over the longer-term, build accountability on Government for adequate resourcing and efficient delivery of social services to improve women s health and education outcomes. Tax reforms, improved budget reporting, and implementation of a Treasury Single Account will improve Government s ability to mobilize and allocate resources to these pressing service delivery needs. Improved management of public resources and an improved business environment will also, over time, contribute to improved economic performance and an expansion in economic opportunities, with international studies showing that increases in disposable household income are associated with higher investment in education, especially for girls. The broader program of Government reforms in the electricity sector is likely to deliver an expansion in access to electricity and reduced electricity prices. This will reduce the burden of accessing alternative energy sources for cooking and lighting, which international experience suggests are often borne disproportionately by women. 13 See IFC s Gender and Investment Climate Reform Assessment for Tonga. 46

53 ENVIRONMENTAL ASPECTS 117. The policy actions supported under the operation are not expected to have a significant impact on Tonga s environment, natural resources, or forests. The policy actions supported under the operation aim to strengthen public financial management, strengthen fiscal policy, and advance structural reform. They do not bear directly on environmental risks. The natural resource revenue regime may help mitigate some environmental risks to the extent that it will provide tools to Government to monitor and regulate some natural resource industries. Over time, the Government s broader planned energy sector reforms are likely to lead to a change in energy mix towards renewable generation. These reforms are also likely to lead to improved safety regulation of private businesses operating in the petroleum sector, reducing risks of environmental damage through leaks or spills. IMPLEMENTATION, MONITORING AND EVALUATION 118. The existing institutional structure for aid management in Tonga will be used to implement and monitor the policy actions supported by the operation. The MFNP will provide overall guidance for the budget support program, and will assume overall responsibility for coordinating the implementation, monitoring and evaluation of the operation. The MFNP will also be ultimately responsible for reporting progress and coordinating actions among other concerns government agencies Specific indicators that the Bank will monitor for each of the policy areas supported by the proposed operation are set out in Annex 2. The Bank will work with the Government to assess the progress of implementation of the policy actions supported by the proposed operation. The Bank will also work with the Government to monitor the specific indicators associated with each of the policy areas support by the proposed operation. The Bank will play a coordinating among development partners, to ensure that there is a single, agreed assessment of the implementation of the policy actions and a single, agreed evaluation of the monitoring indicators. This will reduce the administrative burden the operation imposes on the Government Through its ongoing dialogue with the Government, the Bank will help to sustain the linkages between the policy actions under the proposed operation and the progress of the broader reform agenda these support. The Bank and the Government have built up a strong dialogue on macroeconomic policy issues and public sector and economic reforms, which both parties are keen to maintain. Through this dialogue, the Bank will continue to support the Government as it plans further actions to implement is reform program in the areas of public financial management, fiscal policy, and structural reform. In this way, the Bank will be in a position to support the consolidation of the policy actions undertaken in the proposed operation, as well as the implementation of subsequent reform steps in these areas. The dialogue also will continue to draw on sector expertise within the Bank, and to link sector 47

