4 Papua New Guinea
Author: Mr. Douglas A. Scott1 and Mr. Christopher Browne
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
Language:
English
Keywords:
BOOK; current account; government; gross domestic product; balance of payments; Tonga; development expenditure; demand management; Papua New Guinea authorities; expenditure growth; expenditure cut; Commercial banks; Mining sector; Imports; Pacific Islands; current account receipt
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Abstract

Papua New Guinea comprises the eastern half of the island of New Guinea and several hundred islands to the east and north. The land area is 463,000 square kilometers and the population of 3.6 million is largely Melanesian. Resources include plentiful arable land, extensive forests, rich mineral deposits, and hydroelectric potential. However, much of the terrain is mountainous, which makes travel and communications difficult. The population density is only eight persons per square kilometer and substantial areas of the interior remain unexplored. There are some 700 local languages, and allegiances are closely tied to villages. While social obligations differ among kinship groups, most land is communally owned and members assist others in need. For many inhabitants, contact with the modern world is recent and access to health, education, and other social facilities remains limited. Life expectancy is 52 years and poverty is more pronounced than in other Pacific island countries.

Papua New Guinea comprises the eastern half of the island of New Guinea and several hundred islands to the east and north. The land area is 463,000 square kilometers and the population of 3.6 million is largely Melanesian. Resources include plentiful arable land, extensive forests, rich mineral deposits, and hydroelectric potential. However, much of the terrain is mountainous, which makes travel and communications difficult. The population density is only eight persons per square kilometer and substantial areas of the interior remain unexplored. There are some 700 local languages, and allegiances are closely tied to villages. While social obligations differ among kinship groups, most land is communally owned and members assist others in need. For many inhabitants, contact with the modern world is recent and access to health, education, and other social facilities remains limited. Life expectancy is 52 years and poverty is more pronounced than in other Pacific island countries.

In 1828, the Netherlands took possession of the western half of New Guinea, which is now the Indonesian province of Irian Jaya. In 1884, Germany assumed a protectorate over the northern part and the United Kingdom over the southern part of eastern New Guinea. In 1905, Australia took over responsibility for British New Guinea, which was renamed Papua, and in 1914, following the outbreak of war, acquired German New Guinea. After World War II, the two territories were combined to form the Territory of Papua and New Guinea and Australia’s administrative mandate under trusteeship was reaffirmed by the United Nations. Papua New Guinea became independent in 1975. The National Parliament, which consists of 109 representatives, is democratically elected every five years. The Prime Minister is selected from among its members and appoints a cabinet. Legislation passed in 1976 established elected provincial governments, which assuaged the movements for self government in several regions and for secession on the island of Bougainville. Nevertheless, political consensus has been difficult to achieve and this periodically impedes economic policy formulation.

Despite the country’s ample resource endowment, economic growth after independence did not keep pace with population growth. Few businesses were owned by local citizens and there was a serious shortage of educated nationals to take over the jobs previously performed by expatriates. Successive governments followed generally cautious economic policies, aimed at providing a stable environment conducive to growth, while maintaining sustainable budgetary and external positions. However, structural obstacles to development include adverse topography that fragments domestic markets, limited domestic savings, a high wage structure, shortages of skilled workers, and uncertainty over land rights. Papua New Guinea liberalized policies on land sales and transfers in 1980, but procedures for the leasing of land remain cumbersome. While Australia continues to provide large external grants, the amount has gradually declined in real terms. Annual per capita GDP is about SDR 650.

Economic Structure

Production and Prices

Agriculture is the source of livelihood for about four fifths of the population and accounts for about one third of GDP. The size of the plantation sector has diminished over the past decade because of low investment and difficulties associated with land tenure. Coffee, cocoa, coconut products, and palm oil are the main agricultural exports. A marketing board and stabilization fund exists for each of these crops to lessen the impact of fluctuations in world prices on rural incomes. This is accomplished by building reserves with levies when export prices are high and by making payments when export prices are low. Minor export crops include tea and rubber. The main products for domestic consumption are rice, taro, other root crops, poultry, and pork. Marketing is made difficult by the high cost of transport to urban areas, and the irregularity of and variation in supplies. In addition, rising incomes in urban areas have contributed to growing preferences for imported goods. Production of logs and wood products has grown over the past decade. The fish catch has been small since world tuna prices slumped in the early 1980s.

