Report and Recommendation of the President to the Board of Directors

Project Number: 52030-001 June 2020

Proposed Policy-Based Grant Kingdom of Tonga: Strengthening Macroeconomic Resilience Program Distribution of this document is restricted until it has been approved by the Board of Directors. Following such approval, ADB will disclose the document to the public in accordance with ADB's Access to Information Policy after excluding information that is subject to exceptions to disclosure set forth in the policy.

CURRENCY EQUIVALENTS (as of 25 May 2020)

Currency unit – pa’anga (T$)

T$1.00 = $0.44 $1.00 = T$2.30

ABBREVIATIONS

ADB – Asian Development Bank COP – classification of positions COVID-19 – coronavirus disease GDP – gross domestic product IMF – International Monetary Fund JPRM – joint policy reform matrix PEFA

PFM – –

Public Expenditure and Financial Accountability public financial management

PMS – performance management system TA – technical assistance TSDF

TVET – –

Tonga Strategic Development Framework technical and vocational education and training

NOTES

(i) The fiscal year (FY) of the Government of Tonga and its agencies ends on 30 June.

“FY” before a calendar year denotes the year in which the fiscal year ends, e.g., FY2020 ends on 30 June 2020.

(ii) In this report, “$” refers to United States dollars unless otherwise stated. Vice-President Ahmed M. Saeed, Operations 2 Director General Leah Gutierrez, Pacific Department (PARD) Directors Emma Veve, Deputy Director General and Officer-in-Charge, Social

Sectors and Public Sector Management Division (PASP), PARD Masayuki Tachiiri; Regional Director, Pacific Subregional Office in

Suva, Fiji (SPSO); PARD

Team leader James Webb, Public Management Economist, PASP, PARDa

Team members Tatafu Moeaki, Senior Country Coordination Officer, SPSO, PARD Lyailya T. Nazarbekova, Principal Counsel, Office of the General Counsel Rommel Rabanal, Public Sector Economist, PASP, PARD Leba Sovea, Senior Programs Assistant, SPSO, PARD Jean Williams, Principal Environment Specialist, Portfolio, Results, and Quality Control Unit, PARD

Peer reviewer Rogerio de Sa, Young Professional, Public Management, Financial Sector and Trade Division, Central and West Asia Department

a Outposted to the SPSO.

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

CONTENTS Page

PROGRAM AT A GLANCE

I. THE PROPOSAL 1

II. PROGRAM AND RATIONALE 1

A. Background and Development Constraints 1

B. Policy Reform and ADB’s Value Addition 6

C. Impacts of the Reforms 9

D. Development Financing Needs and Budget Support 9

E. Implementation Arrangements 10

III. DUE DILIGENCE 10

IV. ASSURANCES 11

V. RECOMMENDATION 11

APPENDIXES

1. Design and Monitoring Framework 12

2. List of Linked Documents 15

3. Development Policy Letter 16

4. Policy Matrix 20

Project Classification Information Status: Complete

PROGRAM AT A GLANCE

Source: Asian Development BankThis document must only be generated in eOps. 26052020052224875342 Generated Date: 12-Jun-2020 7:16:59 AM

1. Basic Data Project Number: 52030-001Project Name Strengthening Macroeconomic

Resilience ProgramDepartment/Division PARD/PASP

Country Tonga Executing Agency Ministry of FinanceRecipient Government of TongaCountry Economic Indicators https://www.adb.org/Documents/LinkedD

ocs/?id=52030-001-CEIPortfolio at a Glance https://www.adb.org/Documents/LinkedD

ocs/?id=52030-001-PortAtaGlance

2. Sector Subsector(s) ADB Financing ($ million)Public sector management Economic affairs management 4.50

Public administration 2.50

Public expenditure and fiscal management 3.00

Health Disease control of communicable disease 2.20

Total 12.20

3. Operational Priorities Climate Change InformationAddressing remaining poverty and reducing inequalities

Accelerating progress in gender equality

Strengthening governance and institutional capacity

GHG reductions (tons per annum) 0Climate Change impact on the Project

Low

ADB Financing

Adaptation ($ million) 0.00

Mitigation ($ million) 0.00

Cofinancing

Adaptation ($ million) 0.00

Mitigation ($ million) 0.00

Sustainable Development Goals Gender Equity and MainstreamingSDG 1.5SDG 3.8SDG 8.5SDG 10.4SDG 16.6SDG 17.1, 17.4

Effective gender mainstreaming (EGM)

Poverty TargetingGeneral Intervention on Poverty

4. Risk Categorization: Low .

5. Safeguard Categorization Environment: C Involuntary Resettlement: C Indigenous Peoples: C.

6. Financing

Modality and Sources Amount ($ million)

ADB 12.20 Sovereign Program grant: Asian Development Fund 12.20

Cofinancing 16.70 Government of Australia - Program grant (Not ADB Administered) 7.20 New Zealand Grant - Program grant (Not ADB Administered) 4.00 World Bank - Program grant (Not ADB Administered) 5.50

Counterpart 0.00 None 0.00

Total 28.90

Currency of ADB Financing: US Dollar

I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on a proposed policy-based grant to the Kingdom of Tonga for the Strengthening Macroeconomic Resilience Program. 2. The program aims to strengthen Tonga’s macroeconomic resilience, including to mitigate the impact of coronavirus disease (COVID-19) through supporting government’s response. The program seeks to achieve this through: (i) addressing sources of immediate and structural fiscal and public financial management (PFM) risks; and (ii) improving public sector and national human resource management to both limit the immediate labor market impact of COVID-19 and to encourage long-term growth. The program builds on reforms supported in prior programs in Tonga since 2009.1

