NATIONAL Reserve Bank of Tonga, Monetary Policy Statement, March 2008. Data finalized 20 March 2008.

Monetary Policy Review

Economic activity in Tonga is likely to be contracted markedly in 2007, as the Kingdom's economy suffered following a poor agricultural season, the large-scale reduction in civil service workers and the near-destruction of Nuku'alofa's central business district. Reconstruction is taking a long time with only a few projects underway nearly 18 months following the civil disturbance of November 2006.

The National Reserve Bank of Tonga (NRBT) was active in encouraging economic activity throughout 2007. Early in the year credit ceilings were lifted, banks required reserves were reduced and the amount of liquidity in the banking system has been left at high levels. Consequently lending growth has recovered strongly.

Even with business lending growth rates of nearly 30%, business activity has not returned to early 2006 levels.

Official foreign reserves have been maintained above 4 months of imports for 23 consecutive months. Remittances have picked up again following a slow patch in early 2007, and tourist receipts are growing strongly from a low base. However, imports are rising fast and with high world commodity prices we can expect import payments to continue to rise.

The Tongan Pa'anga (TOP) Nominal Effective Exchange Rate depreciated 1.8 percent over the year ended January. Continuing strength in the New Zealand and Australian dollars offset the pa'anga's appreciation against the United States dollar. In 2007 the pa'anga appreciated 7.4% against the USD mitigating the global rise in oil and food prices to some extent.

Inflation has risen again, reaching 10.6% in the year to January 2008, after averaging 5.8 percent in 2007.

Imported inflation in the form of higher oil prices and imported food is the main culprit, but local firms are having to pass on higher input costs and significant rises in electricity, bread and vegetable prices are largely the result of high international fuel costs.

For the global economy, the long expansion enjoyed by most developed nations appears to be coming to an abrupt halt. The credit crises brought on by large scale defaults on loans in the United States is having farreaching consequences. Growth in the United States is faltering and a period of very low growth, or even recession, is likely. China's outlook for economic growth rate has been pared back slightly, as it can expect lower exports to the United States. Nevertheless, China will still grow strongly and will take over as the main driver of world growth. Slower housing markets and higher retail interest rates in Australia and New Zealand are slowing growth there, but at this stage the economies are doing fine and inflation is the main concern of policy makers.

The US Federal Reserve and the Bank of England have both cut official interest rates, following intervention to ensure sufficient liquidity in their respective banking systems following the credit crisis, suggesting that financial turmoil is not over yet.

Outlook

The outlook for the world economy has changed markedly in the last six months. The fallout from the credit crises in the United States and the United Kingdom has led forecasters to cut growth expectations everywhere.

The United States is expected to grow slowly over the next few years, while the UK, eurozone, Australia, New Zealand and Japan can expect below-trend growth rates. China and India are still projected to once again show rapid growth though at slightly lower rates than in recent years.

Consumer price inflation is becoming a world-wide problem. Previously the growth in China and its rapid industrialization had kept prices from rising (in fact dropping prices) even while commodity prices of inputs rose. China now faces internal inflation of around 5%, and these costs are likely to be passed on to the buyers of China's output. Headline inflation in the United States, Australia and New Zealand have all surpassed 3% and with the United States cutting interest rates, inflation is unlikely to dissipate in the near term.

Oil prices rose above US$100 per barrel for the first time in early March and has generally remained at high level since. While slower industrial production in developed nations may reduce demand, ongoing growth in the developing world will likely see a floor kept under oil prices. Also, food price have been rising strongly as traditional crops are displaced for growing biofuels, at the same time as demand rises. Food prices have dropped slightly on world markets in recent times, but a return to the 'cheap' prices of a few years ago seems unlikely.

The outlook for activity is more positive, as we have already suffered our major growth downturn, and reconstruction activity will outweigh any impact from the slowing global economy on the small export sector.

Even a return to normal levels of activity will be a significant pick-up for the Kingdom. Lending to the business sector suggests investment is taking place and hence confidence in the local economy. Aid received from Australia and New Zealand will give a further boost to investment activity once this is accessible.

This increased activity is likely to be concentrated in construction and related industries and lead to increased imports. An increase in imports will produce some downward pressure on foreign reserves if there is no increase in receipts to cover the expected higher payments. Also, upward pressure on prices is likely as materials for construction have risen in price over the past few years, and the demand for local products and labour rises. The recent strength in the pa'anga is expected to continue and curb some of the imported inflation effect, though this may mean a lower pa'anga valuation for our reserves. Inflation is a major concern over the next year, as oil prices remain high and the demand on local resources intensifies with expected reconstruction activity.

Given the financial position of many businesses, and the need for funding of business rebuilding, the Reserve Bank expects to maintain its current monetary policy stance for at least the next six months.

The Reserve Bank will continue to closely monitor developments in the banking system in order to promote internal and external monetary stability and promote a sound and efficient financial system.

Siosi Mafi

Governor

The National Reserve Bank of Tonga