Mineral resources play a large role in the economy, accounting for two thirds of total exports. The bulk of production originates in two of the world’s largest copper and gold mines, in each of which foreign investors have equity of 80 percent and the Government holds 20 percent. The Bougainville mine commenced production in 1972, and the Ok Tedi mine in 1985. However, as enclave operations far removed from major population centers, the projects have limited impact outside their immediate areas. Small-scale alluvial gold production, which dates back to the late nineteenth century, accounts for the remainder of mining output. The development of a number of major new gold mines is projected for the mid-1990s. Recent exploration suggests that Papua New Guinea could also become an important producer of oil and natural gas.

For most of the period since independence, the economy has not been able to generate employment at a rate sufficient to absorb the growing labor force, including that drawn from traditional village societies. Although firm data are not available, there appears to have been a worsening of unemployment in recent years in the capital, Port Moresby, and other urban areas, especially among young people. The manufacturing sector contributes less than 10 percent of GDP. High wages, lack of managerial and technical skills, and inadequate infrastructure have hampered investment. The exchange and trade system remains largely free of restrictions, with the exception of a few items that are subject to import bans or quotas. The public sector is the most important service activity, providing about one fourth of all formal sector employment.

Consumer prices are influenced by the cost of imports, which come mainly from Australia. Wages are determined largely by regulation rather than by market forces and traditionally have been partially or fully indexed for price changes, a system that has wide social acceptance and is considered helpful to the maintenance of industrial harmony. The key institution in the labor market is the Minimum Wages Board, which is composed of representatives of employers, employees, the Government, and the community at large. The Board oversees the process of wage determination every three years and also establishes minimum urban and rural nominal wages. This wage determination covers about one half of all private sector employees and exercises a strong influence on wages of other employees, including those in the public sector.

Balance of Payments

The external sector is large relative to GDP. Exports, virtually all in the form of semiprocessed mineral and agricultural goods, are equivalent to more than 40 percent of GDP, a much greater ratio than in most other Pacific island countries. The trade balance normally shows a small surplus. However, imports fluctuate considerably in value and composition, reflecting mainly the status of mining projects. A high proportion of other imports consist of food, beverages, and consumer goods. The main destinations for exports are Japan and the Federal Republic of Germany and other Western European countries. The main sources of imports are Australia, which supplies 40 percent of the total, Japan, Singapore, and the United States. The services and transfers account is in substantial deficit, because of payments for freight and insurance, and dividends and interest. The overall balance has generally been in surplus.

Cautious policies are pursued with respect to external debt, reserves, and the exchange rate. External debt was equivalent to about 70 percent of GDP in 1987. About one third of the total represents private borrowing, the bulk of which is guaranteed by the foreign partners in mining operations. Debt service was 20 percent of current account receipts in 1987. Gross official international reserves average the equivalent of about 5–6 months’ imports. The exchange rate is fixed to a weighted basket of currencies of Papua New Guinea’s major trading partners. Since 1983, the rate has been depreciated against the basket several times in order to strengthen the balance of payments.

Public Sector

The public sector consists of the central government, 19 provincial administrations, and about 40 nonfinancial public enterprises. Central government budgetary receipts were equivalent to about 30 percent of GDP in 1987. Domestic revenue represented 23 percent of GDP. The share of direct taxes in total taxation—at two thirds—is large, compared with most other Pacific island countries. Other main sources of taxation are excise and import duties. Revenue from the mineral sector in the form of income tax, dividend withholding tax, and dividends on government equity participation is only 5 percent of the total. The rate of profitability of the Bougainville mine is small, while the taxable profits of the Ok Tedi mine are held down by accelerated depreciation allowances. Recent tax reform included lower personal income tax rates, through the widening of tax bands and the reduction in the maximum marginal rate from 50 to 48 percent; a simplification of the tariff structure, with a maximum rate of duty for most goods of 50 percent; and the introduction of capital gains tax of 15 percent on the sale of most assets, except for family homes.

