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Government of Tonga Medium Term Debt Strategy 2015/16 - 2017/18 Prepared by Debt Management Section Ministry of Finance & National Planning December 2015 Medium Term Debt Strategy (2015-2017) Table of Contents Acronyms and Abbreviations……………………..……..................................…………………......4. Foreword……………………………………………….........................................................………………5. Executive Summary…………………………………................................................……………..........7. 1. Introduction..........................................................................................................................................8. 2. Objectives for Debt Management….............….............................................….…...…………......8. 3. Scope for debt strategy………..........................................................................................................8. 4. Current Debt Portfolio......................................................................................................................9. 4.1 Profile of existing Debt.......................................................................................................9. 4.2 Outstanding debt and composition............................................................................10. 5. Historical Context of Debt Portfolio..…................................................................………….....11. 5.1 Change in size and composition...................................................................................11. 5.2 Management of Guarantees and On-lending to PE's...........................................12. 6. Analysis of Funding Sources........................................................................................................13. 6.1 Financial Characteristics of Existing Debt...............................................................15. 7. Baseline Projections........................................................................................................................16. 7.1 Fiscal........................................................................................................................................16. 7.2 Monetary................................................................................................................................17. 7.3 Other longer terms structural adjustments............................................................18. 8. Risk Scenario Testing......................................................................................................................19. 8.1 Cost and Risk Characteristics of Existing Debt......................................................19. 8.2 Analysis of Cost and Risk Indicators..........................................................................20. 8.2.1 Exchange Rate Risk.............................................................................................21. 8.2.2 Refinancing Risk...................................................................................................22. 8.2.3 Interest Rate Risk................................................................................................23. 8.2.4 Liquidity and Repayment Risk.......................................................................24. 8.2.5 Creditor Concentration Risk...........................................................................25. 8.2.6 Credit Risk of on-lent and guaranteed loans............................................25. 8.3 Other Risks in Managing the Portfolio......................................................................25. 8.3.1 Operational Risk...................................................................................................25. 8.3.2 Strategic Risk.........................................................................................................25. 8.3.3 Financial Risk........................................................................................................26. 1 Medium Term Debt Strategy (2015-2017) 9. Recommended Strategies and desired composition of debt..........................................26. LIST OF TABLES TABLE 1 GOT Target FY 2014/15 ……………………………………………………………….………7. TABLE 2 Disbursed Outstanding Debt as at 30 June 2015………….……..…………………..9. TABLE 3 Government Bonds as at 30 June 2015………………….………………….…………10. TABLE 4 Creditors Cost and Risk Indicators as at June 2015……………………………….14. TABLE 5 Summary of financing sources as at 30 June 2015..………………………………15. TABLE 6 Cost and Risk Characteristics of the Existing Debt Portfolio as at 30 June 2015…………………………………..…………..……………………….…………..…20. TABLE 7 Alternative Borrowing Strategies….………………..………………….………………..27. LIST OF CHARTS CHART 1 Total Public Disbursed Outstanding Debt, FY 2007/08-2029/30..………......9. CHART 2 External Debt Stock by Creditor Category as at 30 June 2010 & 2015.…..10. CHART 3 External Debt Stock by Currency Composition as at 30 June 2009 & 2014…….….………………………………………………………...……….10. CHART 4 Domestic Debt by Holder as at 30 June 2010 & 2015…..………………………..10. CHART 5 Total Public Debt Outstanding to Nominal GDP, FY 2004/05-2014/15....11. CHART 6 Creditor Composition of External Debt as at 30 June, 2010 & 2015............11. CHART 7 Currency Composition of External Debt as at 30 June, 2010 & 2015…..….12. CHART 8 Total Public Debt Service in ratio to Revenue & Expenditure, FY 2006/07-2015/16..……………………………………….……………………………….12. CHART 9 Monthly Pattern of Debt Repayments as at FY 2013/14 & 2014/15..........12. CHART 10 Contingent Liabilities to Nominal GDP, FY 2005/06-2014/15..….…...….....13. CHART 11 External Total Debt Service, Government vs On-lent loans, FY 2014/15..13. CHART 12 GoT Debt by Residency of Creditor as at 30 June, 2010 & 2015...………......15. CHART 13 Total Public Debt Outstanding by Economic Sector as at 30 June 2015….16. CHART 14 Tonga's Economic Performance relative to PICs...…………………………………16. CHART 15 Domestic Budget Performance…………………...…………………………………….....17. CHART 16 Nominal Debt as % of GDP…..…………………...……...……………………………….....20. 2 Medium Term Debt Strategy (2015-2017) CHART 17 Net Present Value External Debt as % of GDP……………………………………....21. CHART 18 Net Present Value of External Debt as % of Exports & Remittances, FY 2003/04-2012/13……………………………..…………………………………..……...21. CHART 19 Total Debt Service as % of Revenue, FY 2003/04-2012/13.…...……...….....21. CHART 20 Total Debt Service as % of Exports & Remittances, FY 2003/04-2012/13..………………….....…………………………………………………21. CHART 21 Foreign Exposure (Tonga vs. the World)…………………………..…..………..…...21. CHART 22 External Debt Outstanding by Currency, FY 2014/15-2030/31...............…22. CHART 23 External Debt Service by Currency, FY 2014/15-2030/31..........................…22. CHART 24 Total Public Debt - Refinancing Risk (ATM)……………………..........................…23. CHART 25 Remaining Maturity Profile for Domestic Debt as at 30 June 2015....……..23. CHART 26 Remaining Maturity Profile for External Debt as at 30 June 2015.….......…23. CHART 27 Cost of Debt - Weighted Average Interest Rate…………………………….…...….24. CHART 28 Share of fixed rate to floating rate debt as at 30 June, 2010 & 2015…...….24. CHART 29 Total Debt Service by Currency, FY 2013/14-2029/30....………………….…..24. CHART 30 Debt to GDP as at end 2017………………………………………....………………….…..30. CHART 31 Present Value of Debt to GDP as at end 2017…………….....…………………..…..31. CHART 32 Interest to GDP as at end of 2017……………………………......…………………..…..31. ANNEX 1 Summary of recommendations specific to segments of the Government Securities Market……….……………………………………………………… ….…………32. ANNEX 2 Total Public Disbursed Outstanding Debt, FY 2003/04-2029/30.......….…33. ANNEX 3 Total Public Debt Service by Currency, FY 2013/14-2029/30....………..….33. ANNEX 4 Macro Economic Data, FY 2003/04-2015/16......………..…………………......….33. 3 Medium Term Debt Strategy (2015-2017) Acronyms and Abbreviations ADB ATM ATR AUD BRIC CBD CDB CNY ComSec CP CS-DRMS DMS DOD DSA EIB EUR EXIM FC FDI FI FY GBP GDP GFC GFS GoT GSM IDA IFAD IMF JPY MoFNP MTDS MTBF NNB NPV NRBF NRBT OPEC PDMC PEs PICs PRC REER RFB SDR TA TDB TDS TOP TSDF WB WPAC - AUS USD Asian Development Bank Average Time to Maturity Average Time to Refixing Australian Dollar Brazil, Russia, India and China Central Business District China Development Bank Chinese Yuan Renminbi Commonwealth Secretariat Debt & Recording Management System Commercial Paper Commonwealth Secretariat Debt Management Section Disbursed Outstanding Debt Debt Sustainability Analysis European Investment Bank Euro Export–Import Bank of China Foreign Currency Foreign Direct Investment Financial Institutions Financial Year Great Britain Pounds Gross Domestic Product Global Financial Crisis Government Financial Statistics Government of Tonga Government Securities Market International Development Association International Fund for Agricultural Development International Monetary Fund Japanese Yen Ministry of Finance and National Planning Medium Term Debt Strategy Medium Term Budget Framework No New Borrowing Net Present Value National Retirement Benefits Fund National Reserve Bank of Tonga Organisation of the Petroleum Exporting Countries Public Debt Management Committee Public Enterprises Pacific Island Countries People’s Republic of China Real Effective Exchange Rate Retirement Fund Board Special Drawing Rights Technical Assistance Tonga Development Bank Total Debt Service Tongan Pa’anga Tonga Strategic Development Framework World Bank Westpac Australia United States Dollar 4 Medium Term Debt Strategy (2015-2017) Foreword In ongoing efforts by the Government of Tonga (GoT) for prudent debt management and development of current practices going forward. This document is the first MTDS produced by