Papua New Guinea
Selected Issues and Statistical Appendix

This Selected Issues paper and Statistical Appendix surveys the main reasons for Papua New Guinea’s disappointing economic performance, highlighting the key impediments to growth in each of the main sectors of the economy. The paper outlines the structural reforms that could help reduce these impediments, so that Papua New Guinea makes progress toward poverty alleviation and the restoration of sustainable development. The paper also describes the evolution of Papua New Guinea’s external debt structure, and assesses the sensitivity of debt dynamics to a number of shocks.

Abstract

This Selected Issues paper and Statistical Appendix surveys the main reasons for Papua New Guinea’s disappointing economic performance, highlighting the key impediments to growth in each of the main sectors of the economy. The paper outlines the structural reforms that could help reduce these impediments, so that Papua New Guinea makes progress toward poverty alleviation and the restoration of sustainable development. The paper also describes the evolution of Papua New Guinea’s external debt structure, and assesses the sensitivity of debt dynamics to a number of shocks.

I. Impediments to Growth1

1. Since the end of the mining-and petroleum-induced boom in the mid-1990s, per capita GDP in Papua New Guinea has contracted. The pace of the decline accelerated in 2000–02, when aggregate real GDP decreased by a cumulative 8 percent. At end-2002, per capita real GDP is estimated to be about 10 percent lower than at the time of independence in 1975 (Figure I.1). Furthermore, social and poverty indicators remain poor, with average life expectancy 20 years below, and infant mortality 10 times above, those in Australia.

Figure I.1.
Figure I.1.

Real GDP per Capita, 1970–2002

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

2. This paper surveys the main reasons for Papua New Guinea’s disappointing economic performance, highlighting the key impediments to growth in each of the main sectors of the economy. The paper also outlines the structural reforms that could help reduce these impediments, in order that Papua New Guinea makes progress toward poverty alleviation and the restoration of sustainable development.

A. Sectoral Challenges

Mineral and petroleum sectors

3. Papua New Guinea has substantial deposits of gold, copper, oil, and natural gas. Foreign companies have undertaken nearly all of the mining activity, and there are few downstream linkages since most mines operate as isolated enclaves. Nevertheless, the mineral sector in the past has yielded significant fiscal revenues for the government that have averaged around 5 percent of GDP a year. In the early 1970s, the Bougainville copper mine generated nearly a third of the national income, contributing to the rapid growth experienced prior to independence. In the 1980s, mineral production was bolstered by the opening of the Ok Tedi mine and the discovery of petroleum and natural gas reserves in the Highlands region. The Kutubu oil fields, as well as the Porgera and Misima gold mines, went on-stream in the early 1990s, just in time to replace the revenue that was lost in the aftermath of the violence and consequent collapse of the Bougainville mine in 1989. Since then, however, new exploration activity has largely dried up, and no new major projects are expected to open in the foreseeable future. Consequently, fiscal revenues are expected to decline to just 2 percent of GDP a year by 2008.

4. The geographic isolation of Papua New Guinea’s resources implies a high extraction cost in addition to the usual capital intensity of mining activity. Given these significant costs, the level of mining and exploration activity has been particularly sensitive to law and order problems, especially in the Highlands region where most of the deposits are located. The collapse of the Bougainville mine, the withdrawal of the foreign owners of the Ok Tedi mine due to ongoing disputes over land use and alleged environmental pollution, and more recently, the felling of power pylons near the Porgera mine by disgruntled landholders and the disruption to transportation from the Kutubu oil fields, have reinforced Papua New Guinea’s image as a relatively high-risk country for large-scale mining investment in the Pacific region.

5. The law and order difficulties faced by the mining and petroleum sectors can be traced to community-based property rights over land, an inefficient court system, and political instability (see Box I.1), all of which have fueled myriad compensation claims from loosely defined landowner groups. The notion of “compensation” has deep historical roots in Melanesian culture. Compensation was traditionally based on gift giving and the asking of forgiveness, often within the context of a feast that brought feuding parties together. In recent generations, however, this traditional system has been replaced by a system in which monetary payments are demanded to redress alleged losses. Since it is typically difficult to precisely assign blame and quantify the loss to the injured party, protracted battles (often legal, but sometimes physical) have ensued over compensation claims.