External grants, virtually all of which are provided by Australia, were equivalent to 7 percent of GDP in 1987. Their share declined from more than half of the total budgetary receipts prior to independence to less than one fifth within the context of a series of five-year financial agreements. For 1976–81, the nominal increase in grants was set at 6 percent annually, which was expected to result in a slight fall in real terms. For 1981–86, the agreement provided for annual reductions of 5 percent in real terms. In light of the severity of the world recession, the agreement was renegotiated in 1983. The rate of reduction was set for Australian fiscal years (July 1–June 30) at 1 percent in 1983/84, 2 percent in 1984/85, and 3 percent in 1985/86. For 1986–91, annual declines of 5 percent at constant prices were agreed for direct budgetary support but, including project aid, the fall in total assistance would be limited to 3 percent annually.

Current expenditure was equivalent to 28 percent of GDP in 1987. Departmental expenses were 40 percent of the total; the public sector wage bill is large in relation to GDP. Transfers to the provinces represented 30 percent of the total, mainly to finance primary and secondary education, health care, and the provision of local infrastructure. Development expenditure was 5 percent of GDP in 1987, with priority assigned to agriculture, transport, and education. Opportunities to orient government spending to better serve development objectives are evolving only slowly as progress is made toward extending national skills; restraining the public sector wage and salary bill; and improving the efficiency of public administration, especially in project planning and implementation.

Fiscal policy is formulated within a medium-term framework, at the center of which is a rolling five-year public investment plan based on the expected availability of resources and macroeconomic objectives. In the shorter-term context, the plan establishes priorities and a level of expenditure for the coming year, which is estimated to be sustainable over the medium term. Projects have to meet specific criteria with regard to their eligibility for concessional financing from abroad and their effect on employment, the balance of payments, and future revenue generation. Whereas immediately after independence, distributional and welfare objectives were of overriding importance, the focus has gradually shifted more toward growth. Under the present strategy, the order of spending priorities is economic services, infrastructure, social services, law and order, and general administration.

Budgetary support for the public enterprises is relatively small, although external grants and government assistance help to finance their investment programs. Guidelines for their operations include a market-oriented pricing policy and minimum rates of profitability for investment projects. Each enterprise must annually submit five-year corporate plans, which should be deemed consistent with overall development objectives, for government approval. As part of its efforts to streamline public sector operations and improve efficiency, Papua New Guinea has adopted a general policy of privatization. It is also considering the reorganization of departmental functions into commercial statutory authorities.

Financial Sector

The financial system consists of a central bank (The Bank of Papua New Guinea), which was established in 1973; six commercial banks, most of which are subsidiaries of foreign banks and provide an extensive branch network throughout the country; the Agriculture Bank of Papua New Guinea, which was transformed from the Development Bank in 1985 with the requirement that 80 percent of its loans should be in agriculture; the Investment Corporation of Papua New Guinea, which was established in 1972 to promote local ownership of business enterprises; savings and loans societies; and finance and insurance companies. The Australian dollar was the domestic currency prior to independence. The national currency, the kina, was introduced in April 1975 and the Australian dollar ceased to be legal tender in December of that year. Exchange control procedures were applied uniformly to transactions with residents of all foreign countries, including Australia, in January 1976.

A main objective of the monetary authorities is to maintain financial stability by neutralizing the impact of temporary fluctuations in liquidity emanating from the external sector, while maintaining credit expansion at a sustainable medium-term rate. For many years, target rates for the growth in broad money were established for this purpose. This approach was discontinued in 1983 because of the limited control that the authorities could exercise over monetary growth. The main instrument for influencing commercial bank liquidity is the liquid asset requirement that specifies the minimum commercial bank holdings of currency, central bank deposits, treasury bills, short-term government securities, and other prescribed assets as a percentage of deposit liabilities. Quantitative ceilings on the permissible growth in bank lending and guidelines on the allocation of bank lending by sector are also issued. Bank interest rates have been largely market determined in recent years, although controls were applied in 1986.