II. PROGRAM AND RATIONALE

A. Background and Development Constraints

3. Development context. Even prior to the COVID-19 pandemic, Tonga faced challenges to macroeconomic resilience because of the country’s geographic disadvantages and exposure to shocks. Small and remote islands face elevated costs, which limit their competitiveness and institutional capacity. Private sector jobs are limited as local business activity is constrained by high costs of doing business, geographic remoteness, and vulnerability. Although overseas workers provide remitted income, sending such workers abroad limits public and private sector capacity and keeps the production base narrow and informal.2 Legislative and cultural barriers limit women’s labor participation and economic empowerment. 4. Economic performance and outlook. Cyclone Gita in February 2018 reduced gross domestic product (GDP) growth to 0.2% in fiscal year (FY) 2018, with a muted recovery of 0.7% in FY2019 supported by reconstruction, remittances, and marine exports. In February 2020 (prior to COVID-19 in the Pacific), the International Monetary Fund (IMF) estimated that Tonga’s GDP would grow by 3.5% in both FY2020 and FY2021 (footnote 2). In April 2020, following the COVID-19-related lockdowns within Tonga and its trading partners, the IMF revised its forecasts for GDP to fall by 1.0% in FY2020 and a further 1.5% in FY2021.3 This economic outlook is subject to a high degree of uncertainty, with the key risk factors being Tonga remaining COVID-free, the length of travel bans, and the economic recoveries of key trading partners. For example, if travel bans extend until December 2020 and remittances dwindle, GDP is estimated to contract by as much as 17% in the calendar year, with the current account rapidly deteriorating and foreign exchange reserves coming under pressure.4

1 The design and monitoring framework is in Appendix 1. ADB. 2009. Asian Development Fund Grant Kingdom of

Tonga: Economic Support Program. Manila; ADB. 2013. Policy-Based Grant Kingdom of Tonga: Strengthening Public Financial Management Program. Manila; ADB. 2016. Programmatic Approach and Policy-Based Loan and Grant for Subprogram 1 to the Kingdom of Tonga for the Building Macroeconomic Resilience Program. Manila; ADB. 2017. Policy-Based Loan and Grant for Subprogram 2 to the Kingdom of Tonga for the Building Macroeconomic Resilience Program. Manila; and ADB. 2019. Policy-Based Grant for Subprogram 3 Kingdom of Tonga: Building Macroeconomic Resilience Program. Manila.

2 International Monetary Fund (IMF). 2020. Article IV Mission Concluding Statement. Washington, DC. 3 IMF. 2020. Assessment Letter for the Asian Development Bank. Washington, DC. This document, available from the

list of linked documents in Appendix 2. 4 ADB. 2020. Asian Development Outlook. Manila; and World Bank. 2020. East-Asia and Pacific Update: East Asia

and Pacific in the Time of COVID-19. Washington, DC.

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5. Economic impacts of COVID-19. Although Tonga was free of the virus as of 3 June 2020, COVID-19 has exposed Tonga’s economic reliance on foreign-sourced income. The three primary transmission channels that impact economic growth are remittance flows, tourism receipts, and disruptions of domestic construction activity. Around 20% of average household incomes, including those of the poorer deciles, are directly tied to remitted income (estimated at 29.3% of GDP in FY2018). Any reduction in remittances stemming from travel restrictions or recessions in source markets could unwind recent development gains and deepen the poverty gap. 5 The collapse in tourism, equivalent to an estimated 9.1% of GDP in FY2018, will add to these losses for as long as travel restrictions are in place, jeopardizing the incomes of around one-third of households. Lastly, reconstruction activity was expected to support growth and employment in FY2020 onwards, but this will be hampered by difficulties in cross-border mobilization. 6. Past fiscal performance. Tonga’s fiscal stance has generally been prudent, and tax reforms have produced good results. Fiscal surpluses since FY2017 have replenished cash reserves, easing cash pressures that had previously disrupted service delivery (Table 1). Tax policy reforms—including increased excises and duties on fuel and “sin” products—and improved tax administration helped raise the tax-to-GDP ratio from 15.9% in FY2012 to 22.1% by FY2018. Expenditure increased in FY2019 due to cyclone recovery-related efforts.

Table 1: Fiscal Framework, FY2017–FY2021 (% of GDP, unless otherwise indicated)

Item FY2017 FY2018 FY2019e FY2020p FY2021p FY2022p

Total revenue and grants 43.6 42.8 43.6 34.8 37.5 42.0 Total revenue 24.2 24.9 24.5 22.3 22.5 24.7 of which: tax revenue 21.2 22.1 19.1 12.5 15.0 17.3 Grants 19.5 17.9 19.1 12.5 15.0 17.3 Total expenditure 40.0 39.9 40.3 40.4 38.7 40.4 Current expenditure 29.6 31.5 31.6 36.8 34.0 31.1 of which: wages and salaries 12.8 11.9 11.2 12.2 12.2 11.4 Capital expenditure 10.4 8.4 8.6 3.5 4.7 9.3 Overall balance, including grants 3.6 2.9 3.3 (5.5) (1.2) 1.6 Overall balance, excluding grants (15.9) (15.0) (15.8) (18.0) (16.2) (15.7) External debt 39.1 36.8 34.1 34.7 32.9 29.4 GDP ($ million, current prices) 455.9 483.7 494.4 496.7 500.4 531.6 ( ) = negative, e = estimates, FY = fiscal year, GDP = gross domestic product, p = projection. Notes: 1. The figures exclude additional grants that development partners are considering for the COVID-19 response. 2. The fiscal year (FY) of the Government of Tonga and its agencies ends on 30 June. “FY” before a calendar year

denotes the year in which the fiscal year ends, e.g., FY2020 ends on 30 June 2020. Sources: Asian Development Bank; Government of Tonga; International Monetary Fund; World Bank.

7. External debt is well below the government’s ceiling of 50% of GDP, declining from 39.1% of GDP in FY2017 to 34.1% by the end of FY2019 due to government commitment to (i) the revenue, expenditure, and debt management reforms supported by previous programs; and (ii) seeking only concessional financing as required. The IMF estimates that Tonga requires annual fiscal surpluses of around 4% of GDP to ensure long-term debt sustainability, suggesting a need for further fiscal consolidation.6 8. COVID-19 fiscal impacts and response. The macroeconomic impacts of COVID on Tonga overshadow earlier external economic shocks and disasters. Mitigating socioeconomic

5 World Bank. 2020. East-Asia and Pacific Update: East Asia and Pacific in the Time of COVID-19. Washington, DC. 6 Tonga’s external debt distress rating changed from moderate risk to high risk in 2017 as the debt sustainability

analysis of the IMF incorporated the effects of disasters into the methodology. IMF. 2018. 2017 Article IV Consultation—Press Release; and the Staff Report for Tonga. IMF Country Report. No. 18/12. Washington, DC.