the Ministry of Finance and National Planning (MoFNP), which provides an overall guidance for the best management of GoT’s debt in the medium term. The GoT’s debt management objective is to maintain sovereign debt within levels that are sustainable over time. This requires regular monitoring of debt levels against commonly accepted debt targets or thresholds established by multilateral institutions while also ensuring that any financing requirements are met at low cost with a minimum degree of risk in the medium term. This general objective and approach is also reflected in the Tonga Strategic Development Framework (TSDF) of 2010-2014 and the MoFNP’s Corporate Plan (2014/15-2016/17). This is the first Medium Term Debt Strategy (MTDS) that government adopts to manage its public debt1. The strategy is a document that describes the plan that Government intends to implement to achieve this composition. Medium-term planning horizon of the Government is usually for 3 to 5 years. This MTDS is in line with the approved budget for current FY 2015/16. The Budget theme follows the National and GoT themes, of: “A More Progressive Tonga”: enhancing our inheritance. As referred in the Budget Statement for FY 2015/16, despite our limited financial circumstances and other constraints, this current budget focuses on improving performance, growth, and wellbeing, while ensuring sound fiscal conditions; these conditions are in turn an essential requirement for our policies and priorities to be successful. The opportunities for new prudent borrowing, resulting from recent progress in lowering our level of debt distress from high risk to moderate risk, are being taken with care. They focus on saving costs, driving growth, and addressing the urgent reconstruction needs as result of recent disasters ie: cyclone Ian in the Ha’apai islands. The GoT is mindful of the risks due to the significant level of external debt that it currently holds, especially from the People’s Republic of China (PRC). Added to this is GoT’s ability to maintain external debt at a sustainable level with any further financing required from abroad over the medium term (even at concessional terms under the budget support 50% loan-grant financing or for other priority GoT projects) and in line with the vulnerability of the economy and exposure to exogenous shocks. Challenges will remain, the development of prudent debt management will require concerted efforts to constantly explore ways to mitigate the costs and risks in Government’s debt portfolio. It may also be necessary to review the legislations and to strengthen institutional arrangements for debt management including implementation of other new policies, as required. This MTDS thereby provides four strategies which 1 Public debt management is the process of establishing and executing a strategy for managing the Government’s debt in order to raise the required amount of funding, achieve its risk and cost objectives, and to meet any other public debt management goals Government may have set, such as developing and maintaining an efficient market for Government securities.” 5 Medium Term Debt Strategy (2015-2017) could help to meet GoT’s debt objectives and to achieve a more balanced composition of public debt. In conclusion, I would like to emphasise GoT’s commitment to promoting transparency and accountability in public financial management. The publication of this inaugural MTDS (2015-2017 will be reviewed annually in line with fiscal and macro development, It will provide a critical tool for informed policy decisions by all stakeholders with the intention to improve the debt burden and other fiscal vulnerabilities and also the relations with external and domestic financiers including development partners. _______________________________________ ‘Aisake Valu Eke Minister for Finance & National Planning 6 Medium Term Debt Strategy (2015-2017) Executive Summary The MTDS (2015-2017) is the first formal documentation of GoT’s strategy for management of debt. Prior to this policy, strategies have been on an ad hoc basis with approvals sought from His Majesty’s Cabinet as required. GoT has been borrowing externally and domestically for many decades. Following impact of the Global Financial Crisis (GFC) and the rapid escalation in Tonga debt for major infrastructural projects from PRC, that Tonga’s debt position has become more worrying. In 2007 Tonga was graded by the International Monetary Fund (IMF) at a high risk of debt distress. However, since mid 2013, due to improvement in economic policy reform to a ‘medium policy level’, Tonga has been upgraded to a moderate risk level. This provides a considerable revision of the debt sustainability thresholds and gives the GoT more scope for prudent borrowing going forward. A review was necessary to enable the revised financing of budget support from the World Bank (WB) and other donors of 50% loan and grant also for other priority external financing requirements by the GoT. In regards to prior GoT’s sustainability targets, while taking note of the low formal export base and inclusion of remittances as significant flows to the economy, revised debt sustainability ratios by IMF-WB are shown in Table 1: Table 1 : IMF – GOT Target FY 2014/15 Prior IMF Particulars threshold NPV of External debt as: % of GDP % of GDP (& remittances) % of exports % of exports (& remittances) % of revenue Total Debt Service as: % of exports % of exports (& remittances) % of revenue Prior GoT threshold Revised IMF-GoT threshold Current Level (FY 2014/15) 30 26 100 90 200 40 100 200 40 36 150 120 250 47 35 233 99 220 15 12 18 18 25 20 16 20 15 6 14 Following the upgrade of Tonga to a moderate risk level, the MoFNP continues to be cautious and to closely monitor GoT’s debt sustainability level in line with the recommended targets. During this initial MTDS period, practical options must be identified for GoT to implement in order to keep its future financing requirements at prudent levels and a minimum degree of cost and risk as a high priority. However, as the preferred option, that GoT will continue to exhaust all possible financing requirements from the grant pool fund as available from our development partners. As feasible, there is also option for domestic financing by issue of GoT securities and MoFNP is working with donors, such as Commonwealth Secretariat (ComSec), and the National Reserve Bank of Tonga (NRBT) for the required development of this area. Strategic advice for the Minister of Finance on advancement of GoT’s MTDS, for consideration of any borrowings required to finance possible budget deficits (GFS definition) and to improve the performance of the debt portfolio will be provided by the Public Debt Management Committee (PDMC). This committee is chaired by the Secretary for Finance and National Planning which comprises of senior officials from 7 Medium Term Debt Strategy (2015-2017) MoFNP and NRBT but due to other priorities have delayed PDMC responsibilities. This final document draws on the valued advices of the WB which has informed the final design of the MTDS for GoT with valued contributions by others working with MoFNP. 1. Introduction 1. The MTDS is a high priority of the GoT, with the prior classification by the IMF-WB of Tonga for high risk of debt distress - now upgraded to a moderate risk of debt distress. 2. GoT has recognised the need to have a formal and explicit MTDS in place to ensure improved debt management as part of a stronger MTBF to ensure GoT finances are placed on a more sustainable footing. 3. The MTDS provides directions and benchmarks for managing the GoT’s debt portfolio. This will lead to the ‘preferred debt composition’, i.e. the preferred costrisk trade-off, taking into account constraints posed by the economic and market environment. 4. This MTDS is an outcome of recommendations made by the recent MTDS Mission by WB to DMS, MoFNP during 5 to 12 August 2014. 2. Objectives for Debt Management 5. The main objectives are: To help MoFNP to manage GoT’s financing requirements are met at the lowest cost in the medium to long-term consistent with a prudent degree of risk. To monitor that the GoT maintains sovereign debt within levels that are sustainable over time; where such levels are regularly monitored against commonly accepted debt targets or thresholds suggested by multilateral institutions and taking into account the unique aspects of the Tongan economy, namely the low formal export base and the large remittance flows. 3. Scope for debt strategy 6. This MTDS covers the GoT’s debt portfolio which includes external debt, domestic debt, and contingent liabilities of on-lent debt and guaranteed debt with the public and other enterprises. 7. External debt is defined as debt denominated in currencies other than TOP while domestic debt is defined as debt denominated in TOP. 8. In line with international reporting requirements, GoT will consider review in future for current reporting of domestic debt (as may be required) to include the outstanding liability for transfer value under the old pension scheme for civil servants to the current scheme. 8 Medium Term Debt Strategy (2015-2017) 9. Although the focus of the MTDS is on actual direct liabilities of the GoT, contingent liabilities (whether explicit or implicit) may have an important bearing on the sustainability of debt and robustness of this strategy. Consequently, GoT has decided that it is prudent to consider the potential risk that contingent exposures could materialise under specific scenarios and thus may need to be addressed in the future. 