6. The absence of clear property rights has impeded foreign direct investment in the mining sector. In some cases, the government has been able to assist companies that wish to lease land, but even in these instances, the legitimacy of many lease contracts has been subject to dispute. Mining companies that wish to tap into Papua New Guinea’s abundant resources must negotiate with numerous landowner groups, and it is expensive and time-consuming to reach an agreement with all parties. In addition, negotiations can suffer if some groups hold out for a larger payment. By demanding more compensation, each landowner group imposes a negative externality on the other groups with the result that the viability of the whole project can be threatened.

Governance Issues

Papua New Guinea’s struggle to improve governance has been exacerbated by political instability, which has manifested itself in the rapid turnover in Parliament of elected members and political parties. In the 2002 elections, almost 3,000 candidates competed for 109 seats in Parliament. Candidates elected rarely represent a majority of the electorate of their district, and in practice often do not serve more than one term in office. Of the 109 incumbent parliamentarians, 80 lost their seats, including most of the members of Sir Mekere Morauta’s cabinet. The 2002 elections were also marred by widespread vote-rigging, intimidation, and other irregularities (in some districts, the number of votes cast exceeded by more than two times the number of people of voting age). The ensuing violence led to the death of over 30 people in the Southern Highlands area, resulting in the cancellation of elections in several districts.

Furthermore, political parties are typically formed on the basis of personal and tribal allegiances (especially to one’s wantok, or extended family) rather than overriding ideological views, and thus the reshuffling of alliances among political leaders is common. As a consequence, it has been difficult to undertake long-term planning since political parties rarely stay in power long enough to implement, and hence be held accountable for, their election promises.

The previous government passed legislation aimed to stabilize the political system. The Organic Law on the Integrity of Political Parties and Candidates introduced, among other reforms, some proportional representation, registration of political parties, state funding of political parties, and penalties against switching parties during a parliamentary term. The legislation is intended to engender more stability in government policy and planning.

Forestry

7. Papua New Guinea has the second largest rainforest in the world. Logging is a major industry and generates about 1–2 percent of GDP annually in the form of export duties. However, due to ambiguous property rights and poor governance, the forestry sector has been plagued by unsustainable practices. Since logging companies cannot buy communal land, they rely on temporary (and often rescindable) logging rights in defined areas. As a result, they have little incentive to maintain the value of the land by taking measures such as replanting trees and avoiding environmentally damaging practices that would enhance the resale value of the land.

8. The absence of property rights over land would not be an insurmountable problem if a strong regulatory regime existed that could supervise the logging industry to ensure sustainable development (as is the case in Canada, where most forestry land is leased by the government to private operators). However, poor governance and law and order problems in Papua New Guinea have impeded the creation of such a regime, although the present government has affirmed its intent to better regulate this sector.

Tourism

9. Tourism offers much potential for Papua New Guinea. The country has coral reefs that are home to five times as many fish species as in the Caribbean; numerous opportunities for trekking, surfing, white-water rafting, and bird watching; a rich culture that encompasses nearly a third of the world’s languages; as well as proximity to the Australian and Japanese markets. Despite all these advantages, only 50,000 tourists visit Papua New Guinea annually (compared with 600,000 tourists each year in Fiji) due to concerns about law and order, inadequate facilities, and sparse infrastructure, particularly in the scenic outlying areas. Furthermore, the lack of property rights over land has made it difficult to build “enclave all-inclusive” resorts that are popular in such regions as the Caribbean. The Papua New Guinea Tourism Promotion Authority (TPA) has been working with the provincial governments to establish Papua New Guinea as a destination for eco-tourism and to enhance the image of the National Capital District as the gateway, although success thus far has been limited.