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impacts to continue to build resilience remain critical. COVID-19 is expected to impact fiscal balances negatively through falls in tax revenues and demand for increased current expenditure. The government has prepared a COVID-19 economic and social stimulus package of $26.1 million (5.2% of GDP) to be implemented through FY2020 and FY2021, with $9.8 million dedicated to health preparedness and response. 7 Most of the package is expected to be supported through development partner grants ($20.3 million), with the remainder to come from budget reallocations ($4.2 million) and government reserves. A fiscal deficit equivalent to 5.5% of GDP is now expected in FY2020 and 1.2% of GDP in FY2021 (footnote 3). COVID-19-related spending of $7.4 million in FY2020 has been funded by budget reallocations and a new domestic bond. The government intends to avoid using external debt to meet expected financing gaps. Assuming no new borrowing, external debt is expected to continue to fall to 29.4% of GDP by 2022, although a second and subsequent fiscal stimulus will likely be needed in the coming fiscal year due to the severity of the economic downturn. With COVID-19 likely to reduce tax revenue dramatically in the short term, maximizing the efficiency of tax and customs administration is crucial to the recovery of fiscal balances.

9. Public financial management. While Tonga’s PFM systems are generally functional and support basic service delivery, challenges remain.8 Annual budget allocations are aligned with the priorities established in the Tonga Strategic Development Framework (TSDF) 2015–2025 and support programs as specified in ministry corporate plans.9 The Public Finance Management Act (2002) provides a robust, comprehensive framework for effective fiscal management. Steady improvements in public sector management have made Tonga one of the best performing Pacific countries, although challenges remain in the areas of public asset management, tax administration, and transparency and accountability.10

10. The government’s public fixed-asset registry is incomplete and outdated, leading to audit qualifications.11 This makes it difficult to determine the value of government assets in financial statements and to plan adequately for required asset replacement or repair, reducing asset effectiveness, service delivery, and asset life. Further, poor cash management has resulted in episodes of cash shortfalls leading to cash rationing and the use of expensive short-term financing instruments, as highlighted in the PFM Reform Roadmap 2015–2019 and Medium-Term Debt Strategy FY2016–FY2018. Although these issues have been avoided with recent operating surpluses, excess reserves can carry a high opportunity cost for government balances, and the risk posed by COVID-19 may create additional demands on cash holdings. Looking forward, there is limited capacity to articulate and implement new reforms. As a diagnostic of the PFM system has not been updated since the Public Expenditure and Financial Accountability (PEFA) assessment in 2010, there is a risk of ad hoc PFM reforms and a lack of strategic planning. In this context, prioritization and proper sequencing of strategies and plans are crucial to facilitate the implementation of reforms, even with limited government capacity.

7 See the Summary of Government COVID-19 Response Measures in Tonga (accessible from the list of linked

documents in Appendix 2). 8 Sector Assessment (Summary): Public Sector Management (accessible from the list of linked documents in

Appendix 2). 9 Government of Tonga, Ministry of Finance and National Planning. 2015. Tonga Strategic Development Framework,

2015–2025. Nuku’alofa. 10 For example, in ADB. 2019. Annual Report on the 2018 Country Performance Assessment Exercise. Manila; World

Bank. 2019. Doing Business 2020. Washington, DC; ADB. 2019. Finding Balance 2019: Benchmarking Performance of State-Owned Enterprises in Island Countries. Manila; Government of Tonga. 2019. Sustainable Development Goals Voluntary National Review. Nuku’alofa; and Government of Tonga and Pacific Financial Technical Assistance Centre. 2020. Public Expenditure and Financial Accountability Assessment: Agile Report. Suva.

11 IMF. 2020. Tonga Public Expenditure and Financial Accountability Assessment: Agile Report. Washington, DC.

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11. Public sector wage bill. The public sector wage bill represents a fiscal challenge, with total renumeration equivalent to 53% of domestic revenue in FY2019. Weak productivity in the public sector continues to hamper institutional capacities for basic service delivery and reform. Lingering horizontal inequities in the remuneration system and poor performance management gave way to pay increase settlements in FY2014 and FY2016. In 2017, the authorities introduced a reform program for the public sector remuneration system and a linked performance management system (PMS) as crucial way of maintaining a competent and affordable civil service. The IMF notes that, although fiscal anchors on the wage bill remain appropriate, further reform should prioritize (i) rationalizing civil service functions and clarifying job descriptions, (ii) identifying and staffing critical positions, (iii) increasing automation toward a phased elimination of redundancies, (iv) prioritizing service delivery, and (v) gradually aligning compensation with market pay levels while eliminating overtime to improve work incentives and reduce turnover. A 2018 ADB evaluation recognized the need to improve job descriptions to support job-sizing, and to update the classification of positions (COP) to support the PMS.12 12. Labor market risks. The shock to the domestic economy from COVID-19 risks the livelihoods of 43% of salaried workers in private sector employment. Moreover, previous short-term losses in employment due to business closures have had long-term structural impacts on the private sector, for example, following the recessions of FY2006 and FY2007.13 Beyond the limited private sector, Tongans have increasingly looked to overseas employment. Tonga is among the main beneficiaries of seasonal worker schemes in both Australia and New Zealand, with an estimated 5,774 workers (14.2% of the total domestic workforce in 2016) engaged in temporary worker programs in FY2019, and a diaspora of 33,667 across both countries. COVID-19 travel restrictions will limit seasonal worker schemes in late FY2020 and FY2021, and remittances from the broader diaspora are also likely to fall. There is no precedent for such a synchronized slowdown in Tongan sources of remitted income. 13. While recovery will depend on the trajectories of major remittance and tourism markets, improved frameworks for labor mobility and diversified skills training will position Tonga to take advantage of future labor opportunities. Although women remain underrepresented and generally have poorer labor outcomes in Tonga than men, employment programs in Australia and New Zealand offer important opportunities for greater inclusiveness and higher incomes.14 Yet, the institutional and regulatory frameworks to manage Tonga’s participation in labor mobility schemes remain underdeveloped and uneven, with current institutions not well directed toward emerging opportunities. Formal technical and vocational education and training (TVET) is provided by a wide variety of providers in public, church, and private institutions, but the sector lacks an overarching mechanism to design and coordinate the program. The demand side—for both the domestic and overseas labor markets—is generally underrepresented in sector planning and management, limiting the effectiveness of current training programs.