Developments in the 1970s

Real GDP growth averaged 4 percent annually during the first half of the 1970s, despite the adverse impact of the oil price increases. The main impetus to growth was the commencement of operations at the Bougainville mine. Agricultural output also expanded steadily, including diversification into palm oil, in response to favorable world markets. Rising incomes spread rapidly from the export sector to the rest of the economy. During 1972–75, real urban minimum wages doubled as a result of decisions by the newly formed Minimum Wages Board. These decisions were based primarily on the concept of family needs as well as the general economic prospects. Although inflationary pressures intensified as a result of the favorable export performance and rising Australian grant assistance, the economy accommodated large increases in import demand without creating external payments difficulties.

The worldwide economic slowdown during 1975–76 was reflected in weakening demand for copper, and attendant implications for fiscal revenue and the balance of payments. Higher prices for essential imports contributed to domestic inflationary pressures. To restrain domestic demand, budgetary policy was tightened mainly by expenditure restraint; urban minimum wages were frozen for a 15-month period from January 1976; and more pronounced efforts were made to enforce existing price controls. The measures succeeded in restoring financial stability. From mid-1976, prices for Papua New Guinea’s exports turned sharply higher. In view of the improved balance of payments prospects, the kina was appreciated by 5 percent in July 1976 to moderate the impact of rising import prices on domestic prices.

The rate of growth remained modest, with real GDP increasing by only 1–2 percent annually during the second half of the decade. Developments in the plantation sector, including management difficulties and land tenure problems after independence, depressed agricultural output. Declining ore grades at the Bougainville mine constrained the growth of mineral production. However, higher world market prices resulted in buoyant export receipts, while import growth was subdued. As a result, the external current account was generally in surplus and the overall balance of payments remained satisfactory. External commercial borrowing was limited, and gross official reserves increased from five months of imports in 1976 to eight months in 1979.

The average annual rate of inflation during the second half of the 1970s was several percentage points lower than the average for Papua New Guinea’s major trading partners. This favorable outcome was attributable partly to the agreement reached with the managements of the commodity price stabilization funds to sterilize part of the higher agricultural export earnings. Reserves were largely placed in accounts at the central bank, rather than in commercial bank deposits, which would have added considerably to liquidity in this period. Full indexation was reintroduced for most employees under the three-year wage agreement for the period 1977–79. With the abatement of inflation, the rate of wage increases moderated. In view of the sound external position, the kina was revalued on several occasions to further hold down price rises. Price controls were eased to permit adjustments that were broadly in line with market developments.

Fiscal and monetary policies were fully consistent with the maintenance of financial stability and a sound external position. In view of reduced Australian budgetary support, domestic revenue was increased in relation to GDP, mainly through higher mining taxation, and tight controls were implemented to limit expenditure growth. The budget deficit was limited to an average of 2 percent of GDP during 1976–79, and nonbank borrowing largely provided the required financing. Balance of payments surpluses were the source of rapid liquidity expansion. The agreement by which most of the reserves of the commodity boards were held in the form of interest-bearing deposits at the central bank offset much of the potential for credit creation. This practice constrained the growth in commercial bank liquidity and facilitated monetary management.

Developments in the 1980s

The further round of oil price increases and the global recession had a severe impact on Papua New Guinea during 1980–82, with deteriorating terms of trade and stagnant output combining to produce large reductions in real incomes. Wage adjustments continued to be based primarily on providing compensation for price increases, without regard to the adverse impact on national income of the change in the terms of trade. Faced with growing fiscal and external imbalances, the Government borrowed abroad and external debt rose sharply. In light of the weak external position, demand management policies were gradually reoriented to promote adjustment. Economic conditions improved considerably during 1983–84, principally because of higher export prices. With the more favorable terms of trade, incomes recovered and the overall balance of payments strengthened. The rate of economic growth rose substantially in 1985–87, led by increased mining output. In addition, progress was made in medium-term efforts to restrain public spending and limit fiscal deficits. The Government also refrained from further foreign commercial borrowing.

Domestic and External Imbalances in 1980–82

During 1980–82, real GDP fell slightly. Agricultural production declined mainly in response to lower export prices, although the effects of the downturn on producer incomes were partially alleviated by the operations of the commodity stabilization boards. Gold and copper production declined, reflecting lower ore grades from the Bougainville mine. The fall in output would have been much more pronounced except for high expenditure at the Ok Tedi mine, as a result of which domestic investment rose from 25 percent of GDP in 1980 to 32 percent in 1982. The rate of inflation rose sharply, mainly because of higher import prices. Despite the poor economic climate, under the Minimum Wages Board determination for the period 1980–83, wages were fully adjusted for increases in the consumer price index up to 8 percent per annum, with partial indexation for increases up to 14 percent.