4. Current Debt Portfolio 4.1 Profile of existing debt 10. The total volume of outstanding debt as at 30 June 2015 as shown in Table 2 is estimated at $422.6m, with an additional T$52.4m of contingent liabilities. This contingent liability consists of T$0.01m of loan guarantee at Tonga Development Bank (TDB), $51.1m on-lent loans due to the GoT from various public and other enterprises and $1.2m due to the Government from private sectors under Agriculture and Fisheries Market Fund. The existing debt portfolio is composed of 90% external debt and 10% domestic debt. The majority of external debt comes from bilateral creditors (68%), dominated by the EXIM at 66% (T$250.3 m) and the ADB at 16% (T$61.4m). Domestic debt is predominantly held by Financial Institutions (FI) at 47% ($19.2m), Retirement Fund Board (RFB) at 36% ($15m) and Companies at 6% ($2.4m). Table 2: Disbursed Outstanding Debt as at 30 June 2015 (TOPm) Domestic Debt GoT Bonds Total Domestic Debt External Debt Multilateral Creditors Bilateral Creditors Total External Debt Total Public Debt Outstanding Contingent Liabilities Guaranteed Debt On-lent Debt Government Fund Total Contingent Liabilities 11. Amount 41.0 41.0 122.8 258.8 381.6 422.6 0.01 51.1 1.2 52.4 Chart 1 below shows the actual and estimated position of total public DOD over the maturity period for the Chinese loans (excluding any fluctuation of FC rates). It shows a steady increase since FY 2007/08 as result of the disbursements on Central Business District (CBD) and Roads loans. However, there is a downward trend from FY 2018/19 going forward mainly as result of the projected principal repayments beginning for both these loans. Domestic debt is based on the current bond maturity structure at June 2015 and proposed rollover at a minimum of 6 years. Chart 1: Total Public Disbursed Outstanding Debt2, FY 2007/08–2028/29 (TOPm) 2 Excludes future fluctuations of FC rates 9 Medium Term Debt Strategy (2015-2017) TOP(m) 450.0 400.0 350.0 300.0 250.0 200.0 150.0 100.0 50.0 0.0 07/08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17 17/18 18/19 19/20 20/21 21/22 22/23 23/24 24/25 25/26 26/27 27/28 28/29 External 12. Domestic FY At end June 2015, loans from bilateral and multilateral sources account for $381.6m of the total external portfolio. During the 5 years period from 2010, there has been a significant change, where the official bilateral creditors account for the majority of GoT’s external debt at 67.8% mainly comprising of the 2 big loans from EXIM. Chart 2: External Debt Outstanding by Creditor Category (%) as at 30 June, 2010 & 2015 June 2010 June 2015 67.8% 40.7% 59.2% Multilateral 32.2% 0.1% Bilateral Commercial Multilateral Bilateral 4.2 Outstanding debt and composition 13. At end June 2015, CNY debt accounted bilateral loans being the largest share of the external portfolio at 67.8% followed by SDR with 32.2% (with breakdown by its currency component of USD accounting for 13.5%, Euro (EUR) for 12.0%, Great Britain Pounds (GBP) for 3.6% and Japanese Yen (JPY) for (3.0%). The currency composition of external debt has changed visibly over five years. At end June 2015, the CNY composition increase by 27% from end June 2010. Chart 3: External Debt Outstanding by Currency Composition (%) as at 30 June, 2010 & 2015 June 2010 40.4% June 2015 67.8% 0.1% 24.5% 12.9% 22.2% CNY 14. USD 0.7% 5.5% 6.6% GBP JPY NZD EUR CNY 3.2% 3.9% AUD 0.1% 14.3% USD GBP JPY EUR At end June 2015, Domestic debt is recorded at $41.0m, for GoT bonds issued. The main holdings are by FI, RFB and Companies. The main change during the 5 year period was an decrease of holdings by FI of over 20%. Chart 4: Domestic Debt by Holder (%) as at 30 June, 2010 & 2015 10 Medium Term Debt Strategy (2015-2017) June 2010 June 2015 55.7% 82.7% 15.1% 1.9% 9.8% 4.2%1.4% Financial Institutions (FI) FI Staff Retirement Fund Companies 15. 0.8% Retirement Fund Board Individuals Financial Institutions Retirement Fund Board Individuals 2.0% 25.5% FI Staff Retirement Fund Companies The primary domestic securities market is currently made up of GoT Bonds (fixed coupon) with main holdings taken up by the local FIs. GoT mainly issues bonds with a maturity of 6 years. Table 2 shows the volume on issue for each term. Issuance is authorised and capped operationally by the Minister of Finance while the NRBT is Registrar for issuance of the domestic bonds. The prospectus is published on the NRBT website, local newspapers and on the radio. The issuance is on a roll over basis, with maturing Bonds being financed by the new issues. Table 3: GoT Bonds as at 30 June 2015 (TOPm) Amount 19.2 21.8 41.0 Maturity 5 years 6 years Total 5. Historical Context of Debt Portfolio 5.1 Change in size and composition 16. Over the 10 year period, external debt has increased significantly since FY 2008/09 when the drawdown on the CBD loan from EXIM began in September 2008 and followed by the Roads loan in March 2010. Domestic debt has remained relatively unchanged. 17. In Chart 5, the trend of debt to GDP shows a decrease from FY 2005/06 resulting from a stable level of DOD while GDP grew. The ratio increase from FY 2007/08, despite GDP growth remaining positive for most of the period to 2012/13, DOD expanded more rapidly, However, by end June 2015, as result of full drawdown for both the loans from EXIM, although GDP growth slowed, the ratio increased. Chart 5: Total Public Debt Outstanding to Nominal GDP % (TOPm), FY 2005/06-2014/15 T$m 500.00 55.0% 400.00 50.0% 45.0% 300.00 40.0% 200.00 35.0% 100.00 30.0% 0.00 25.0% 05/06 18. 06/07 07/08 External 08/09 09/10 10/11 Domestic 11/12 12/13 TPD to GDP 13/14 14/15 FY's Over the last 10 years, there has been a significant change in the main external creditors and the currency components. Prior to June 2010, the ADB was GoT’s main external creditor and the SDR accounted for the main borrowing currency. 11 Medium Term Debt Strategy (2015-2017) The significant change in the position since June 2010 is due to drawdown for the CBD and Roads loans from EXIM denominated in CNY. 19. At end June 2010, EXIM accounted for the main creditors at 37.3% and increased to 65.6% at end June 2015. Tonga’s main three creditors in order of rank are EXIM (65.6%), ADB (16.1%) and IDA (WB) (13.7%). Chart 6: Creditor Composition of External Debt (%) as at 30 June, 2010 & 2015 June 2010 June 2015 2.3%2.2% 34.6% 37.3% 13.7% 65.6% 0.1% 16.1% 0.3% 3.1% 4.5% ADB 20. EIB 19.4% IDA IFAD BOC EXIM ADB EIB IDA IFAD BOC EXIM WPAC - AUST The currency composition of debt has changed markedly over the five year period. At end June 2010, the USD currency comprised 29.7% of loan portfolio followed by CNY at 28.6%. At end Jun 2015, the CNY accounts for over 65.6% of external debt, compared to just 29%. Chart 7: Currency Composition of External Debt (%) as at 30 June, 2010 & 2015 June 2015 65.6% June 2010 27.0% 28.6% 6.7% 12.9% 8.0% CNY 21. USD 3.2% 3.9% 29.7% GBP JPY EUR CNY AUD 0.1% 14.3% USD GBP JPY EUR Chart 8 shows the trend of debt servicing payments during the 10 year period and in comparison to ratio of revenues and expenditures. It shows a fluctuating trend in the prior 5 years period and a steady increase in FY 2014/15. Chart 8: Total Public Debt Service in ratio to Revenue and Expenditure % (TOPm), FY 2006/07–2015/16 25.0 20.0% 20.0 15.0% 15.0 10.0% 10.0 5.0% 5.0 0.0 0.0% 06/07 07/08 External 22. 08/09 09/10 Domestic 10/11 11/12 12/13 TDS to Revenue 13/14 14/15 15/16 TDS to Expenditure As shown in Chart 9, the repayment profile exhibits periodicity, with peak repayment volumes in March, September for external repayments to EXIM and also June and October to ADB. For domestic repayments, peaks are in August and June. There is a risk that in a period of low GoT cash balances, there will be insufficient funds set aside to make debt repayments during these months; hence the objective of holding sufficient cash balances. Chart 9: Monthly Pattern of Debt Repayments (TOPm) as at FY 2013/14 & 2014/15 12 Medium Term Debt Strategy (2015-2017) T$m 8.0 6.0 4.0 2.0 0.0 Jul Aug Sep Oct Nov 13/14 Dec Jan Feb Mar Apr 14/15 May Jun 5.2 Management of Guarantees and On-lending to PE’s 23. Chart 10 below shows the contingent debt position over the last 10 years and in comparison to GDP. Performance shows a general decreasing trend during the earlier years and an increasing trend in the later years due mainly to the on-lent loans for CBD project. However, by June 2015 there is a decrease due to end of a number of guaranteed loans. Chart 10: Contingent Liabilities to Nominal GDP % (TOPm), FY 2005/06–2014/15 80.0 10.0% 8.0% 60.0 6.0% 40.0 4.0% 20.0 2.0% 0.0 0.0% 05/06 06/07 07/08 08/09 On-lent Loans 09/10 10/11 Loan Guarantees 11/12 12/13 13/14 14/15 Contingent Liabilities to GDP 24. At end June 2015 outstanding guarantees are estimated at T$0.01m or 0.001% of GDP. Total on-lent loans as at end June 2015 due to the GoT from various public and other enterprises is estimated at $62.5m (at 7.5% of GDP and 18.6% of total external loans). 25. In reference to comparison of the external debt service by GoT and the repayment of on-lent loans in Chart 11, there is a clearly a mismatch between monthly flows of the payments both in the amount and frequency. 26. The external TDS by GoT was estimated at $13.4m with high peaks during September and March for the loans to EXIM as compared to $0.8m from on-lent borrowers mainly during July 2014 to June 2015. Chart 11: External Total debt service - GoT vs On-lent Loans (TOPm), FY 2014/15 4.00 3.00 2.00 1.00 0.00 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 External Dec-14 Jan-15 Feb-15 Onlent Mar-15 Apr-15 May-15 Jun-15 13 Medium Term Debt Strategy (2015-2017) 6. Analysis of Funding Sources Reconstruction spending is a near-term priority, while in the medium term, GoT will aim to gradually reduce the debt-to-GDP ratio. Tonga continues to be exposed to natural disasters, as well as the priority development needs, which requires careful management of fiscal space. 