12 ADB. 2018. Sector and Thematic Analyses in Policy Development. Consultant’s report. Manila (TA 8819-REG). 13 ADB. 2012. Continuing Reform to Promote Growth Update of the Private Sector Assessment for Tonga. Manila. 14 According to the 2016 Census of Population and Housing, women have a lower participation rate than men (56.7%

versus 71.2%), lower employment rate (28.4% versus 45.2%), and higher unemployment rate (26.8% versus 7.6%). The 2017 World Bank Pacific Possible report documents that Tongan seasonal workers earned more than five times what they would have earned had they stayed in Tonga, and that their households had substantially higher per-capita savings and expenditure, and higher rates of school enrollment and attendance. In FY2016, only 11.5% of Tongan seasonal workers were women. While these schemes initially concentrated on horticulture and viticulture, new sectors such as accommodation, tourism, and aged care have since been included in Australia’s Seasonal Workers’ Program in certain locations, creating additional employment opportunities for women.

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14. ADB contributions. Since 2009, ADB has engaged with the government and development partners in supporting policy reforms under the joint policy reform matrix (JPRM) through technical assistance (TA) and three earlier ADB operations (footnote 1).15 Earlier policy-based operations backed the government’s tax mobilization measures, which led to rapid domestic revenue growth through the revised Revenue Services Administration Bill.16 Reforms have also addressed civil service performance management, introduced a new debt management law and medium-term fiscal targets, implemented a procurement tracking database, and supported better procedures to address audit recommendations. Advisory services provided by ADB helped the government strengthen corporate governance practices, commercialize select state-owned enterprises, and approve a foreign investment bill.17 ADB also supported a review of public service reforms in 2018, which recommended including standardized job descriptions and a revised COP (footnote 12). Regarding the COVID-19 response, ADB disbursed a $470,000 grant from the Asia Pacific Disaster Resilience Fund to strengthen the Ministry of Health’s ability to contain and control the virus, and a $6 million grant from the Pacific Disaster Resilience Program (Phase 2).18 The ongoing JPRM policy dialogue was broadened to engage on the COVID-19 response, and the ADB stands ready with a possible COVID-19 Pandemic Response Option should this be requested by the Government of Tonga. 15. Lessons learned. This program reflects lessons from previous policy-based operations, including: (i) budget support can achieve results if there is strong government ownership; (ii) coordination with development partners is critical, especially in sectors where ADB has limited engagement; (iii) TA, provided parallel to budget support programs, aids the implementation of reform; (iv) flexibility helps ensure that policy actions remain relevant; and (v) limiting reforms to a few substantive actions and sequencing implementation avoids overloading national capacity.19 The program supporting the government’s rapid response to the COVID-19 outbreak and associated economic impacts exemplifies adaptation to local conditions and priorities. 16. Alignment of the program. This program is consistent with ADB’s Strategy 2030 priorities for small island developing states, namely, strengthening governance and institutional capacity.20 The program is included in the Country Operations Business Plan for 11 Small Pacific Island Countries and it aligns with the ADB Pacific Approach.21 The program also aligns with the following impacts of the TSDF 2015–2025: (i) more inclusive and sustainable growth and development; (ii) a more inclusive, sustainable, and dynamic knowledge-based economy; and (iii) more responsive good governance (footnote 9). The emergence of COVID-19 pivoted government policy priorities towards mitigating the short- and long-term impacts of COVID-19, and specific COVID-response policy actions within the program are consistent with the ADB’s Comprehensive Response to the COVID-19 Pandemic.22 This is achieved by supporting the

15 The FY2020 JPRM (implemented July 2019 - April 2020) is listed in the Supplementary Documents in Appendix 2. 16 The revised Revenue Services Administration bill was submitted to and approved by Parliament in 2019. However,

the King’s Privy Council subsequently requested amendments to the bill before the King would provide royal assent. The revised bill has been approved by the cabinet and is expected to be resubmitted to Parliament in 2020.

17 ADB. 2019. Technical Assistance for the Pacific Private Sector Development Initiative, Phase IV. Manila. 18 ADB. 2020. Tonga: COVID-19 Emergency Response (Additional Financing). Manila; ADB. 2019. Pacific Disaster

Resilience Program (Phase 2). Manila. 19 Independent Evaluation Department. 2015. Corporate Evaluation Study: ADB Support to Small Pacific Island

Countries. Manila; ADB. 2011. Policy Brief: Policy-Based Programs for the Pacific Islands. Manila. ADB. 2019. Policy-Based Grant for Subprogram 3 Kingdom of Tonga: Building Macroeconomic Resilience Program. Manila.

20 ADB. 2018. Strategy 2030: Achieving a Prosperous, Inclusive, Resilient, and Sustainable Asia and the Pacific. Manila 21 ADB. 2019. Country Operations Business Plan: 11 Small Pacific Island Countries 2020–2021. Manila; and ADB.

2016. Pacific Approach, 2016–2020. Manila. Originally this program was referenced as the New Economic Management Program, Subprogram 1 (PBL) in the Country Operations Business Plan.