54 projects to the Government s broader public sector and economic reform agenda. In addition, the Bank will continue to work closely with other development partners, to coordinate support for the implementation of the Government s program FIDUCIARY ASPECTS Public Financial Management Environment 121. The 2010 PEFA assessment indicated an improvement in Tonga s PFM systems over the three years following the 2007 PEFA assessment. The number of satisfactory ratings that Tonga received increased from 16 to 20 out of the 27 indicators, and there were also improvements in the ratings within the satisfactory category. Satisfactory ratings were received on all indicators and sub-indicator dimensions of the credibility of the budget and on comprehensiveness and transparency. Within the areas of policy-based budgeting and predictability and control in budget execution, most ratings and sub-indicator dimensions were satisfactory, but some unsatisfactory ratings were issued for aspects of the multi-year perspective in fiscal planning, expenditure policy and budgeting, the effectiveness in the collection of tax payments, competition, value for money and controls in procurement, and the effectiveness of internal audit. The weaknesses in the multi-year perspective are not uncommon in thin capacity environments, where the focus is rightly placed on the annual budget, while the weaknesses noted in the collection of tax payments stemmed from both the timing of a set of assessment and delays in the collection some large arrears which are before the courts. The Government has taken steps to address the weaknesses in its procurement process, with the adoption of new procurement regulations in late The 2010 PEFA indicated areas of weaknesses in accounting, recording and reporting and in external scrutiny and audit, which the Government is taking steps to address. Within the area of accounting, recording and reporting, unsatisfactory ratings were issued on the availability of information on resources received by service delivery units and the quality and timeliness of AFS. Making improvements on accounting by service delivery units is not necessarily a challenge that is suitable for the Government to address immediately, but the Government has now cleared the backlog in its AFS. More significant weaknesses were identified in each of the aspects of external scrutiny and audit: the scope, nature and follow-up of external audit; legislative scrutiny of the annual budget law; and legislative scrutiny of external audit reports. The proposed operation is supporting the Government s efforts to addressing the second area, and it is envisaged that the first and third areas will be addressed under a possible subsequent operation Reflecting reform efforts over the recent years, Tonga s CPIA rating has increased from 2.9 to 3.5 over the last five years, with Tonga s policy and institutional performance now above average for IDA countries. Given these improvements, but acknowledging the identified weaknesses and reforms still required, the overall fiduciary risk is rated as High. This conclusion is based on the 2010 PEFA s assessment that the legal and 48

55 regulatory framework for PFM in Tonga provides a solid basis for budgeting, spending and accountability, and on the Government s commitment to continue to implement PFM reforms Opportunities to gradually reduce the fiduciary risk have been identified and associated actions have been considered. A number of areas were identified and require further improvement in order reduce the government s overall fiduciary risk to the moderate level. One area for further reform highlighted in the PEFA is accountability and transparency relating to external audit. Improvements in the coverage of audit reports to include the Financial Statement of Government as supported by the proposed operation will contribute to a reduction in this fiduciary risk. Foreign Exchange Environment 125. In terms of the foreign exchange environment, there is no current IMF Safeguards Assessment of the NRBT, as Tonga has not accessed IMF funds. A Safeguards Assessment is likely to be completed prior to the proposed operation going to the Board. The NRBT publishes its annual report together with the audited accounts and the report of the independent auditors on those accounts. The FY2009/10 annual report has been published and the audited financial accounts were unqualified. The NRBT has an established Revaluation Reserve Account, which provides an additional buffer for any foreign exchange losses and maintains foreign reserves composed of a basket of currencies reducing the sensitivity to exchange rate risk as movements of these currencies generally offset each other There is no indication of substantial issues within the foreign exchange environment. Until an IMF Safeguards Assessment is concluded, however, there is insufficient information available to draw any substantiated conclusions, so the foreign exchange risk must be rated as High. DISBURSEMENT AND AUDITING 127. The disbursement measures proposed are to ensure that the grant funds disbursed by the Bank are deposited in a dedicated account of the NRBT, and then an amount equivalent to the grant is credited to an account of the government available to finance budgeted expenditures. The grant will be disbursed according to IDA disbursement procedures for development policy operations. The full grant amount of US$ 5 million equivalent will be disbursed against satisfactory completion of the specified policy actions as listed in Table 3 and the Government agreement as summarised in the letter of the development policy, and is not tied to any specific purchases. Once the grant is approved by the Board and becomes effective, the proceeds of the grant will be deposited by IDA in one tranche, at the request of the Recipient, into a dedicated Foreign Currency Deposit Account at the NRBT. 49