27. In reference to the Budget Statement 2014/15, as learnt over recent years, there is no scope for further fiscal expansion from large external loans. Fiscal expansion beyond the capacity of domestic revenue must be funded by increases in budget support and external aid, issuance of domestic bonds that mobilizes excess domestic liquidity, with some prudent external borrowing for viable projects, on highly concessional terms also for financing required for budget support under the revised 50:50 loan-grant mix. 28. For financing of the budget gap for the various initiatives taken by GoT in efforts to stimulate the economy. During 2014/15, half of the financing requirements will be sourced from highly concessional external borrowing from WB for budget support (loan portion) also for the reconstruction project in Ha’apai. The balance will be sourced domestically by issue of GoT bonds to the public at an average of 6 years at 3% per annum. For the 2 outer years, similar financing methods will also be taken. GoT proposes to seek only grant funding for hosting of the South Pacific Games in 2019, by Tonga. However, should a cost overrun result where debt financing will be required, it could return Tonga to a high risk of debt distress. 29. During this 3 year period of the MTDS, GoT does not project to undertake any external borrowing under commercial terms but only on concessional terms. On other financing options as explored in this MTDS it includes ‘existing’ sources and also ‘potential’ sources that GoT can consider to seek financing from. Table 4 provides information on related Creditors and briefly includes some cost and risk indicators on the various types of financing. Table 4: Creditors Cost and Risk Indicators Multilateral Creditors Cost indicators Risk Indicators: Existing: Highly IDA, ADB, IFAD, EIB Concessional Potential: Japan Highly Concessional Very low interest rates Very low interest rates Fixed Interest rates Long amortization profile Foreign currency, risk mitigated by the long amortization profile Fixed Interest rates Long amortization profile Foreign currency, risk mitigated by the long amortization profile Bilateral Existing: China Potential: Semi-concessional low interest rates Rep. of Korea Focusing on rural development and ICT India Focusing on agricultural projects Foreign currency indicators Fixed interest rates Depending on the source of financing Depending on the source of financing 14 Medium Term Debt Strategy (2015-2017) Creditors Cost indicators Risk Indicators: Theme Funds Potential: Climate Change Funds Grants/Loans depending on the source of financing Domestic Bonds 30. 31. Market - will reflect market development Depends on tenors achieved, may be some refixing, indexation creates other risk exposures Under non-traditional sources of financing, such as Climate Change ‘theme funds’, that the WB manages 6 climate change funds, which could provide important amounts of financing for member countries. For consideration in future periods, some semi or concessional financing may also be available from other sources such as Brazil, Russia, India, China, South Africa (BRICS), and from the Organisation of the Petroleum Exporting Counties (OPEC). 6.1 32. Domestic Financial Characteristics of Existing Debt During the last 5 years, there has been an increase in the external portfolio of $134.1m mainly due to the loan disbursements from EXIM. Chart 12: Government Debt by Residency of Creditor (%) as at 30 June, 2010 & 2015 June 2010 June 2015 91.1% 90.3% External 8.9% Domestic 9.7% External Domestic 33. The terms of the current loans from multi-lateral institutions are generally with maturity of 40 years at 10 years grace period and 30 years repayment at fixed interest rate of 0.75-1.5% per annum. 34. However, there is some debate on concessionality of the loans from bi-lateral institutions in PRC based on use of different discount rates. That it is not within the recommended 35% grant element for developing countries such as Tonga. The terms of the current loans are at maturity of 20 years with grace period deferred by 5 years resulting in 10 years grace and 10 years repayment at fixed interest rate of 2% per annum and other loan fees. 35. For domestic debt, the current terms of GoT bond issues are mainly at 5 years at fixed interest rate of 3.1%-6.5%. In prior years temporary financing was taken through overdraft facilities at local commercial banks at market rates, while Treasury Bonds were also issued at 3-6 months duration. Interest income on GoT securities is tax exempt. 36. As referred earlier, the bi-lateral creditors remain the major source of external financing (EXIM) and followed by multi-lateral creditors (ADB and IDA) and fixed coupon bonds account for the only domestic financing source. 37. At end June 2015, financing sources as tabulated in Table 5 below: Total of 44 loans being 28 external loans (mainly from bi-lateral sources) and 16 domestic bonds (fixed coupon bonds). These loans from ADB (13 loans), WB (6 loans), PRC 15 Medium Term Debt Strategy (2015-2017) for loans from EXIM and CDB (4 loans), IFAD (3 loans), EIB (2 loans), WPAC Australia (1 loan) and domestic bonds. Table 5: Summary of financing sources as at 30 June 2014 Creditor No. of loans Range of years IN rate (%) 13 1977-2002 1.0-1.5 ADB 7 1987-2005 0.75 WB 4 2008-2010 2.0-2.5 PRC 3 1983-1993 1.0 IFAD 1 1979 1.0 EIB 16 2009-2020 3.1- 6 Bonds 44 Total 38. Total (TOPm) 61.4 52.4 258.8 8.7 0.3 41.0 422.6 With reference to how the external and domestic financing was used for development of respective sectors of the economy, as in Chart 13. Chart 13: Total Public Disbursed Outstanding Debt by Economic Sector (%) as at 30 June 2015 23.16% 0.05% Agriculture 1.13% Economic & social development 7.90% Education & training Energy (electricity) 2.69% 3.77% Finance & Insurance Fishing 4.03% 9.20% 2.46% 0.03% 2.73% 3.22% 0.97% 5.85% Health & Social welfare Housing & Urban development Industrial development Infrastructure development Multi-sector Roads & Bridges Telecommunications Tourism & Hotel industry 32.81% 39. Budget Financing In line with best practice and to maintain transparency and predictability of GoT’s domestic bond issuance, that MoFNP will consider in future to also publish some of the details on its website: 7. Baseline Projections Chart 14 shows Tonga’s performance over the related 10 year period. In general, Tonga has not done well. Chart 14: Tonga’s Economic Performance relative to PICs 16 Medium Term Debt Strategy (2015-2017) 10.0 5.0 0.0 -5.0 -10.0 -15.0 -20.0 -25.0 -30.0 -35.0 1.0 -0.8 3.9 3.2 -0.4 -0.5 -18.1 -24.3 -23.9 -29.8 (%) Tonga (2000-2007) Tonga (2010-2013) Tonga (2014-2019) 7.1 Fiscal 40. GoT fiscal policy is its primary tool to improve income distribution through both its revenue and spending policies. Fiscal policy are designed to support macroeconomic stability, correct market failures and provide public goods with particular emphasis on inclusiveness, in particular elderly welfare, special needs of vulnerable groups and disable, access to free and improved health care, and free basic primary education and subsidised post secondary education. 41. The GoT’s recurrent budget shows the significant contribution of budget support relative to domestic revenue of T$19.3m. The share of staff costs compared to operating expenditure continue to account for over 50%. The small cash surplus in 2013/14 and estimated larger surplus in 2014/15 (arising from deferral of the EXIM Bank loan repayments) will contribute to GoT cash balances. These related infos are shown in Chart 16. Chart 15: Domestic Budget Performance 250 200 150 100 Accumulated Bank Deposit Accumulated Overdraft Total Domestic Receipts (w/o BS) Receipts + Budget Support Total Recurrent Payments Available Payments w/o debt service Total budget support Required Bank Balance 2 months 50 0 42. The main principles to be followed (with support of specific policies): 17 Medium Term Debt Strategy (2015-2017) improving estimation of funding ceilings based on realistic assessments of revenue raising capacity, budget support and development assistance, and where appropriate prudent borrowing; more careful assessing and managing of appropriate levels of public debt and cash reserves required to create fiscal space to respond to shocks and unforeseen events; improving budget allocation across sectors by better analysis, prioritization and discussions to better align funding allocations to Ministry corporate plans based on the TSDF and overall available funding; improving quality of expenditure by ensuring commitments are properly costed and funded, restricting ad hoc funding additions during the year, improved financial management and reporting, linked to reporting on progress against corporate plan indicators. 7.2 43. Monetary The roles of monetary policy include (with support of specific policies): ensuring sound financial institutions (encourage strong and viable banking); maintaining adequate foreign reserves (at least 3 months cover of imports); protecting external balance (balance of payments and currency convertibility); supporting price stability (low inflation); facilitating growth of the domestic economy. 44. Both GoT and the NRBT recognise the very limited options for expansionary monetary policy and domestically funded fiscal expansion in a small open economy. Prudent and coordinated decisions between both policies are critical. Imprudent policies can quickly generate a macroeconomic and fiscal crisis which would set progress back, in all areas, for many years. Macroeconomic stability will thus remain the corner stone of the collaboration between fiscal and monetary policy. 