22 ADB. 2020. ADB’s Comprehensive Response to the COVID-19 Pandemic. Manila.

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government’s economic and social stimulus package, which includes measures to limit employment losses, fund health priorities, and protect vulnerable groups. B. Policy Reform and ADB’s Value Addition 17. Government strategy. Tonga has adopted a vision for “a more progressive Tonga supporting a higher quality of life for all,” following the TSDF 2015–2025 (footnote 9). This vision is translated into five pillars, of which “economic institutions” seeks to address constraints to more inclusive, sustainable, and resilient economic growth, including through improved macroeconomic management and increased access to economic opportunities. The government moved rapidly to mitigate the macroeconomic and social risks posed by the possible spread of COVID-19, implementing a full lockdown of the border. The government’s COVID-19 economic and social stimulus package, in part, seeks to sustain the country’s productive sectors and employment. 18. Partner coordination. Since 2011, the JPRM process has provided an effective platform to coordinate support among the key development partners, including for the government’s COVID-19 response. The process brings together key ministries and development partners to map out critical constraints, design policy and TA measures, monitor reform implementation, and mobilize financial assistance to support the government.23 ADB, the World Bank, Australia, and New Zealand coordinate budget support and related TA through the JPRM process, with the IMF’s Pacific Financial Technical Assistance Centre and European Union also participating.24 JPRM partners coordinate activities and mutually reinforce policy actions across all of the areas of the JPRM, including those in the proposed ADB program. To mount an immediate COVID-19 response, ADB has been coordinating with the Joint Incident Management Team, led by the World Health Organization Pacific office, along with other humanitarian and development partners. 19. Program description. This program aims to strengthen Tonga’s macroeconomic resilience, including to mitigate the impact of coronavirus disease (COVID-19) through supporting government’s COVID-19 response. The program seeks to achieve this through: (i) addressing sources of immediate and structural fiscal and PFM risks, and (ii) improving public sector and national human resource management to both limit the immediate labor market impact of COVID-19 and to encourage long-term growth. The program has completed 11 prior actions under two reform areas. A post-program monitoring framework promoting continued reform efforts towards the JPRM’s medium-term objectives, was agreed with government. It will guide continued policy dialogue, and coordinate TA to further program objectives beyond its completion date. Framework implementation will be supported by coordinated TA from all partners, while progress within the framework will be closely monitored and guide the development of future policy-based operations. 20. Reform Area 1: Sources of fiscal and PFM risk reduced. In the immediate term, this area addresses the economic and fiscal risks of the COVID-19 pandemic by mobilizing the government’s response. In the longer term, the policy actions focus on mitigating other sources of fiscal risk through improving the capacity, quality, efficiency, and accountability of Tonga’s public financial system and practices. 21. Fiscally responsible COVID-19 response. As a prior action, the government approved the $26.1 million COVID-19 economic and social stimulus package (equivalent to 5.2% of GDP) to mitigate the economic and social damage caused by the virus and its associated control efforts.

23 The JPRM, FY2019–FY2020 forms the basis for reforms supported under the program. The policy matrix and post

program monitoring framework supports a subset of broader JPRM reforms and can be found in Appendix 4. 24 The European Union coordinates TA and policy dialogue through the JPRM process, but not its budget support.

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The government has ensured that this will be done in a fiscally sustainable manner—the package is funded through government reserves ($1.7 million), the reallocation of existing government programs ($4.2 million), and grant financing ($20.3 million). This ensures that the government will limit debt financing and maintain prudent reserves to meet operational needs, consistent with the debt strategy supported under the previous ADB program and the cash management policy supported under the current program. The package also mitigates key fiscal risks posed in the health sector by dedicating an additional $9.8 million to assist with preparedness and protection, medical supplies, and the COVID-19 pandemic plan. 22. PFM assessment. As a prior action, the cabinet approved and published the PEFA Agile and gender responsive budgeting assessments in partnership with the IMF to identify priorities in future PFM reform planning. This will determine future PFM reform actions under the post-program monitoring framework.25 23. Tax administration. As a prior action, the cabinet approved amendments to the regulations to operationalize the relevant sections of the Revenue Services Administration Bill supported under the previous ADB program once it receives royal assent.26 The act obliged taxpayers to apply for a tax identification number, and the regulatory amendments provide greater clarity concerning the documentary evidence required for tax identification number applications. The regulations encourage compliance by modernizing the tax clearance certificate procedures and Tax Tribunal provisions, reducing the administrative burden, and increasing transparency. 24. Financial management of government assets and liabilities. As a prior action, the cabinet approved a systematic framework and policy for the recording and reporting of public fixed assets to help improve the life-cycle management and resilience of public infrastructure through accurate financial reporting. The policy outlines the fixed asset reporting framework and responsibilities for determining asset strategy; performance evaluation; registration and reporting; acquisition, management, and disposal; and facilitates the management of capital goods and links capital and medium-term maintenance spending. Improving the government’s asset management will reduce life-cycle costs, boost the sustainability of these assets (including resistance to impacts from changing climactic conditions), and ensure continuous service delivery. 25. Cash management. As a prior action, the cabinet established a liquidity buffer target band.27 The policy supports better coordination of cash management-related activities (including with the National Reserve Bank) and preparation of operational procedures for when operating balances are outside of the defined target band. This will mitigate the risks posed by previous cash management practices and ensure that balances are not allowed to sit idle. 26. Strengthening anticorruption. As a prior action, the government confirmed that it has fully acceded to the United Nations’ Convention Against Corruption, and that the rules surrounding anticorruption efforts are now legally binding. This will further enable oversight institutions to

25 Areas identified in the gender responsive budgeting assessment include the need for gender responsive budgeting

training for ministries and the collection of sex-disaggregated data in ministry annual reporting. 26 Penalties related to tax administration (i.e., registration, late lodgment and payment, false or misleading statements,

and dishonored checks) and tax offences (i.e., failure to maintain proper records, fraud, and obstruction) are clearly defined, and graduated penalties (i.e., where the penalty increases, depending on the severity and/or length of time of the infraction) have been introduced for several offences to encourage compliance.

27 The band is set at 1–2 months of recurrent expenditure to balance the need to mitigate insolvency risk with the cost of holding excessive cash reserves. The Ministry of Finance analysis of historical cashflow volatility indicates that this lower bound would be adequate to meet unexpected cash needs, with a 99% confidence interval.