The external current account recorded deficits of 11 percent of GDP in 1980 and over 20 percent in both 1981 and 1982. Apart from the increased costs of petroleum products and other imports, capital equipment imports for the mining sector were substantial. Increased freight and insurance, as well as dividends and interest payments, contributed to the deficit on the services account. Private capital inflows financed part of the investment in the mining sector, but the Government borrowed extensively from external commercial sources. External debt increased from 24 percent of GDP in 1980 to 54 percent in 1982, while official reserves declined from seven months of imports to four months of imports over the same period. The debt service ratio increased from 7 percent in 1980 to 17 percent in 1982.

The overall budget deficit rose from 1 percent of GDP in 1980 to 6 percent in 1981. Total receipts remained relatively stable at 33 percent of GDP. However, total expenditure increased from 35 percent of GDP in 1980 to 39 percent in 1981, reflecting the growth in wages and salaries, debt service on external commercial borrowing, and increased public investment. As the balance of payments problem became increasingly severe, fiscal policy was tightened to contain imports. Expenditure cuts were made in the 1982 budget, although because of the decline in revenue from the mining sector, the deficit remained at 6 percent of GDP.

After a sharp increase in credit during 1980, a marked tightening of credit conditions occurred in 1981–82. The balance of payments deficit reduced bank liquidity, while administered interest rates were increased to levels that were high by international standards. Steps were also taken to improve the flexibility of monetary policy, including the introduction of an auction system for treasury bills. However, by late 1982 the Government alleviated some of the adverse consequences of the restrictive monetary conditions, because of a concern that additional restraint would exacerbate the already sluggish state of the economy and that more of the adjustment burden would therefore need to be borne by fiscal and other policies.

Adjustment and Recovery in 1983–87

During 1983–87, real GDP grew at an annual average rate of about 4 percent. The operations of the Ok Tedi mine contributed substantially to growth, although its export revenue and government tax payments were below expectations. Disagreements in 1984–85 between the Government and the other shareholders about the pace of copper and gold production and the timing of additional investments caused interruptions in output and cost overruns. After a new agreement was negotiated in 1986, operations proceeded smoothly. Modest growth was achieved in the agricultural sector, with the procurement prices of the commodity boards gradually adjusted upward in view of rising export prices. Domestic investment fell from 32 percent of GDP in 1983 to 22 percent in 1985–87 because of lower spending in the mining sector and the squeeze on public expenditure.

In response to the Government’s increased emphasis on employment creation, rigidity in real wages was reduced from 1983. The Minimum Wages Board determination in that year provided for full indexation only for the first 5 percent of inflation, with no compensation for higher inflation. A broadly similar system was incorporated into the 1986 determination, under which wages were fully indexed for the first 5 percent of inflation, with no adjustment for larger increases up to 10 percent and compensation for only half of any inflation between 10 and 15 percent. The Board also established a new youth minimum wage of half of the adult minimum; it applies to all new young entrants into the labor market. Although the decline in real wages under these arrangements has so far been relatively modest, because the rate of inflation exceeded the threshold level only in 1983, the rigid link between wages and prices has been broken.

Fiscal policy was employed with great success as the chief instrument of external adjustment. The Government reduced budgetary expenditure by 3 percentage points of GDP in 1983–84, which cut the deficit to 1 percent of GDP. It streamlined administrative functions and retrenched 6 percent of the public sector work force. Unintended shortfalls in development spending, associated with difficulties in project implementation, also aided the adjustment effort. Against the background of the improved fiscal and external balance, budgetary policy shifted toward supporting growth. Some of the services that had been cut during the recession were reinstated in 1985. However, later in that year, a reassessment was made of the assumptions underlying the budget, including copper and gold prices and the exchange value of the Australian dollar. Additional expenditure cuts were imposed to limit the overall deficit to 2 percent of GDP in 1985. Consistent with the re-establishment of the cautious external borrowing policy, expenditure was restrained to hold the overall deficit at about the 1986–87 level. By holding down the growth in purchases of goods and services, wages and salaries, and transfers to the provinces and public enterprises, total spending was steadily reduced from 36 percent of GDP in 1983 to 31 percent of GDP in 1987.