45. The NRBT already is following as relax a monetary policy as prudence would allow. The banking system is still working off the high level of non-performing loans from the last attempt to boost lending beyond prudent levels. Bank lending to business continues to decline, though less rapidly, while lending to households (which includes some commercial activity) is growing. Monetary policy will work to mitigate against a future building up in the level of non-performing loans while encouraging lending for commercially viable investments. 46. The rate of the core inflation, which excludes food and energy prices, increased by 5.6% over the year to February. Inflation is projected to be around 2.5% in June, before falling to 0% at the end of 2015. 47. Interest rates have fallen by between 36 and 71 basis points since the end of the last financial year. Bank loan rates have fallen by more, because the composition of lending has shifted towards lower-risk lending products (lending rates low by standards of past periods). Deposit rates are little changed. NRBT sees little room 18 Medium Term Debt Strategy (2015-2017) for lending rates to fall much further despite increased competition in banking services. 48. Total bank lending balances grew by 8.9% over the year to February 2014. The growth was all to households with a continued, but slower, decline to businesses NRBT anticipates a further growth in lending of 10% over the current year and 2015 which will support the anticipated improvements in GDP growth. Key challenges for Tonga: There are several downside risks to the baseline macroeconomic outlook. These include the risk of not securing sufficient grant financing for the hosting of the South Pacific Games; remittances and tourism not increasing as robustly as expected; the Government not being able to control the wage bill combined with a tax reform not resulting in the expected revenue increases. These risks are likely to dampen growth prospects, put downward pressure on the exchange rate, and lead to a rise in domestic and/or external borrowing needs. Continuation of financial difficulties in the main origin countries of remittances from Tongans abroad and main sources of tourists (New Zealand and Australia) would negatively affect the expected economic growth rate. Furthermore, any delays in implementing revenue reform and reducing the wage bill weight in government expenditures could exert further pressure to resort to additional borrowing. 7.3 Other longer term structural adjustments The TSDF, which encompasses nine priority areas, continues to guide the overall strategic reform of GoT. In support of addressing the current debt overhang and the requirement for fiscal consolidation and structural reform in the medium term, the TSDF covers the following related areas beyond the MTDS. 49. Structural Policy: Structural reforms to facilitate the functioning of credit markets need to be implemented and with renewed vigour. GoT intends to gradually phase out existing ad hoc tax incentives. The promotion of foreign direct investments (FDI) should focus on business enabling structural reforms, while the use of tax incentives should be minimised and well targeted. GoT is also committed to further strengthening the private sector partnership to increase competition which helps improve quality and lower prices for customers. Promoting FDI should focus on business enabling structural reforms, and there is the need to strike the right balance between promoting FDI projects and protecting revenue base. 50. Improving the way GoT operates is key to a more efficient, effective and affordable public service needed to deliver GoT policies and services while ensuring fiscal stability. Major reforms are under way and these relate to economic and social policy analysis, national and corporate planning and budgeting, staff performance and management, improved governance and transparency as well as other technical areas. 51. On development of domestic debt market, especially of GoT securities, this is an alternative financing option. Follow up technical assistance (TA) by ComSec is being carried out by DMS of MoFNP in liaison with the NRBT. For details of priority areas for assistance as regarding institutional arrangements, scope of instruments and investors, this is referred in Annex 1. 19 Medium Term Debt Strategy (2015-2017) 52. GoT recognises that the medium-term prospects for Tonga, depend on the continued implementation of its wider program of structural reforms as well as retaining a focus on the MTDS within the wider strengthening of the MTBF to ensure GoT finances are on a sustainable path. This will also provide policy space to allow better response to future shocks. 8. Risk Scenario Testing 53. There are several inherent risks in the debt portfolio. The GoT has in recent years, noted the priority need to employ various measures to mitigate these risks and to minimise the impact of various exogenous shocks on the portfolio. The GoT will continue to identify and mitigate risks to the implementation of the debt management strategy. Prudent debt management practices will be pursued over the medium-term with a view of satisfying the mandate as outlined in the MTDS. 54. Stress testing involves deciding on realistic problems (downside risks) that the country might face, and looking at how they are likely to affect the country’s future economy. GoT recognises that stress testing is an important part of a debt sustainability analysis, where the effect of downside risks on the ability of a country to continue to make debt repayments is examined. 8.1 Cost and Risk Characteristics of Existing Debt Table 6 looks at position of GoT’s debt portfolio and what are the major costs and risks and how they can be mitigated in the medium term. Table 6: Cost and Risk Characteristics of the Existing Debt Portfolio as at 30 June 2015 Particulars Amount (in millions of TOP) NPV debt as % GDP Cost of debt Weighted Av. IR (%) Interest ATR (years) Debt refixing in 1yr (% of total) rate risk Fixed rate debt (% of total) FX debt (% of total debt) FX risk ST FX debt (% of reserves) 55. External debt 381.6 44.0% Domestic debt 41.0 3.5% Total debt 422.6 44.5% 1.3 9.3 4.3 99.9% 5.0 0.5 1.6 0.1% 2.0 8.8 5.9 100.0% 92.1% 130.8% The total public debt to GDP ratio is estimated at 51.5%, with external debt at 46.5% and domestic debt at 5.0. At end June 2015, the debt portfolio of GoT wasmainly comprised of external debt at 90% and domestic debt at 10%. In comparison of Tonga’s external debt position with other countries as in Chart 17, it is under the island average but above the upper middle income level. For domestic debt, Tonga’s position is below both the island and upper middle income average. Given this, it supports the strategy by GoT for development of the domestic market. Chart 16: Nominal debt as % of GDP 20 Medium Term Debt Strategy (2015-2017) % of GDP 120 100 80 60 40 20 0 45.80 Total debt External debt Domestic debt 42.30 3.60 56. The majority of the external debt is from EXIM as denominated in CNY at 66%, and from the ADB and IDA as denominated in SDR at 18% and 14% respectively. 57. External debt is mainly on a concessional basis at a fixed interest rate of 0.75% to 2% per annum. With the most part to mature in more than 10 years time at 97.8%. Domestic debt is on a more commercial basis at a fixed coupon rate of 3.1% to 6.65% per annum. The majority of debt will mature in 1-3 years at 64.4%. 58. 8.2 Analysis of Cost and Risk Indicators 59. Looking forward over the next 3 years, the debt sustainability position will change as result of the revised thresholds and assuming no new borrowing, that most of the indicators will not be breached (includes fluctuations3). However, cautious monitoring by MoFNP of GoT’s debt sustainability level is required and especially on any ease for future external borrowing and to coincide with improvement in our current level of economic activity and prudent public debt management, in order to mitigate the vulnerability to shocks. Chart 17: NPV External Debt as % of GDP Chart 18: NPV External Debt as % of Exps & Remittcs 200.0% 50.0% 100.0% 0.0% 0.0% 04/0505/0606/0707/0808/0909/1010/1111/1212/1313/14 04/05 05/06 06/07 07/08 08/09 09/10 10/11 11/12 12/13 13/14 NPV External Debt as % of GDP NPV External Debt as % of exports & remittance GoT Threshold Chart 19: TDS as % of Revenue Chart 20: TDS as % of Exports & Remittances 20.0% 30.0% 25.0% 15.0% 20.0% 15.0% 10.0% 10.0% 5.0% 5.0% 0.0% 0.0% 04/05 05/06 06/07 07/08 08/09 09/10 10/11 11/12 12/13 13/14 TDS as % of revenue GoT Threshold 03/0404/0505/0606/0707/0808/0909/1010/1111/1212/13 TDS as % of exports & remittance 60. Over the last 10 years (FY 2004/05-2013/14), Chart 18 - 21 show the debt sustainability position of the GoT’s debt portfolio (excludes fluctuations). Since FY 2007/08 when disbursements began for the EXIM loans, there has been a significant rise in the Net Present Value (NPV) ratios and where the thresholds 3 Nominal GDP, Exports & Remittances decrease by 2%, Revenue decrease by 1%,& FC rates increase by 5% 21 Medium Term Debt Strategy (2015-2017) were breached in the last few years. The TDS ratios have shown a fluctuating trend but have remained well below the thresholds. 