56 128. Flow of funds (including foreign exchange) is subject to normal Financial Management processes. It is not possible to track the ultimate use of the foreign exchange provided by the development policy operation proceeds, but grant proceeds flow into a dedicated Foreign Currency Deposit Account at the NRBT and from it to the budget of the Government, and are thus subject to normal PFM processes and NRBT procedures. By way of a letter, the Government will provide confirmation to the Bank when the grant amount has been credited to a Local Currency Deposit Account used to finance budgeted expenditures The Bank will retain the right to request the auditors of the Government to conduct a special audit of the dedicated Foreign Currency Deposit Account established in the NRBT. The audit will cover the following: (i) the accuracy of the summary of the transactions of this account, including accuracy of exchange rate conversions; (ii) that this account was only used for the purposes of the operation and that no other amounts were deposited into this account, including confirmation from corresponding bank(s) involved in the funds flow; and (iii) that payments from this dedicated Foreign Currency Deposit Account were in a timely manner (normally within 30 days of disbursement) transferred to a Local Currency Deposit Account available to finance budgeted expenditure. The audit will be provided to the Bank as soon as available, but not later than six months after the last disbursement from the Association, and will be made publicly available in a timely fashion. RISKS AND RISK MITIGATION 130. The proposed operation carries three main risks, for which risk mitigation strategies have been adopted. These risks relate to the thin capacity and small size of the public sector in Tonga especially in the context of the current Government restructure,tonga s extreme vulnerability to external economic conditions and natural disasters, and political uncertainty following institutional reform. These risks and the associated risk mitigation strategies are described below The thin capacity and small size of the public sector in Tonga poses a risk for the successful implementation of the policy actions supported by the proposed operation. Tonga experiences the thin capacity typical of public sectors in very small states, with a small number of public servants called upon to implement the many tasks of a central government. Limited staff numbers and an absence of staff with some of the required technical qualifications and experience to undertake supported reforms, particularly in the energy sector, may mean that the reform program cannot be implemented as successfully or as quickly as expected. This risk is especially relevant in the context of the current Government restructure, which is likely to represent a major drain on existing Government capacity over the first half of FY2012/13 as administrative systems and staff arrangements are revised to reflect the smaller number of ministries. This risk is being somewhat mitigated by strong dialogue through which the Government and the Bank have carefully selected a limited number of policy actions that are key priorities to the Government. The Government and the Bank have also discussed the implementation requirements for each action at length, to ensure 50

57 that expectations regarding the timeframes for implementation are realistic. The risk is also being mitigated through the provision of dedicated technical assistance from various development partners to the achievement of nearly all specified actions. Technical assistance support to policy actions supported by this operation is outlined in Appendix 3. Specific risks arising from disruptions associated with the restructuring are mitigated by the Bank s provision of specialist public service reform technical assistance to restructuring efforts within the Public Service Commission, which should ease the capacity burden associated with transition Potential shocks, including natural disasters, a deterioration of global economic conditions, domestic policy slippages, or a reduction in external assistance, pose risks to the maintenance of macroeconomic stability. Ongoing macroeconomic stability is dependent on successful fiscal consolidation, recovery of remittances, and continuing grant support from donors. The Government remains committed to necessary expenditure and revenue reforms, but political pressures for further payroll expenditure, in the context of growing expectations surrounding a planned remuneration review in late 2012, present an important risk. Remittance flows will be largely determined by economic conditions in the US, New Zealand and Australia, which are the major sources of remittances. Similarly, Tonga s economic outlook remains heavily dependent on the timely provision of budget support grants from development partners. A shortfall or substantial delay in the provision of budget support would undermine cash management and disrupt service delivery. Macroeconomic disruption arising under several feasible scenarios would distract available capacity and resources from implementation of actions supported by the program, as well as undermining the impact of these actions on growth and poverty-reduction. Tonga also remains vulnerable to natural disasters, which could have severe impacts on growth and revenue, or exacerbate existing expenditure pressures, as well as diverting scarce Government administrative capacity towards emergency operations. Risks associated with these various external vulnerabilities are being mitigated through: i) the conservative tax revenue forecasts adopted by the MFNP for FY2012/13, which are consistent with IMF projections; ii) development partners contributing critical resources to support the budget in challenging fiscal circumstances, allowing the accumulation of cash reserves to manage shocks over the medium-term; and iii) the Bank s dialogue with Government on appropriate ways to approach and manage expenditure or revenue shocks and pressures Tonga s political system has been recently reformed and is subject to uncertainty. While Government has remained stable over the length of the current term, political dynamics within the new system remain a source of potential uncertainty. There have been two reshuffles of key Ministerial positions leading to the appointment of new Ministers of Finance. Further changes in the composition of key Ministerial posts could present challenges to the momentum of progress with specified actions. Broader political changes remain a possibility in the current challenging economic environment, and represent a source of substantial uncertainty, given the recent reform of political institutions. Risks associated with 51