Agricultural sector

10. More than 85 percent of the population lives in the rural areas, and most are dependent on subsistence activity. Coffee, which grows well in the temperate Highlands regime, is the main cash crop. Development of the formal agriculture sector has been impeded by the deterioration of roads due to an inefficient allocation of development expenditure, especially for feeder roads which fall under the responsibility of the provincial governments, and by roadside bandits (it has been estimated that 20 percent of coffee production is stolen in highway hold-ups). Both of these factors have limited the opportunity for farmers to bring goods to market.

11. Although several large palm oil estates, mainly in New Britain, continue to flourish, large scale coffee plantations have virtually disappeared. The collapse of large-scale farming in Papua New Guinea can be traced back to the country’s land tenure system and ongoing security problems, especially in the Highlands region where coffee is grown. Unlike smaller “village” plots, it is expensive to secure plantation land. Although stealing crops from neighboring villages is considered reprehensible, theft from plantations, which are typically run by non-Melanesians, reportedly carries less stigma. As a result, land holdings tend to be very small and do not benefit from scale economies and modern management practices.

Urban sector

12. Although the vast majority of people in Papua New Guinea live in rural areas, urban centers in general, and Port Moresby in particular, have grown rapidly since independence. However, limited employment opportunities in the formal urban sector have resulted in growing unemployment. According to BPNG’s employment index, total private nonmining formal sector employment on average declined by nearly 1 percent annually since 1996, and the rate of decline in private employment has accelerated over the past two years. This deterioration has occurred in all regions of the country, and the construction and transportation sectors have experienced the biggest declines.

13. The consequent squatter settlements around existing urban areas, especially in Port Moresby, have become associated with criminal activity. Since 1990, serious crimes reported to police have increased substantially although many crimes (especially sexual assaults) go unreported. These law and order problems impose a significant cost on private businesses. While Duncan and Lawson (1997) estimate that the direct costs of security in Papua New Guinea represent about 3 percent of total business costs, “indirect costs” are probably far greater.2 In particular, estimates of direct security costs understate the actual cost to the economy since they focus only on existing businesses, and not the businesses that would have formed if security costs were lower. High security costs also limit the geographical vicinity in which businesses can operate, the times at which they can operate (when business owners are reluctant to operate after dark), and the scale and capital intensity of operations.

14. In addition to problems with lawlessness, the growth of private employment has been hamstrung by a shortage of available land and high unit labor costs. Although detailed data on commercial and residential real estate prices are not available, prime real estate land in Port Moresby is expensive. Furthermore, to avoid landowner disputes, several businesses have had to establish themselves on reclaimed land in the Port Moresby harbor which has added to the cost of business. Additionally, unit labor costs in Papua New Guinea are higher than those in other Asian countries. Duncan and Lawson estimate that unit labor costs averaged 80–100 percent of those of the United States for the period 1970–94, compared to 40 percent for the Philippines and Malaysia. Although the real depreciation of the kina over the past few years has lowered labor costs while inflation has eroded the real value of the minimum wage so that in most cases, it is no longer binding, sustained decreases in unit labor costs in the future will require stronger productivity growth and greater labor market flexibility.

15. The lack of entrepreneurial experience among the Melanesian population has further impeded the growth of urban industries. Many businesses continue to be owned and managed by ex-patriots, which represent less than 1 percent of the population. The paucity of Melanesian owned businesses reflects the lack of ethnic business networks, which in most countries are important in nurturing small businesses, low levels of education, and the limited experience that much of the population has in dealing with markets. As a result, many of the best workers have been drawn to the public sector and state owned enterprises, thus limiting the pool of skilled workers that are capable of establishing successful private firms. In addition, the wantok system, which obliges members of a wantok to share wealth with their extended family, imposes a high de facto marginal tax on wealth accumulation, thus limiting the pecuniary incentive to entrepreneurial risk-taking.