8.2.1 Exchange Rate Risk 61. Foreign exchange rate risk relates to vulnerability of the debt portfolio and the impact on GoT’s debt servicing cost due to a depreciation of the TOP against the currencies in which the external debt is denominated. Chart 22 shows a comparison of related risks for Tonga’s external debt position with other countries. Clearly, in general, Tonga is way above the average position. Chart 21: Foreign Exposure (Tonga vs. the world) % 100 90 80 70 60 50 40 30 20 10 0 92.30 Foreign Debt % of Total Short-term Foreign Debt % of Reserves (RHS) 14.10 Tonga Island average Upper Middle Income Average Lower Middle Income Average 16 14 12 10 8 6 4 2 0 Low Income Average 62. Of the external debt, $381.6m (90%) is denominated in currencies other than the local currency and is therefore exposed to exchange rate changes. This is considered to be the most serious of the potential risks given the major foreign currency, the CNY, is anticipated to appreciate against the TOP (also the SDR). Chart 22: External Debt Outstanding by Currency, FY 2014/15-2030/31 400 300 200 100 0 13/14 14/15 15/16 16/17 17/18 18/19 19/20 20/21 21/22 22/23 23/24 24/25 25/26 26/27 27/28 28/29 29/30 CNY USD GBP JPY EUR AUD 63. Foreign exchange movements will change both the amount of debt servicing and the value of debt outstanding, TOP, and therefore the related debt ratios. 64. Chart 24 below shows that the CNY accounts for the major component of debt service at (70%) followed by USD (12%), EUR (11%) and the remaining currencies are estimated at less than 7% (includes fluctuations). Chart 23: External Debt Service by Currency, FY 2014/15-2029/30 22 Medium Term Debt Strategy (2015-2017) 40.0 30.0 20.0 10.0 0.0 14/15 15/16 16/17 17/18 18/19 19/20 20/21 21/22 22/23 23/24 24/25 25/26 26/27 27/28 28/29 29/30 CNY USD GBP JPY EUR AUD 65. It is estimated that the annual external debt servicing obligations will increase in FY 2018/19 by $10m or around 1.2% of the projected GDP. 66. The annual external debt service will increase to over $20m and will remain at that level over the next 13 years or so (this excludes any fluctuation of borrowing currencies in future). This is due to reschedule of principal repayments on the major loans from EXIM, due to start from September 2018. 8.2.2 Refinancing Risk 67. Rollover risk is the risk that maturing debt cannot be replaced or refined, or that the replacement debt will be more expensive. 68. At end June2015, the proportion of domestic debt falling due within one year is 20.3% of domestic debt while 22.4% of domestic debt will mature in 1 to 2 years. The ATM of the total debt portfolio is 8.8 years in FY 2013/14, with external and domestic debt portfolios recording 9.3 years and 2.6 years respectively. The debt maturing in one year is 5.9% of total public debt. For the external debt portfolio 4.3% matures in one to two years whilst about 1.6% of the domestic debt portfolio matures in one year. 69. In comparison of refinancing risk for Tonga with other countries,, for external debt portion it is below the island average but above the upper middle income level position. However, for domestic debt that Tonga is well below all the country averages (as shown in chart 25). Chart 24: Total Public Debt - Refinancing Risk (Average Term to Maturity) 18 16 14 12 10 8 6 4 2 0 9.70 Total debt External debt Domestic debt 10.30 2.50 Years 70. The GoT is aware of the refinancing risk that is inherent in the current structure of the domestic debt portfolio, due to its shorter maturity, and therefore will pursue the strategy to extend the maturity profile of new issues to more than 5 years with the maturing bond in June 2015, as below. There is a great opportunity for this strategy given the over subscription of the bond roll over during the last few years. 23 Medium Term Debt Strategy (2015-2017) Currently, all bonds are essentially funded on a roll over basis, with new issuance funding maturities and a nil net effect on financing. Chart 25: Remaining Maturity Profile of Domestic Debt (TOPm) as at 30 June 2015 6 yrs 3.0 5 yrs 5.0 4 yrs 2.5 3 yrs 5.0 2 yrs 8.0 1 yr 6.0 0 1 2 3 4 5 6 7 8 9 71. At the end June 2015, the proportion of external debt with maturity of less than 10 years is estimated at 2.1% while 97.9% has more than 10 years to maturity with the majority of repayments to be made in the distant future. Chart 26: Remaining Maturity Profile of External Debt (TOPm) as at 30 June 2015 15+ yrs 182.6 10 - 15 yrs 146.5 5 - 10 yrs 2.9 3 - 5 yrs 4.2 1 - 2 yrs 0.2 0.0 20.0 40.0 60.0 80.0 100.0 120.0 140.0 160.0 180.0 200.0 8.2.3 Interest Rate Risk 72. Interest rate risk is the risk associated with interest rate changes in the debt portfolio. 73. At end June 2015, the weighted average interest rate of external debt is estimated at 1.6% and of domestic debt at 4.3%. 74. As shown in the chart 28, in comparison of Tonga’s position to other countries, it is well below the related average. Chart 27: Cost of debt – weighted average interest rate Percent 12 10 8 6 4 2 0 1.80 Total debt External debt Domestic debt 4.30 1.60 75. The proportion of the instruments is mainly of fixed-rate and a minor amount of variable-rate. During the 5 year period, there has not been much change.. Chart 28: Share of fixed rate to floating rate debt (%) as at 30 June, 2010 & 2015 24 Medium Term Debt Strategy (2015-2017) 0.1% 100% 80% 60% 40% 100.0% 100.0% 100.0% Domestic Debt at end June 2009 Domestic Debt at end June 2014 99.9% 20% 0% External Debt at end June 2009 External Debt at end June 2014 Fixed-rate Loans Variable-rate Loans 8.2.4 Liquidity and Repayment Risk 76. Servicing debt is a primary concern for debt management and to ensure that the total expenditure including debt service costs does not exceed revenue collected. This risk can be expressed as the cost of debt repayments compared with funds available. 77. This is a real risk for GoT especially from FY 2018/19 with the projected large increase in external debt servicing costs. In comparison of these costs to both revenue and expenditure it may create inability to meet all the repayments as due. 78. Chart 30 below shows the costs for debt servicing over the next 16 years, with external debt accounting for bulk of the costs at over 73% (includes fluctuations) Chart 29: Total Public Debt Service by Currency, FY 2013/14-2029/30 50 40 30 20 10 0 13/14 14/15 15/16 16/17 17/18 18/19 19/20 20/21 21/22 22/23 23/24 24/25 25/26 26/27 27/28 28/29 29/30 CNY USD GBP JPY EUR AUD TOP 79. Due to the impact of this real risk, the two major loans from EXIM Bank of China (CBD and Roads) have been rescheduled with Amendment Agreements signed in June 2014. This debt service has now been deferred for another 5 years with repayments (CBD) to begin in FY 2018/19 (September 2018) until maturity (Roads) in FY 2029/30 (February 2030). However, with this temporary relief, that it will cost more for GoT in future years. Unless, PRC will consider favourable cancellation of a portion of this outstanding debt (if not all). 8.2.5 Creditor Concentration Risk 80. Creditor concentration risk refers to risks associated with most of the debt portfolio being held by one or two creditors. Those who hold a large proportion of debt could have a vested interest in the course of a country’s affairs and could potentially have an undue influence in policy development. 81. For domestic debt, the major holders of GoT bonds are the FI at 56% and followed by RFB at 25% and Individuals at 8%. In order to diversify the investor base, the MoFNP will work closely with NRBT in liaison with ComSec as may be required to explore the scope and options of instruments to offer the domestic market. 25 Medium Term Debt Strategy (2015-2017) 8.2.6 Credit Risk of on-lent and guaranteed loans 82. With the current level of outstanding on-lent loans from GoT there is implicit exposure to default and non-payment of obligations by these entities also from those borrowers of those loans are guaranteed. Introducing more analysis and oversight of these transactions will reduce the overall risks embedded in the GoT’s debt portfolio. These are not covered in detail in this initial MTDS but will be developed as part of ongoing work by DMS (MoFNP) and for future reporting. 83. In the near term, the MoFNP will also consider review of the draft Policy Framework for GoT in particular for contingent liability management. This document will be formalised and for subsequent implementation with related capacity building of staff. 8.3 Other Risks in Managing the Portfolio 8.3.1 Operational Risk: 84. The operational risks facing the DMS in Tonga stems from the small staff size and limited capacity, which is also vulnerable to staff movements. At end June 2014, there are only three staff and therefore MoFNP cannot take advantage of the controls that come with separations between front, back and middle office, as is the case with larger Sovereign Debt Management offices. The difficulty in developing and retaining skilled staff in this area is a risk for Treasury and MoFNP, in general. In order to address this risk, DMS staff mainly attend external trainings funded by donors such as the ADB, ComSec, IMF-WB. Other sources of external assistance are in-country missions to MoFNP on respective areas for development of debt management. In the near future, DMS staff may also get an opportunity for secondment arrangements to either regional offices or direct with donors such as WB. There is also proposal by ComSec for re-instatement of the Regional Advisor programme which gives closer access for user countries of the ComSec Debt and Recording Management System (CS-DRMS) to expert advice both on policy and technical system issues. 8.3.2 Strategic Risk 85. Strategic risk is the risk that decisions made about management of the debt portfolio have a high opportunity cost. 86. If GoT decides not to borrow, then it could miss out on grant funding (if grant funding for these projects is not available from other sources). If decisions to borrow for particular projects do not match expectations, then this money could have been better spent elsewhere on other, more beneficial projects. Money spent on servicing debt might be better spent on providing essential services. 