Monetary conditions eased abruptly from mid-1983 as the balance of payments improved, but private sector credit demand was slow to respond to the upturn in economic activity. The authorities decontrolled virtually all bank lending and deposit rates in late 1983 and maintained an accommodative monetary stance throughout 1984 that was guided primarily by a desire to support the expansion. When credit rose rapidly in 1985, action to tighten bank liquidity was taken through the withdrawal of access to the discount facility and interest rates increased sharply. In the face of continued strong credit demand during 1986, interest rates remained positive in real terms on most bank deposits and loans. For most of 1987, the emphasis was placed on frequent changes in the liquid assets ratio to ensure adequate bank liquidity, while slowing the rate of growth of private sector credit.

The external current account deficit was reduced to 16 percent of GDP in 1983, 13 percent in 1984, and 9 percent in 1985. As a result of the export recovery and the fall in imports by the mining sector, the trade account moved back into surplus. The deficit on services and transfers was broadly unchanged. The kina was depreciated in line with the 10 percent devaluation of the Australian dollar in March 1983 and by 5 percent against the basket of currencies in November 1985. Financing of the current account deficit still required considerable private and official external borrowing. Outstanding external debt rose to 91 percent of GDP and the debt service ratio reached 30 percent in 1985. More restrictive demand management policies held the external current deficit to 5 percent of GDP in 1986 and 7 percent in 1987 and permitted a halt in external commercial borrowing. Assisted by the conversion into equity of substantial foreign loans for the Ok Tedi mining operation, outstanding external debt was reduced considerably in relation to GDP.

Table 1.

Papua New Guinea: Gross Domestic Product by Expenditure, 1978–87

(In millions of kina at current prices)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.

Goods and nonfactor services.

Table 2.

Papua New Guinea: Output of Main Commodities, 1978–87

(In thousand a of metric tons)

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Source: Data provided by the Papua New Guinea authorities.
Table 3.

Papua New Guinea: Consumer Price Index, 1978–87

(Annual average percentage change)

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Source: Data provided by the Papua New Guinea authorities.
Table 4.

Papua New Guinea: Central Government Budget, 1978–87

(In millions of kina)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.

Includes income tax, dividend withholding tax, and dividends on the government equity from mining operations that are paid into the Mineral Resources Stabilization Fund.

Table 5.

Papua New Guinea: Central Government Revenue, 1978–87

(In millions of kina)

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Sources: Data provided by the Papua Mew Guinea authorities; and Fund staff estimates.

Excludes royalties to provincial governments and local authorities (less than 1 percent).

Table 6.

Papua New Guinea: Central Government Expenditure, 1978–87

(In millions of kina)

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Source: Data provided by the Papua New Guinea authorities.
Table 7.

Papua New Guinea: Monetary Survey 1978–87

(In millions of kina; end of period)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.

Total liquidity less deposits of stabilization funds and of Bougainville Copper Ltd.

Table 8.

Papua New Guinea: Interest Rate Structure, 1978–87

(In percent per annum; end of period)

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Source: Data provided by the Papua New Guinea authorities.

The discount facility was suspended from November 1985 to February 1986.

Table 9.

Papua New Guinea: Balance of Payments, 1978–87

(In millions of SDRs)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.
Table 10.

Papua New Guinea: Exports by Commodity, 1978–87

(Value in millions of SDRs, volume in thousands of metric tons, unit value in SDRs per metric ton)

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Source: Data provided by the Papua New Guinea authorities.

Volume in thousands of kilograms: unit value per kilograms.

Table 11.

Papua New Guinea: Imports by Commodity Group, 1978–86

(In millions of SDRs)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.
Table 12.

Papua New Guinea: External Debt and Debt Service, 1978–87

(In millions of SDRs)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.
Table 13.

Papua New Guinea: International Reserves, 1978–87

(In millions of SDRs; end of period)

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Source: Data provided by the Papua New Guinea authorities.