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execute their legal function.28 The convention covers five main areas to combat corrupt practices: preventive measures, criminalization and law enforcement, international cooperation, asset recovery, and TA and information exchange. Strengthened anticorruption efforts will enhance oversight functions within the government and build confidence in both crisis response measures and overall governance. 27. Reform Area 2: National human resource support and management improved. This reform area aims to mitigate the immediate labor market impacts of the COVID-19 crisis by providing short-term employment support and supplementing the incomes of vulnerable households reliant on informal employment. It also targets a longer-term economic recovery from COVID-19 through improvements in public service management, structured access to labor migration (particularly for women), and skills accumulation. 28. Short-term support for employment. As a prior action, the government has put in place a $9.8 million economic support scheme that (a) subsidizes employers to retain staff, including in the informal sector, thereby limiting the long-term structural damage to the domestic private sector and employment outcomes;29 and (b) provides employment subsidies for those who have lost their jobs due to the economic impacts of the pandemic. The first round of employment support is a T$535 payment to eligible individuals who apply to the government for assistance. Second and subsequent rounds will be considered subject to budget constraints and access to finance. 29. Supporting the income of vulnerable groups. As a prior action, to support the needs of the vulnerable and those reliant on informal employment, the government’s COVID-19 package includes (a) one-off cash transfers for vulnerable and poor households (including female-headed households); (b) income-generating activities for women’s groups; and (c) a waiver on local consumption taxes until 30 June 2020 as a cost-of-living subsidy for consumers. The payments to vulnerable households include a one-off T$100 payment and 1-month advance for the estimated 4,000 elderly and 1,000 people with disabilities, as well as T$200 each for the estimated 1,000 households under the poverty line. 30. Public service management. The government took the following prior actions: (a) the adoption of a new public-sector COP that provides clarity on the overall job family structure, groupings and levels, and remuneration; and (b) the adoption of standardized job descriptions to support the transition toward consistency and job sizing across the public service, along with increased efficiency and transparency in performance evaluations. Left unaddressed, such concerns could undermine confidence in the PMS and threaten the government’s new framework for wage bill management. It will lessen pressures for arbitrary wage increases, contain the overall wage bill, and build institutional resilience. 31. Labor mobility policy. As a prior action, the cabinet has approved a gender-sensitive labor mobility policy framework to balance the positive development impacts of labor mobility while mitigating the negative social effects (such as “brain drain” and social disruption). The policy provides guiding principles, a detailed medium-term action plan with associated outputs (for FY2020–FY2024), and a proposed institutional framework for the management of low- and semi-skilled overseas employment opportunities and migrant workers from Tonga. The labor mobility policy framework also includes gender analysis and commits to measures to support women’s

28 Parliament created a Standing Committee on Anti-Corruption in 2015, established a local chapter of the Global

Organization of Parliamentarians Against Corruption, and passed the Anti-Corruption Commissioner Act in 2016. 29 Of this package, $4.4 million is dedicated to support the tourism sector, which has suffered the twin impacts of a

COVID-19-induced slowdown in demand and damage from Cyclone Harold. Consumption taxes on reconstruction material and goods that support tourism, agriculture, and fisheries have also been waived.

9

empowerment, including (a) research on the role of women in labor mobility to better understand opportunities, barriers, and risks; (b) prioritizing opportunities for women workers; (c) women’s economic empowerment programs, including programs to facilitate the development of women’s collective enterprises; and (d) the inclusion of women’s groups in the governance arrangements. 32. Technical and vocational education and training. As a prior policy action, the cabinet approved a TVET sector strategic policy framework to help diversify employment opportunities for both men and women. The policy aims to (a) enhance the quality and alignment of TVET programs with private sector needs; (b) guide the prioritization of public funding to address identified skills gaps; (c) foster greater participation and equity in TVET programs; (d) better integrate traditional (academic) education and TVET; and (e) enhance the governance structures and qualification framework of the TVET sector, including the quality assurance system through the Tonga National Quality and Accreditation Board. This will be an area of ongoing analysis and reform. Additionally, strengthening institutions that train, promote, and support labor mobility can help enhance the capacity of Tongans—especially youths and women—to take full advantage of local private sector employment opportunities and overseas worker programs once COVID-19 restrictions are lifted. C. Impacts of the Reforms 33. This program supports the reduction of adverse social and economic impacts stemming from the COVID-19 pandemic and builds on previous policy-based operations to strengthen Tonga’s macroeconomic resilience. Reform area 1 (para. 20) will help the government manage and control COVID-19 and its immediate impact on the Tongan economy without jeopardizing debt sustainability, with other policy actions supporting macroeconomic resilience in the future by addressing sources of fiscal risk. Reform area 2 (para. 27) guards against the immediate impacts of employment losses in the private sector, which have been previously shown to be difficult to recover, as well as supporting vulnerable households. This reform area also supports the recovery from the COVID-19 crisis by strengthening public service management and expanding the labor supply into semi-skilled opportunities, as measured by the expansion of registered semi-skilled worker pools. This will mitigate the impacts of future economic shocks by diversifying sources of remitted income and increasing the financial capacity of households. D. Development Financing Needs and Budget Support

34. Excluding grants, the FY2020 fiscal deficit could reach the equivalent of $89.4 million, largely because an additional $26.1 million is needed to fund the COVID-19 economic and social stimulus package (para. 7). The government has requested a grant not exceeding $12.2 million from ADB’s Special Funds resources (Asian Development Fund) to help finance the program. In light of higher development financing needs due to reduced revenue expectations and the need to fund the COVID-19 response, the program amount was increased from the originally programmed $5 million. At the same time, the government wished to progress the program as actions were already advanced, and in expectation that any second round of COVID-19 stimulus in FY2021 would be in the context of a constrained reform environment and better supported through a COVID-19 Pandemic Response Option. General budget support grants totaling $28.9 million from JPRM partners are planned for FY2020: the World Bank expects to disburse $5.5 million, Australia has increased its budget support from $2.6 million to $7.2 million in response to COVID-19, and New Zealand has increased support from $1.5 million to $4.0 million. ADB grant proceeds will support development financing needs, excluding ineligible items.30

30 List of Ineligible Items (accessible from the list of linked documents in Appendix 2).

10

E. Implementation Arrangements

35. The government’s existing Budget Support Management Committee leads the JPRM process and oversees the program, with the Ministry of Finance as the executing agency. The committee provides overall guidance and is responsible for coordinating program implementation, monitoring, and evaluation. The Ministry of Revenue and Customs, the Public Service Commission, and the Prime Minister’s Office are also implementing agencies. The JPRM process will continue to facilitate broad consultations on reform priorities. The government has consulted with the private sector and civil society on individual reform initiatives as needed. The program is expected to be implemented from July 2019 to July 2020. ADB will monitor the implementation of reforms under the post-program monitoring framework. The proceeds of the policy-based grant will be withdrawn, upon effectiveness, in accordance with ADB’s Loan Disbursement Handbook (2017, as amended from time to time).