87. Alternatively, it is better to pay down debt (which saves the GoT future interest payments and increases borrowing opportunities in the future) rather than spending funds unwisely. In view of this risk, the MoFNP as part of the annual budget preparation needs better review and coordination to best determine for any financing that the GoT may require and to analyse the related costs and risks for those options. 8.3.3 Financial Risk 26 Medium Term Debt Strategy (2015-2017) 88. Financial risk is the risk that the GoT’s portfolio management is so poor that it creates a source of instability for the private sector. The risk for Tonga is that a poorly managed debt portfolio will mean that less money is available for servicing the country’s basic needs which could undermine development and progress towards the MDGs. 89. A burgeoning debt portfolio or a build-up of debt arrears might negatively influence investor confidence, weakening private sector activity, leading to a withdrawal of investment in the country, a decline in GDP growth and a further increase in debt to GDP ratios. This is an extreme risk as seen recently in some European countries. 9. Recommended Strategies and desired composition of debt 90. The DMS has considered four main strategies as practical that GoT will explore in the next three years and the analyses done takes into account the debt management objectives and also the debt sustainability position under various macro scenarios. These strategies do not exclude each other and can be implemented at the same time. There are also other strategies available for GoT to consider but as a priority that these main strategies to be implemented, are as referred below. 91. These strategies include: Strategy 1: For current practice of mainly external financing (semi and concessional) and some domestic bond financing To evaluate the cost and risk aspects of a continuation of current borrowing practices for Tonga, and to use these factors to set a benchmark for examining different approaches. For the Baseline strategy, of implied net borrowing (or retirement of debt) over the simulation period, 50% was assumed to be sourced from Multilateral Creditors (eg: IDA, ADB) at highly concessional terms, and the remaining 50% from issuance of domestic debt in maturities of 6 years (Table 7) Table 7: Alternative Borrowing Strategies 27 Medium Term Debt Strategy (2015-2017) In conclusion, this strategy is based on current practice of external and domestic borrowing, that it does not best address the priority issues of foreign exchange risk, liquidity and repayment risk, creditor concentration risk and refinancing risk. Under the cost and risk analysis over the 3 year period as referred below in point 109 this strategy in comparison to 2, 3 and 4, provides medium to high risk mainly due to the foreign exchange factor and low to medium cost in relation to GDP. Strategy 2: For development of domestic securities market To examine the cost and risk aspects of taking steps to further develop the domestic debt market, Strategy 2 highlighted an overall balance of new borrowing that tapped the domestic market for 95%of financing requirements, and the external debt market for 5%. A domestic yield curve was established following the existing rate structure in Tonga for the 5-6 year debt stock, and extended to cover the issuance span from 1 to 10 year maturities. Bond issuance was posited to be concentrated by almost 60% (of domestic flows) in 5-6 year bonds—deepening the existing market, while building to an average 30% concentration in 10-year bonds—establishing a longer term maturity in the market; and by an average 7% at the 1-year maturity. A priority, one would anticipate greater costs for this strategy vis-à-vis baseline, given the higher level of domestic interest rates versus international concessional ones; but exchange rate risk would be diminished by the higher share of domestic-currency denominated debt. In conclusion, this strategy best addresses the priority issue of foreign exchange risk and liquidity and repayment risk with roll over of domestic securities on maturity. Under the cost and risk analysis over the 3 year period as referred below in point 109, this strategy in comparison to 1, 3 and 4, provides low risk mainly 28 Medium Term Debt Strategy (2015-2017) due to the foreign exchange factor of external borrowing and high cost in relation to GDP due to the interest rate factor and shorter maturity compared to external borrowing. Strategy 3: For highly concessional financing Strategies 3 and 4, in contrast to Strategy 2, examine the tradeoffs in expanding external borrowing, in Strategy 3 by boosting the proportion of gross external borrowing over the 2015-2022 period to 83% from 50% in the baseline, here concentrated in concessional multilateral borrowing. Domestic debt issuance is diminished to 17% of total financing requirements. In conclusion, this strategy best addresses the priority issue of refinancing risk. Under the cost and risk analysis over the 3 year period as referred below in point 85, this strategy in comparison to 1, 2 and 4, provides medium risk mainly due to the foreign exchange factor and lowest cost in relation to GDP due to the interest rate factor available from multilateral sources offering highly concessional terms. Strategy 4: For bilateral financing Strategy 4 looks at an alternative approach to making use of the external market, by borrowing from “new” bilateral creditors carrying quasi-or semi concessional terms (almost 70% of international flows), in addition to multilaterals (at half of baseline proportions), and a small 8% share of domestic debt. In anticipation of results, Strategy 3 should exhibit a lower cost profile given advantageous interest rate terms, but foreign exchange risk may be heightened. Strategy 4 may show a low-cost/higher risk profile as well. In conclusion, this strategy best addresses the priority issue of creditor concentration risk. Under the cost and risk analysis over the 3 year period as referred below in point 85, this strategy in comparison to 1, 2 and 3, provides highest risk mainly due to the foreign exchange factor and less concessional terms also medium cost in relation to GDP due to the higher interest rate (from terms offered by multilateral sources). 92. To determine the cost-risk profile of the baseline macroeconomic scenario-borrowing strategy combination, a set of standard market shock tests are applied to the strategy in order to assess the different vulnerabilities to exchange and interest rate fluctuations. Three currencies were considered in the analysis: the U.S. and Australian dollars and the Chinese Yuan. The market shocks included: (i) two standard shocks to baseline exchange rates (one of 15% depreciation and another of 30% depreciation, both in the first year of the forecast); (ii) two interest rates shocks (here 100 and 200 basis-point increases to domestic interest rates were imposed), and (iii) a combined shock, which simulates the effects of the 100 basis point interest rate increase with a 15% exchange rate shock. The assumptions did not include any shocks to the external debt instruments, as all but one small loan feature fixed interest rates, and any future external loans are expected to 29 Medium Term Debt Strategy (2015-2017) come in IDA standard terms and therefore also with fixed rates and very little chance for future increases in rates. Cost4 for a particular borrowing strategy is defined for example, as the calculated ratio of debt to GDP as of the last forecast year (2022). Risk for the same strategy is calculated as the maximum change in cost (in points of GDP) between the “worst-case stress test” version of the borrowing strategy and that strategy without stress simulations applied. Cost-risk can also be examined from the interest cost of debt service perspective, looking at the interest to GDP ratio at the end of the simulation period. The reason for focusing on the last year of the period is that differences on a year to year basis, especially when most of the debt is on concessional terms, do not show substantial changes. Moreover, the purpose of the analysis is to verify whether the objectives of the strategy are achieved at the end of the period. 93. In reference to the preferred position of GoT to improve its current debt portfolio. The recommended strategies provided in this document consider what are some practical options to minimise the cost and risks in particular of the external debt and to also have a more balanced composition to the domestic debt (i) To summarise, the following Table refers on the position of each of the four strategies including the combined macro scenarios applied over the 3 year period and the related indicator of the GoT’s debt portfolio. Charts 31 – 33 highlight the results of the simulations for the four borrowing strategies outlined under the baseline macroeconomic fiscal projections as presented in this above. The table shows the set of risk indicators as found in the earlier analysis of the characteristics of the current debt portfolio—this time featuring the current profile, together with the four borrowing strategies for FY2022. The figures present the cost –risk ‘tradeoffs’ for the four borrowing strategies together, where Chart 30 shows the Debt to GDP ratio as a measure of cost (y axis), and risk measured as the change in cost under the ‘worst case’ stress test (x axis). (ii) All borrowing strategies result in a substantial (about 15 point) decline in Tonga’s expected debt to GDP ratio over the 8-year span between FY2015 and FY2022. This is due to two factors--fiscal (largely revenue enhancement) assumptions built into the baseline macro-fiscal scenario which yields a primary balance surplus over several years of the simulation; and