B. The Way Forward

16. Reviving growth prospects, generating higher private sector employment, and alleviating poverty are the main policy challenges in Papua New Guinea. The government has two broad roles to play. First, it needs to ensure that a framework is put in place that preserves macroeconomic stability in order to facilitate the development of private sector activity. Against the background of the decline in mineral receipts in the coming years, the authorities’ macroeconomic framework envisages a budget deficit of around 1 percent over the medium term in order to keep inflation low, the exchange rate broadly stable, and the debt-to-GDP ratio on a declining path. Second, the government needs to address the deep-seated structural impediments to growth in each sector of the economy. Since these impediments are intertwined and mutually reinforcing, a comprehensive approach to structural reform is necessary, which will require sustained and ambitious actions by the authorities. Nonetheless, given the enormity of the challenge that the present government faces, achieving significant progress in these difficult areas is likely to take considerable time. The main areas for reform are outlined in the remainder of this chapter.

17. While there is still much work to be undertaken, Papua New Guinea has begun to address the law and order problems that must be overcome to revive growth and reduce poverty.3 This will require an active government policy to discourage predatory, or rent-seeking, behavior while augmenting the incentive to engage in productive employment. Tensions in Bougainville have been steadily abated as the government has worked with local leaders to redraft the constitution in order to grant more autonomy to the province. The government has called for fresh elections in those areas of the Highlands in which voting during the 2002 election broke down, while augmenting the police presence there to preclude another breakdown of law and order. Furthermore, with the assistance of AusAID, the Papua New Guinea defense force is being re-organized following several mutinies, and efforts are continuing to improve the constabulary. There has also been discussion of strengthening Papua New Guinea’s traditional tribal justice system which is simpler and less expensive to administer, and in many parts of the country carries more legitimacy than the modern system.

18. The introduction of a modern system of land tenure has the potential to significantly expand activity in the mining, agriculture, and forestry sectors, as well as boosting tourism. At present, “customary” land, which accounts for 97 percent of all land, can not be bought or sold, which has been a major impediment to growth (Box I.2). Furthermore, with a population growth rate among the highest in the South Pacific, demographic pressures have heightened the need to clarify land ownership. Young people, no longer able to make a living on their ancestral land, have moved to urban centers, and as many as 100,000 people in Port Moresby are now living on untitled land in settlements and surrounding areas.

19. In recognition of the potential benefits of land reform, the government has on several occasions tried to establish a land registry system. It was hoped that creating a database of land claims would facilitate the transfer of communal land into private hands. However, popular opposition to land reform has thwarted the creation of a registry, and the vast majority of customary land remains unmapped. This reflects in large part popular concern that the new registry system could be used to shift communal land into the hands of elite members of society, thus dispossessing the current inhabitants of their land. As a result, achieving a successful land reform will require good governance.

The Benefits of Land Reform

Proponents of land reform note a variety of mechanisms by which customary land tenure retards economic growth:

  • In the absence of a formal land title, control of customary land is associated with insecurity since ownership, use, and succession of land is determined not by a formal written record, but by oral tradition and the judgments of tribal elders. This insecurity has the potential to exacerbate law and order problems as different groups compete for control of the land.

  • Customary land tenure also reduces the incentive for landholders to improve their land since the cost is largely borne by the individual landholder while the benefits (typically in the form of higher agricultural yields) are shared with the entire community.

  • The inability to use land as collateral prevents the development of rural credit markets and new investment, a problem that is especially acute when land is the only potentially marketable asset that rural people hold.

20. While land reform would facilitate an increase in agricultural output, the poor quality of rural development expenditure, particularly with respect to rural transportation, has impeded the ability of farmers to bring their crops to market, which in turn has increased rural poverty. It has also weakened the credibility of government policy and exacerbated the law and order problem as rural inhabitants, who may feel that the fiscal benefits from resource projects in their vicinity are not passed back to them by the national and subnational levels of government in ways that can augment their economic opportunities, pursue compensation claims directly against resource developers.