III. DUE DILIGENCE

36. Governance. Despite capacity limitations, the 2020 PEFA Agile assessment indicated that Tonga’s PFM system is generally functional and supports basic service delivery. The government is able to implement its budget, but there are procurement, accounting, financial reporting, and auditing weaknesses (footnote 8). This program, complemented by development partner TA, addresses many of those weaknesses. Tonga has taken steps to strengthen anticorruption measures, including creating the Parliament Standing Committee on Anti-Corruption and acceding to the UN Convention Against Corruption. ADB’s Anticorruption Policy (1998, as amended to date) was explained to and discussed with the government. 37. Poverty and social. The public sector is a key provider of services to low-income households, and reform area 1 will help ensure that the government has the fiscal resources to respond to future economic shocks and disasters (which disproportionately affect the poor) while maintaining critical public services. The COVID-19 economic and social stimulus package targets specific support for household income, particularly among the most vulnerable.31 Reform area 2 will improve public service delivery by contributing to the performance management system for public servants, as well as increasing the access of poor households to overseas employment opportunities and the associated remitted income. 38. Gender. This program is classified as effective gender mainstreaming and includes four policy actions that directly address key gender gaps in PFM, human resource management, and the economic impacts of COVID-19 on women and girls. Key gender gaps in labor market outcomes include lower labor force participation and employment rates for women. This gap is particularly pronounced in the uptake of overseas labor opportunities, where only one in 10 workers is female. In addition, COVID-19 will have widespread adverse impacts on women’s ability to earn income in both formal and informal spheres. Proactive gender features include (i) a gender-responsive COVID-19 economic stimulus package that includes employment support, cash transfers for vulnerable and poor households (including female-headed households), and income-generating activities for women’s groups; (ii) gender-responsive budgeting actions. including a PEFA gender responsive budgeting assessment, gender impact analysis of expenditure proposals, and budget allocations for gender initiatives, including women’s microfinance and women’s crisis centers; (iii) the approval of a gender-sensitive labor mobility policy that commits to women’s economic empowerment programs and prioritizes the

31 Summary Poverty Reduction and Social Strategy (accessible from the list of linked documents in Appendix 2).

11

employment of women; and (iv) a TVET policy framework that specifically helps women engage in nontraditional disciplines. 39. Safeguards. Following ADB’s Safeguard Policy Statement (2009), this program is classified as category C for the environment, involuntary resettlement, and indigenous peoples. Program activities will be confined to policy and institutional reforms. The prior policy actions have been assessed and are not expected to result in or lead to involuntary resettlement, or negatively affect indigenous peoples or the environment. 40. Risks. Major risks and mitigating measures are summarized in Table 2 and described in detail in the risk assessment and risk management plan. 32 Development partners have determined that PFM systems can provide mostly reliable services for budget support. Policy reforms and TA address the remaining fiduciary risks (para. 36). The integrated benefits are expected to outweigh the costs.

Table 2: Summary of Risks and Mitigating Measures

Risks Mitigation Measures

The impacts of the coronavirus disease pandemic and other potential shocks far exceed expectations, undermining economic stability and fiscal sustainability

The Asian Development Bank will monitor national, regional, and global economic developments and stand ready for further assistance in coordination with other partners, should the economic downturn become more severe than anticipated or there are further economic shocks from other sources.

High staff turnover further aggravates capacity constraints, affecting reform formulation, coordination, and implementation, thus delaying reform implementation.

Reforms are prioritized and sequenced to avoid overburdening the small public administration and decision makers. Technical assistance will be mobilized by development partners on an as-needed basis to supplement capacity.

Source: Asian Development Bank.

IV. ASSURANCES

41. The government and the Ministry of Finance have assured ADB that implementation of the program shall conform to all applicable ADB policies including those concerning anticorruption measures, safeguards, gender, procurement, consulting services, and disbursement as described in detail in the grant agreement. No disbursement shall be made unless ADB is satisfied that government has completed the policy actions specified in the policy matrix of the program.

V. RECOMMENDATION

42. I am satisfied that the proposed policy-based grant would comply with the Articles of Agreement of the Asian Development Bank (ADB) and recommend that the Board approve the grant not exceeding $12,200,000 to the Kingdom of Tonga, from ADB’s Special Funds resources (Asian Development Fund) for the Strengthening Macroeconomic Resilience Program, on terms and conditions that are substantially in accordance with those set forth in the draft grant agreement presented to the Board.

Masatsugu Asakawa President

16 June 2020

32 Risk Assessment and Risk Management Plan (accessible from the list of linked documents in Appendix 2).

12 Appendix 1

DESIGN AND MONITORING FRAMEWORK

Country’s Overarching Development Objective

A more inclusive, sustainable, and dynamic knowledge-based economy promoted (Tonga Strategic Development Framework, 2015–2025)a More responsive good governance achieved (Tonga Strategic Development Framework, 2015–2025)a Adverse social and economic impact by the COVID-19 pandemic reduced. (ADB’s Comprehensive Response to the COVID-19 Pandemic)b

Results Chain Performance Indicators with

Targets and Baselines

Data Sources and Reporting

Mechanisms Risks

Effect of the Reform Macroeconomic resilience of Tonga enhanced

a. By 2022, income support provided to at least 1,500 workers that lose their jobs due to COVID-19 (2019 baseline: 0)

b. By 2022, government daily cash balance maintained at an average equivalent to 1-2 months of recurrent expenditures (2019 baseline: daily cash balance equivalent to 3 months of recurrent expenditures)

c. By 2022, the number of Tongans in the Ministry of Internal Affairs worker pools increased to at least 900 new workers (50% women) (2019 baseline: 511; 32% women)

a. Government financial reporting.

b. National financial reporting documents

c. Ministry of Internal Affairs reporting

Deterioration in macroeconomic conditions or economic shock cause government to shift resources away from sustaining the reforms COVID-19 impacts on the fiscal position degrades ability of Government to maintain cash balances within the target band Economic downturn in overseas labor markets and/or decline in overseas labor programs

Reform Areas

1. Sources of fiscal and PFM risk reduced.

Key Policy Actions

By April 2020:

1.1 Cabinet approved an economic stimulus package consistent with the government debt strategy (FY2019 baseline: not applicable)

1.2 Government approved and published the PEFA Agile Assessment and Gender Responsive Budgeting Assessment in partnership with the IMF (FY2019 baseline: Previous PEFA was approved in 2010)

1.3 Cabinet approved regulations to improve compliance with the newly revised Revenue Services Administration Bill (FY2019 baseline: not approved)

1.1 Cabinet decision, COVID Action Plan

1.2 IMF PEFA Secretariat website

1.3 Copies of the revised Regulations, Cabinet decision

Capacity constraints, workload pressures, staff turnover reduce continuity and quality of reform implementation Stakeholders interfere with reform process because of opposing individual interests

