Papua New Guinea’s recent economic history has been one of sustained growth and stability, underpinned by a favourable external environment - in particular, high prices for its commodity exports – sound domestic policy settings, and progress on important structural reforms. The global financial crisis, and the associated sharp downturn in global activity, clearly poses significant policy challenges for the authorities, while last year also saw a pickup in inflationary pressures associated with higher food and energy prices, demand pressures associated with a major resource development, and strong growth in bank liquidity, while monetary policy settings have been tightened in response. On the fiscal side, the authorities have chosen to use a portion of the earlier accumulated savings from the commodity price boom to buttress domestic demand and improve the provision of services and infrastructure essential to enhancing the productive capacity of the economy and addressing development needs.
GDP growth is expected to remain robust in 2009, if somewhat more subdued than the very strong performance of the last two years. The continued strength of activity in the mining and agricultural sectors is expected to offset declines in the petroleum sector, while structural reforms in telecommunications are expected to sustain growth in the non-mining sector, albeit below the unprecedented levels of recent years. The coming year should see a continuation of solid growth, albeit at a lower rate than the 7.2% achieved in 2008. There is also some evidence of an easing in inflationary pressures, with measures of underlying trend inflation showing some moderation through the June and September 2008 quarters. While the external current account is expected to shift into deficit in 2009, holdings of international reserves are expected to remain high, at around five months import cover according to Fund estimates. Nevertheless, the authorities acknowledge the need for policy settings to remain responsive to the significant downside risks associated with the deteriorating global environment.
PNG continues to face daunting development challenges, compounded by the nation’s impenetrable geography and ethnic and cultural diversity – with over 800 spoken languages, PNG is the most linguistically complex country in the world. This inevitably influences the political economy of reform. Indeed, the re-election of the Somare Government in 2007 for a second five-year term represents a period of political stability unprecedented in recent PNG history. In the area of economic policy, it has facilitated the adoption of significantly improved medium-term policy frameworks relating in particular to fiscal policy and development strategy.
The 2009 Budget is the first to be delivered following the Government’s endorsement of a refined Medium Term Fiscal Strategy (MTFS) for the period 2008-2012. The MTFS: limits ongoing expenditure in line with ‘normal revenues’, defined as non-mineral revenues plus mineral revenues equal to 4% of GDP (based on assumptions regarding long run price levels for Papua New Guinea’s commodity exports); requires that additional mineral revenues above this norm be used to fund public investment projects (70%) and repay debt (30%); and caps the actual level of public investment expenditure sourced from additional revenue in any given year to 4% of GDP, with the remainder to be saved. Also, under the Fiscal Responsibility Act (2006), the Government can not increase the level of net public sector debt.
In his budget speech, the Minister for Treasury and Finance underscored the importance the authorities attach to this framework, both as a tool for stable and responsible macroeconomic management and as a benchmark for preserving PNG’s policy credibility in the eyes of international investors and donors. The authorities will therefore give careful consideration to staff’s recommendation that the Framework be fine-tuned to take explicit account of the cyclical position of the economy in determining the excess mineral revenue to be spent in any year.
Nonetheless, the existing Framework has required that the 2009 budget be framed in the context of significant declines in the level of budgeted revenues, and the absence of any ‘additional revenue’, as a result of sizeable falls in export prices for Papua New Guinea’s major commodities. Within these constraints, the authorities have sought to allow for increased funding of key development priorities, focused on transforming the rural sector into a major driver of sustainable growth, and to support domestic demand in the face of increasing global uncertainties. In this connection, the authorities agree with staff that the key development challenge relates to unlocking the potential of the non-mineral sector.
Development spending will be guided by the priorities set out in the Medium-Term Development Strategy (MTDS), which targets an increasing share (82.7% in 2009) of overall development funding to seven priority areas: primary and preventive health care; HIV/AIDS prevention; basic education; development-oriented adult education; transport; promotion of income-earning opportunities; and law and justice. The authorities are committed to addressing administrative and capacity constraints which have hitherto resulted in shortfalls against the MTDS’s annual targets. And they consider the significant increase in funding for the District Services Improvement Program (DSIP) will help overcome endemic administrative and other capacity constraints which, in the past, have undermined community level service provision in PNG’s eighty-nine districts.
In the minerals sector, the authorities consider that the public equity investment in the proposed major LNG project, scheduled to come on line in late 2013, will ensure that the public interest is appropriately reflected in the development of a significant national resource. They fully concur with staff’s observations regarding the importance of making sure that the returns to the public sector are used effectively to foster a broader-based, sustainable development.