58 various political uncertainties are being mitigated through the Bank s dialogue with a range of Ministers and officials on macroeconomic policy issues, which has helped strengthen support around planned reforms across a broad cross-section of Government Ensuring ongoing coordination between development partners remains a priority for mitigating identified risks. Strong coordination between donors has assisted in mitigating risks to date through: i) ensuring consistency in dialogue regarding economic and public finance issues; ii) supporting the mobilization of required technical assistance at appropriate times; and iii) achieving consistency and complementarities across elements of the reform agenda supported by various donors. Maintaining this level of coordination is vital for the mitigation of identified risks and continued progress with reform actions, and will require the continuing dedication of adequate Bank staff time. 52

59 Annex 1 : LETTER OF DEVELOPMENT POLICY 53

60 54

61 55

62 Annex 2 : SECOND TONGA ECONOMIC RECOVERY OPERATION POLICY MATRIX First Tonga Economic Recovery Operation (Actions Taken) Strengthening Public Financial Management 1. The Recipient has instituted an in-year budget reporting system that tracks key budget information on a monthly and quarterly basis to strengthen budget execution. 2. The Recipient has reformed the budget calendar so as to make budget proposals available to the public when tabled in the Recipient s Legislative Assembly, in order to improve transparency in the process for adopting the budget. Second Tonga Economic Recovery Operation (Prior Actions ) 1. A Treasury Single Account has been implemented for all Government-funded operations, as evidenced by letter No. 69/7/2/238 from the Minister of Finance, dated September 11, 2012 received by the Association. 2. Quarterly reports have been made available on the Ministry of Finance and National Planning website on a timely basis (within 45 days of the end of the reporting period), as evidenced by the publication on August 10, 2012 of same for the period ending on June The Recipient s Cabinet has approved the submission to Parliament of the audited Financial Statements of Government up to FY2010/11 as evidenced by the Cabinet minutes No 813 and the Cabinet minutes No 814, Output/Outcome Indicators 14 (Unless otherwise stated, targets to be achieved by the end of the 2013 calendar year). Outcome: The budget is credible at the level of disaggregated expenditure. Indicator: The extent to which the variance in the primary expenditure composition exceeds the overall deviation in primary expenditure. Baseline: 0 5 percent in FY2006/07; percent in FY2007/08; 5 10 percent in FY2008/09; 0 5 percent in FY2009/10; 5 10 percent in FY2010/11. Equivalent to a C on PEFA PI-2. Target: 0 5 percent in FY2011/12 and FY2013/14 (equivalent to at least a B on PEFA Performance Indicator 2). Outcome: Public access to key fiscal information increases. Indicator: Number of elements defined in the PEFA criteria for public access to key fiscal information (PI-10) that are satisfied 15 Baseline: One element satisfied in FY2010/11 (equivalent to a C on PEFA PI-10). 14 Some indicators included in the previous operation have not been included in the current matrix as corresponding actions are no longer being supported under the Second Tonga Economic Recovery Operation. The team, however, will continue to monitor progress against indicators included under the previous operation but excluded from the current matrix 15 Elements included for this measure are: i) annual budget documentation a complete set of documents can be obtained by the public through appropriate means when it is submitted to the legislature; ii) in-year budget execution reports the reports are routinely made available to the public by appropriate means within one month of their completion; iii) year-end financial statements the statements are made available to the public through appropriate means within six months of completed audit; iv) external audit reports all reports on central government consolidated operations are made available to the public by appropriate means within six months of completed audit; v) contract awards award of all contracts with value above USD100,000 equivalent are published at least quarterly through appropriate means; and vi) resources available to primary service units information is publicised through appropriate means at least annually, or available on request, for primary service units with national coverage in at least two sectors (such as elementary schools or primary health clinics). 56