Appendix 1 13

Results Chain Performance Indicators with

Targets and Baselines

Data Sources and Reporting

Mechanisms Risks

1.4 Cabinet approved a systematic framework and policy for the recording and managing of public fixed-assets (FY2019 baseline: not approved)

1.5 Cabinet approved a policy that establishes a liquidity buffer target band to support enhanced cash management (FY2019 baseline: not approved)

1.6 Accession of the Tongan Government to the United Nations’ Convention Against Corruption (FY2019 baseline: not acceded)

1.4, 1.5 Cabinet decisions

1.6 Confirmation from the UN Secretary-General that the Convention has entered into force

2. National human resource support and management improved

2.1 Cabinet approved measures that will mitigate employment losses during the COVID-19 pandemic, including (a) subsidizing employers to retain staff to limit long-term damage to employment outcomes, and (b) providing employment subsidies for those that have lost their jobs due to the economic impacts of the pandemic. (FY2019 baseline: not applicable)

2.2 Cabinet approved measures which mitigate the impacts of COVID-19 on vulnerable members of the community including (a) once-off cash transfers for vulnerable and poor households (including female headed households); (b) income generating activities for women’s groups; and (c) a waiver on local consumption taxes until 30 June 2020 (FY2019 baseline: not applicable)

2.3 The Public Service Commission adopted a standardized public service job description template and revised the Classification of Positions (FY2019 baseline: not adopted)

2.4 Cabinet approved a gender-sensitive labor mobility policy framework (FY2019 baseline: not approved)

2.1, 2.2 Cabinet decision, COVID Action Plan

2.3 Cabinet decision, confirmation letter from PSC CEO

2.4, 2.5 Cabinet decisions

Capacity constraints, workload pressures, staff turnover reduce continuity and quality of reform implementation

14 Appendix 1

Results Chain Performance Indicators with

Targets and Baselines

Data Sources and Reporting

Mechanisms Risks

2.5 Cabinet approved a technical and vocational education and training sector policy framework (FY2019 baseline: not approved)

Budget Support

Asian Development Bank: $12.2 million grant Government of Australia: $7.2 million grant (A$11 million) Government of New Zealand: $4.0 million grant (NZ$6.5 million) World Bank: $5.5 million grant

Each development partner manages the disbursement of their respective grants in parallel.

COVID-19 = coronavirus disease 2019, IMF = International Monetary Fund, FY = fiscal year, GDP = gross domestic product, PEFA = Public Expenditure and Financial Accountability, PFM = public financial management, Q = quarter, TA = technical assistance. Note: Joint policy reform matrix actions not supported under ADB’s program are excluded from the policy matrix but are part of the supplementary documents. Indicative actions 1.1,1.2, and 1.6 are not part of the joint policy reform matrix. a Government of Tonga, Ministry of Finance and National Planning. 2015. Tonga Strategic Development Framework,

2015–2025. Nuku’alofa b ADB. April 2020. ADB’s Comprehensive Response to the COVID-19 Pandemic. Manila. Source: Asian Development Bank.

Appendix 2 15

LIST OF LINKED DOCUMENTS http://www.adb.org/Documents/RRPs/?id=52030-001-2

1. Grant Agreement

2. Sector Assessment (Summary): Public Sector Management

3. Contribution to the ADB Results Framework

4. Development Coordination

5. Country Economic Indicators

6. Tonga—Assessment Letter for the Asian Development Bank

7. Summary Poverty Reduction and Social Strategy

8. Risk Assessment and Risk Management Plan

9. List of Ineligible Items

Supplementary Documents

10. Joint Policy Reform Matrix, FY2020–FY2021

11. Overview of Past and Planned Policy Reform Actions, 2009–2019

12. Summary of Government COVID-19 Response Measures in Tonga

13. Background on Tonga’s Labor Market and Technical and Vocational Education and Training

16 Appendix 3

DEVELOPMENT POLICY LETTER

Appendix 3 17

18 Appendix 3

Appendix 3 19

20 Appendix 4

POLICY MATRIX: Tonga - Strengthening Macroeconomic Resilience Program

Reform areas Policy Actionsa

Post program partnership framework

1. Sources of fiscal and PFM risk reduced.

1.1 Cabinet approved an economic stimulus package consistent with the government debt strategy

The recovery from the COVID-19 pandemic will require ongoing monitoring, and possibly further intervention. The JPRM partners will maintain close surveillance. With the finalization of the PEFA Assessments (action 1.2) the Government will develop a new roadmap for reforms, the roadmap will pick up on many of the areas of reform that laid foundational work during this program, including on gender-responsive budgeting and revenue management, but also procurement and debt management.

1.2 Government approved and published the PEFA Agile Assessment and Gender Responsive Budgeting Assessment in partnership with the IMF 1.3 Cabinet approved regulations to improve compliance with the newly revised Revenue Services Administration Bill 1.4 Cabinet approved a systematic framework and policy for the recording and managing of public fixed-assets 1.5 Cabinet approved a policy that establishes a liquidity buffer target band to support enhanced cash management 1.6 Accession of the Tongan Government to the United Nations’ Convention Against Corruption

2. National human resource support and management improved

2.1 Cabinet approved measures that will mitigate employment losses during the COVID-19 pandemic, including (a) subsidizing employers to retain staff to limit long-term damage to employment outcomes, and (b) providing employment subsidies for those that have lost their jobs due to the economic impacts of the pandemic.

Reforms surrounding public service management and wage management are expected to continue such as overtime and allowances, sexual harassment, or further improvement on workplace standards and conditions. There is an expectation that skill-focused reform will continue, with policy or governance reforms that address identified skills and gender gap in secondary education or the technical and vocational education and training sector.

2.2 Cabinet approved measures which mitigate the impacts of COVID-19 on vulnerable members of the community including (a) once-off cash transfers for vulnerable and poor households (including female headed households); (b) income generating activities for women’s groups; and (c) a waiver on local consumption taxes until 30 June 2020 2.3 The Public Service Commission adopted a standardized public service job description template and revised the Classification of Positions 2.4 Cabinet approved a gender-sensitive labor mobility policy framework

2.5 Cabinet approved a technical and vocational education and training sector policy framework

a All policy actions complete.