This approach is also more broadly consistent with the authorities’ adoption of a Public-Private Partnership (PPP) approach to shaping the public sector’s role in the provision of both economic and social goods. The Asian Development Bank has been assisting the authorities in the development of an appropriate PPP framework.
With regard to the immediate future, the authorities acknowledge staff’s concerns regarding the sustainability of budgeted spending, in particular regarding the implications for debt sustainability, and fully concur with the need to monitor developments carefully, and if necessary to adjust the budgetary stance at the time of the midyear review. They have expressed interest in further dialogue with Fund staff at that time on this issue.
Looking to medium term, institutional reforms have been initiated in the area of tax administration, focused on building the capacity for a more risk-based approach to auditing and enforcement activities, alongside more decentralised revenue collection arrangements involving the creation of provincial revenue offices. The authorities are exploring options for utilising technical assistance for this through PFTAC.
Monetary Policy and the Exchange Rate
The staff’s recommendation regarding the stance of monetary policy and, in particular, the potential need for the Bank of PNG to be prepared to loosen quickly if leading indicators suggest domestic demand, and inflationary pressures easing more than expected, has been noted by the authorities. However, they remain inclined to caution on this front.
While there is evidence that the earlier impact of high global food and energy prices on domestic inflation eased through the latter half of 2008, domestic inflation pressures remain high. The monetary authorities considered it appropriate to progressively raise the Kina Facility Rate by 200 basis points, to 8% by December 2008, which will see real interest rates return to positive territory over the next few months in line with the forecast decline in inflation to around 6%.
This represented a response to continued strong growth in bank liquidity and credit. It also reflected an awareness of the potential for the preparatory activity, and related confidence effects associated with the proposed major LNG project referred to above to underpin domestic inflationary pressures. Looking forward, the current expansionary fiscal policy stance, and the impact of the recently-approved increase in the minimum wage (of 170% to be phased in over 40 weeks commencing in mid-February), together with, more generally, evidence of rapid employment growth and skilled labor shortages in the formal sector, all also argue for close monitoring of inflationary pressures.
The authorities are continuing to progress arrangements to consolidate the public sector trust accounts – many of which are currently held in the private banking system – at the Bank of PNG. They agree with staff that this offers a cost-effective way of removing excess liquidity from the system.
As noted in the staff report, the real effective exchange rate appreciated over the last year, initially driven by the earlier positive terms of trade shock. More recently, the Bank of PNG has sought to lean against subsequent depreciation pressures, in order to moderate the impact on inflation and inflationary expectations. This approach reflects the importance of imports in PNG’s consumer basket and doubts about the relative effectiveness of other monetary policy transmission mechanisms. The optimal pace and size of this exchange rate adjustment, however, have been the subject of debate within PNG. The authorities are very conscious of the collapse in the terms of trade and the risks that the exchange rate not adjusting would pose for competitiveness, domestic incomes and tax revenues and, ultimately, for the buildup of imbalances which would precipitate a disorderly adjustment. The points made by staff regarding the need to allow the exchange rate to adjust in response to commodity price movements, and to preserve the level of international reserves in these uncertain times, are therefore well taken and will be given careful consideration.
The Financial System
As noted by staff, PNG’s financial system has been relatively unaffected by the recent global turmoil. The major banks are well-capitalised with relatively strong credit books and limited direct exposure to global markets. Similarly, the superannuation funds have continued to show positive investment returns. In both cases, this reflects to some extent the relatively undeveloped nature of PNG’s financial sector (and in the case of superannuation funds, recent very strong domestic property returns). The authorities agree that this remains a longer term weakness in terms of enhancing potential growth and development. They also acknowledge the potential for the current global turmoil to negatively affect the PNG financial system indirectly through the downside risks to trade and the real sector. It is in this context that they continue to express their interest in participating in the Financial Sector Assessment Program (FSAP) later this year.
Implementation of the institutional changes previously suggested in addressing the need to improve the quality and timeliness of macroeconomic data has proven problematic.
However, the authorities appreciate that this remains a very serious issue for the Fund, and for the quality of policy-making more generally, and one that must be dealt with. They will continue to engage candidly and constructively to explore practical options which can be pursued.
Finally, on this and on all other issues discussed during the consultation, my authorities would like to express their appreciation for the professionalism, technical expertise and candor that Mr. Hunt and his team brought to the table. They have indicated their agreement to publishing PNG’s 2008 Article IV Report and Selected Issues papers.