63 Strengthening Fiscal Policy 3. The Recipient has brought recruitment in all parts of the public service under centralised control and has applied a partial hiring freeze in the Recipient s fiscal year to improve the management of the public service wage bill. Promoting Structural Reform 4. The Recipient has approved guiding principles for reforming the electricity tariff structure, aimed at a financially sustainable and efficient electricity sector, taking into account the planned shift to renewable energy, with adequate protection for the poorest consumers. both dated September 18, Details regarding the cost by category of tax expenditure during the previous year have been published in the annual Budget Statement for FY2012/13, as evidenced by the Budget Statement dated June 2012 received by the Association. 5. The Recipient s Cabinet has approved the introduction of a presumptive tax for SMEs, consistent with the recommendations of the PFTAC Tax Review, as evidenced by the Cabinet minutes No 781, dated September 14, The Recipient s Cabinet has approved the introduction of a natural resource revenue regime, consistent with the recommendations of the PFTAC Tax Review, as evidenced by the Cabinet minutes No. 781 dated September 14, The Recipient s Cabinet has approved the submission to Parliament of legislative changes to reduce the number of business license classes and extend license duration, as evidenced by the Cabinet minutes No.810, dated Target: Three elements satisfied (equivalent to a B on PEFA PI-10). Outcome: Improved control of the wage bill. Indicator: Variance between the budget and outturn for the government-funded public service wage bill Baseline: Variance of an average 3.7 percent from budget estimate (FY2000/01 FY2010/11, excluding FY2005/06, when the civil service strike and major wage settlement occurred) Target: Variance within 2.5 percent of the budget estimate for FY2011/12 and FY2012/13. Outcome: Growth in the cost of exemptions is curtailed Indicator: Cost of consumption tax and duty exemptions as a proportion of total revenues from these sources. Baseline: Exemptions granted worth 30 percent of total revenue from consumption tax and duties in FY2010/11 Target: Exemptions granted are worth less than 30 percent of total revenue from consumption tax and duties in FY2012/13. Outcome: Costs of doing business are reduced Indicator: Cost of acquiring business licenses as measured in the Doing Business Survey Baseline: TOP$ (DBS 2012) 16 TOP is the standard abbreviation for the local currency unit, Tongan Pa anga. 57

64 5. The Recipient has amended the petroleum pricing templates in general accordance with the recommendations of the independent reviews of said templates, in order to ensure that consumer prices are an accurate reflection of existing costs. 6. The Recipient has published the audited accounts of the designated major public enterprises in order to improve the transparency of the financial management of said designated major public enterprises. September 14, Target: TOP$100 (DBS 2014) Outcome: Financial transparency of major public entities is increased Indicator: Public availability of key financial information on major public enterprises. Baseline: Audited accounts of designated major public enterprises not available to the public (FY2009/10). Target: Audited accounts of all designated major public enterprises are available to the public within 6 months of the end of the previous financial year (FY2010/11, FY2011/12, and FY2012/13). Outcome: Energy prices better reflect costs of supply Indicator: Basis of calculating retailers margin for petroleum. Baseline: Retailers margin set on a percentage-of-cost basis Target: Retailers margin set on a per-liter basis 58