the contribution to debt reduction stemming from a cumulative four year repayment of outstanding debt with China EXIM by 2022. If the left-hand scale in figure 8a is examined, the range can be seen to be fairly narrow. (iii) When comparing borrowing strategies in Chart 31, it is observed that Strategy 3 (highly concessional borrowing) could be deemed the most beneficial, as it focuses on concessional funding. It should be pointed out however that availability of highly concessional funding is limited, and will gradually reduce over time as the Tongan economy develops. (iv) It is noted that Strategy 2 (domestic market development) carries the highest cost among alternatives in terms of Debt to GDP, largely due to higher 4 The use of these two cost measures was discussed with the authorities. Alternative measures, such as interest cost to revenues etc. could also be used 30 Medium Term Debt Strategy (2015-2017) domestic interest rates (contrasted with low international rates) being established by new bond issuance. But risk is somewhat lower for Strategy 2, in part due to the lower foreign exchange exposure to which the other borrowing plans are subject. (v) In contrast to Strategy 1 (current practices), both borrowing options 3 and 4 explore a more intensive sourcing of finance from international markets. Strategy-3 (Multilaterals) shows lowest cost characteristics across strategies, at 28% of GDP, tied to the concessional terms of borrowing from these institutions. (vi) While Strategy 4 (New Bilateral Creditors) shows higher costs and risks than the former, against the background of somewhat less concessional terms on lending, and exposure to foreign exchange fluctuations. Both Strategies exhibit improvements in cost vis-à-vis current practices, suggesting that placing some emphasis (in the wake of revisions to the NNB policy) on renewed concessional- or quasi-concessional borrowing could be more cost effective. It should be noted that bilateral borrowing shows highest risk characteristics of the group, once more due to foreign exchange considerations. 94. The related macro scenarios applied to the strategies, as below: I. Baseline scenario of variables at June 2015 (using Budget and DSA) The baseline macro scenario did not take into consideration the fact that, following the upgrade in DSA risk ratings, previous amounts of grants might not materialise, and therefore the financing gap would be larger and new loans required. II. Lower revenues of 50% less grants The first alternative grant level scenario “lower ” posits a 50% reduction in budget support grants beginning in 2017 increasing the financing requirement by some 20% of GDP by 2020, while experiencing a slight increase in indicators due to higher domestic interest rates and foreign exchange risks. III. Debt relief of the 2 major loans from Exim Bank of China The second alternative scenario: “debt relief” serves to lower borrowing requirements by almost 25% of GDP, on the assumption T 25% thatofaGDP Debtttfor Development agreement is reached with Chinese authorities. 95. Charts 31 - 33 show position of the four strategies after taking into account the cost and risk analysis based on the various macro and fiscal scenarios applied Chart: 30 Debt to GDP As at end of 2017 Cost (%) 43.45 S2 43.40 43.35 S1 S3 43.30 S4 Risk 43.25 3.70 3.75 3.80 3.85 3.90 3.95 4.00 4.05 4.10 4.15 4.20 31 Medium Term Debt Strategy (2015-2017) In comparison of the four strategies under this analysis, Strategy 3 provides the lowest cost due to the highly concessional loan terms offered by multilateral sources such as IDA and ADB. However, Strategy 2 provides the lowest risk due to domestic borrowing by issue of GoT securities and no exposure to foreign exchange movements. Chart: 31 PV of Debt to GDP as at end of 2017 Cost (%) 36.0 S2 35.0 34.0 S4 S1 33.0 S3 32.0 2.6 2.6 2.7 2.7 2.8 2.8 Risk 2.9 2.9 In comparison of the four strategies under this analysis, Strategy 3 provides the lowest cost and risk due to the highly concessional loan terms offered by multilateral sources such as IDA and ADB. However, Strategy 3 is exposed to foreign exchange movements due to external borrowing. Chart: 32 Interest to GDP as at end of 2017 Cost (%) 0.9 S2 0.9 0.8 S1 0.8 S4 S3 0.7 - 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 Risk 0.10 In comparison of the four strategies under this analysis, Strategy 3 provides the lowest cost and risk due to the very low interest rate (less than 1%) 96. Given the analysis above and based on the lowest cost and risk between the four strategies, Strategy 3 best addresses that requirement. However, on the priority requirement to minimise the significant level of foreign exchange risk as result of the high proportion of external debt at 91% (compared to 9% of domestic debt), under this strategy GoT will continue to be vulnerable to this risk in the medium term. Further, with progressing of Tonga’s economy that access to highly concessional borrowing from multilateral sources will also become limited. 97. To consider the strategy that best addresses the high risk of foreign exchange and comparison of difference between cost and risk of the four strategies. Strategy 2 is the preferred option for GoT to implement in the medium term. Although it provides a higher interest cost than the other strategies that it is minimal compared to the difference in risk level due to no exposure of domestic borrowing to foreign exchange. With gradual development of the domestic market that it would also provide a more balanced composition of public debt with less external debt and more domestic debt. Annex 1: Summary of recommendations specific to certain segments of the GSM 32 Medium Term Debt Strategy (2015-2017) MONEY MARKET DEVELOPMENT The liquidity in the banking system to be kept on balance over a period of time. Recent amendment to NRBT ACT 2007 to be reviewed to enable NRBT to conduct open market operations using outright transactions as well repos transactions in Government securities Central Bank and market repo to be introduced Short term Treasury Bills to be used for funding temporary cash mismatches of Government in place of overdraft facility from a commercial bank at the commercial rate of interest. NRBT to compile and disseminate money market transactions to market at a regular interval. PRIMARY MARKET Adopt issuance policy based on Commercial Paper (CP) type issuances Consult market actively before announcement of tenor, target issuance amounts and pricing. Place a limit for issuance for each maturity year to contain refinancing risk Adopt and publish guidelines for issuance of Treasury Bills and Bonds Shift to auction process at later stage Improve effectiveness of Cash Management by improving forecasting of cash balance, establishing a link between forecasted cash position and primary issuance and adoption of a comprehensive Treasury Single Account INVESTORS BASE AND SECONDARY MARKET Initiate an investor education program Undertake feasibility study for undertaking issuance of ‘diaspora bonds’ on a regular basis Reinstate the authority to the NRBT to acquire and own Government securities Set up legal framework for Insurance business MARKET INFRASTRUCTURE Introduce system of dematerialisation of securities and phase out physical form of holding securities. Introduce a DvP based settlement of securities using DvP I mode Facilitate introduction of a simple system for execution of sale and purchase of securities by buyers and sellers MoFNP and NRBT MoFNP and NRBT MT5 L ST H NRBT MoFNP and NRBT MT MT H M NRBT LT L MoFNP and NRBT MoFNP and NRBT MoFNP ST H ST H MT M MoFNP and NRBT MoFNP MoFNP MT M LT ST M M MoFNP MT M MoFNP and NRBT MoFNP and NRBT MoFNP MT M ST H MT H NRBT and MoFNP NRBT ST H MT H NRBT MT H Annex 2: Total Public Disbursed Outstanding Debt (TOPm), FY 2003/04-2029/30 5 MT: Medium-Term, ST: Short-Term, L: Low, M: Medium, H: High 33 Medium Term Debt Strategy (2015-2017) FY’s 03/04 04/05 05/06 06/07 07/08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 16/17 17/18 18/19 19/20 20/21 21/22 22/23 23/24 24/25 25/26 26/27 27/28 28/29 29/30 External 152.7 149.6 165.6 161.4 157.9 202.4 228.8 274.9 322.6 343.1 336.5 381.6 382.1 374.5 367.7 346.7 321.2 291.0 260.9 230.6 200.9 170.7 140.6 111.9 83.1 61.8 47.8 Domestic 31.4 28.8 27.3 25.7 22.5 22.5 29.5 29.5 29.5 29.5 29.5 41.0 56.0 56.0 56.0 56.0 56.0 56.0 56.0 56.0 56.0 56.0 56.0 56.0 56.0 56.0 56.0 Annex 3: Total Public Debt Service by Currency, FY 2013/14-2029/30 CNY USD GBP JPY EUR 14/15 6.7 2.8 0.8 0.6 2.6 15/16 6.9 2.9 0.8 0.6 2.6 16/17 6.3 2.9 0.8 0.6 2.6 17/18 5.6 2.8 0.8 0.6 2.5 18/19 19.0 2.7 0.7 0.6 2.4 19/20 23.2 2.7 0.7 0.6 2.4 20/21 27.3 2.6 0.7 0.6 2.3 21/22 26.8 2.7 0.7 0.6 2.4 22/23 26.4 2.7 0.7 0.6 2.4 23/24 25.1 2.6 0.8 0.8 2.6 24/25 24.7 2.5 0.8 0.8 2.5 25/26 24.2 2.3 0.6 0.6 2.0 26/27 23.8 2.2 0.6 0.5 2.0 27/28 23.3 2.1 0.6 0.5 1.9 28/29 16.1 2.1 0.6 0.5 1.8 29/30 9.1 2.0 0.5 0.5 1.6 Total 184.1 178.4 192.9 187.1 180.4 224.9 258.3 304.4 352.1 372.6 365.9 422.6 438.1 430.5 423.7 402.7 377.2 347.0 316.9 286.6 256.9 226.7 196.6 167.9 139.1 117.8 103.8 AUD 0.1 0.1 0.1 0.1 0.1 0.04 0.02 - TOP 8.0 7.8 4.4 6.4 3.9 7.4 8.0 7.8 4.4 6.4 3.9 7.4 8.0 7.8 4.4 6.4 Total 13.7 14.0 13.3 12.5 25.8 29.8 33.7 33.1 32.8 31.6 32.1 31.5 29.6 29.1 28.4 20.9 Annex 4: Macro Economic Data (TOPm), FY 2003/04-2015/16 FY 03/04 04/05 05/06 06/07 07/08 08/09 09/10 10/11 11/12 12/13 13/14 14/15 15/16 GDP 474.8 513.3 594.6 602.9 659.3 664.3 711.4 783.4 781.5 836.1 829.5 821.3 897.2 Revenue 112.3 117.8 148.2 151.5 161.8 186.8 159.6 151.0 146.7 159.7 136.7 141.4 152.2 Remittances 202.8 202.8 186.9 202.6 202.8 175.2 157.4 146.5 112.3 113.3 110.7 114.7 118.6 Exports 83.1 77.0 81.9 65.6 93.6 95.1 83.2 100.3 103.1 154.8 149.8 153.9 158.8 34