65 Annex 3 : IMF PUBLIC INFORMATION NOTICE EXTERNAL RELATIONS DEPARTMENT P ublic Information Notice (P IN) No. 12/64 FOR IMMEDIATE R E LEASE June 27, 2012 International Monetary Fund h Street, NW Washington, D. C U SA IMF Executive Board Concludes 2012 Article IV Consultation with Tonga On May 16, 2012, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Tonga. 1 Background Tonga's economy is recovering gradually from the effects of the global slowdown and the domest ic credit crunch, thanks to the pickup in construction activity and rebound in tourism. However, private consumption has been anemic due to the decline in remittance inflows. In addition, banks' lending standards have remained tight, constraining p rivate consumption and investment. R eal GOP growth is forecast to be around 1 Y2 percent in F Y2011 / 12, led by stronger tourism activity and a continued fiscal stimulus funded by donor aid and previously contracted concessional loans. CPI inflation declined to 2% percent y/y in February 2012, reflecting main ly stabilization in fuel and food prices as well as exchange rate appreciation. Inflation is likely to average around 4 % percent in FY2011/ 12. The fiscal position has strengthened but vulnerabilities remain. Generous grant inflows from donors contributed to narrowing the fiscal deficit to an estimated 2% percent of GOP in 2011 / 12 (from about 6 percent o f GOP in FY201 0/11 ). Capital expenditure is 1 Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions w ith members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities. An explanat ion of any qualifiers used in summings up can be found here: 59

66 2 expected to be lower by 2 percentage points of GOP due to the completion of the reconstruction of the central business district and near completion of the road projects using the China EXIM Bank loans. Nevertheless, Tonga remains at a "high risk of external debt distress" according to th is year's World Bank-IMF debt sustainability analysis. Buoyant official development assistance helped improve the balance of payment position, which allowed the National Reserve Bank of Tonga (NRBT) to let the currency appreciate by 6 percent against the US$ and real effective terms in 2011 to help curb inflation pressures stemming from rising fuel and food import prices. The level of reserves increased to around $130 million as of end-2011, covering more than 6 months of imports of goods and services. Monetary conditions have remained accommodative over the past two years, but with no signs of a pickup in private credit. Monetary policy has been appropriately geared toward encouraging bank lending. The banking system is adequately capitalized and profitable but credit costs re lated to the rise in non-performing loans (NPLs) following the credit bubble remain high; and banks have continued to restrain credit amidst an uncertain outlook. Executive Board Assessment Directors welcomed Tonga's recovery from the global crisis but noted remaining vulnerabilities and a high debt burden. With downside risks clouding the outlook, Directors emphasized the importance of strengthening policy buffers and the foundation for faster and more inclusive growth. Directors concurred that fiscal consolidation is needed to rebuild the government's cash balances and safeguard debt sustainability. Accordingly, containing the public sector's wage bill, prioritizing expenditures, and broadening the tax base remain top policy priorities for the period ahead. More broadly, Directors encouraged the authorities to implement their fiscal plans within a medium-term framework and further improve the quality of public spending to meet Tonga's development objectives. Directors considered the current accommodative monetary policy stance appropriate in light of the banks' cautious approach to lending. Taking note of the staffs assessment that the exchange rate is broadly in line with fundamentals, Directors agreed that, going forward, the exchange rate could absorb the bulk of external shocks with official intervention limited to smoothing operations. Directors supported steps underway to reduce credit risk and strengthen financial intermediation. They welcomed recent legislation to improve the registration of collateral and recommended further financial sector reforms such as establishing a centralized credit bureau, facilitating land leases, and enacting a bankruptcy law. Directors also urged the authorities to continue to resist pressure to administer bank lending rates. 60

67 Directors underscored the importance of removing structural hurdles to private investment and reducing the cost of doing business, including through public enterprise reforms. Steps in this direction would lay the groundwork for broadening the production base and reducing poverty. Public Information Notices (PINs) form part of the I MF's efforts to promote transparency of the I M F's views and analysis of economic developments and policies. With the consent of the country (or countries) concerned, PINs are issued after Executive Board discussions of Article IV consultations with member countries, of its surveillance of developments at the regional level, of post-program monitoring, and of ex post assessments of member countries with longer-term program engagements. PINs are also issued after Executive Board discussions of general policy matters, unless otherwise decided by the Executive Board in a particular case. 61