21. The government has committed itself to significantly increasing rural infrastructure spending as part of its strategy to develop new agricultural exports, as well as enhancing the prospects for the traditional exports of coffee, palm oil, copra, and cocoa. For its part, the World Bank has approved additional funds for highway and feeder road development.4 The provincial governments, which are responsible for the construction and maintenance of feeder roads, will also need to ensure that outlying communities have better access to the major roads.

22. The lack of good governance has weakened efforts to improve the land tenure system, exacerbated problems in the forestry sector, prevented the development and enforcement of an appropriate institutional and legal setting, and impaired the delivery of social services, especially in rural areas.5 The government has begun to take steps to curtail opportunities for corruption by establishing the Independent Public Business Corporation (IPBC) to manage government assets at an arms length from the political process, pledging to establish an Independent Commission against Corruption (ICAC), and having public hearings into past misdealings in the administration of the National Provident Fund and in the sale of PNG Banking Corporation to Bank South Pacific. Furthermore, the World Bank has recently begun to assist the authorities in modernizing procurement procedures, with the aim of improving transparency, reducing waste, and curbing informal payments in procurement contracts.

23. Finally, microeconomic reforms are necessary to support private sector activity, especially in the agricultural sector and among small and medium-sized enterprises in urban areas. Additional progress will be needed to reduce the size of the government bureaucracy and the amount of red tape. The establishment of an Independent Consumer and Competition Commission (ICCC), which has been granted greater responsibility for adjusting controlled prices (including for utilities) and for implementing new competitive laws that come into force in May 2003 is a welcome development. Further, the expected establishment of a “one-stop shop” to streamline license approval for new investment and to grant work permits and visas more liberally would also be a step forward. Training program to support entrepreneur-ship as well as expanded use of microfinance projects and greater labor market flexibility could also be useful in fostering private sector growth. Moreover, policies that stimulate the private sector and thereby reduce unemployment will likely lead to substantial improvements in law and order, which will in turn further stimulate private sector activity.

C. Conclusion

24. Papua New Guinea benefits from a democratic heritage, robust civil liberties, a rich culture, a free-press, and an independent judiciary. These elements, combined with large endowments of natural resources, substantial grant flows, and proximity to the Australian and Asian markets, have the potential to serve as a springboard to high levels of sustainable growth. However, to underpin robust rates of growth and make strong inroads towards poverty alleviation, sustained actions will be needed across a wide range of structural reforms while maintaining macroeconomic stability in the face of changing economic circumstances. Although undertaking such actions will not be easy, and achieving significant results is likely to take considerable time, any delay will further undermine the prospects for economic recovery.

II. External Debt Sustainability Analysis1

1. The evolution of Papua New Guinea’s private and public external debt has been closely tied to developments in the mining and public sectors. Until the 1970s, the economy was almost entirely agriculture based and the limited foreign financing needs were met largely through concessional project financing. This changed markedly with the discovery and exploration of large mineral deposits (gold, copper, and oil) in the 1960s and 1970s. This note describes the evolution of Papua New Guinea’s external debt structure, and assesses the sensitivity of debt dynamics to a number of shocks based around the methodology outlined in the recent Assessing Sustainability paper (SM/02/166). Additional stress tests are conducted that are particularly pertinent to this economy.

A. Evolution of External Debt

2. Over the last two decades, Papua New Guinea has evolved from a country with low levels of external debt to one where debt dynamics are a source of concern. At the end of the 1970s, external debt levels hovered around $500 million dollars, or around 20 percent of GDP. By the end of 2002, total external debt is estimated to have quadrupled to almost $2 billion, or 72½ percent of GDP. The underlying trends for private and public debt have been quite different. Private external debt—virtually nonexistent at the beginning of the 1980s—increased to a peak of 63 percent of GDP in 1992, but has since declined sharply along with the life-cycle of mineral projects (to around 18 percent of GDP at end-2002). Public external debt (defined as central government plus central bank debt, excluding contingent liabilities), in contrast, has been rising steadily (in U.S. dollar terms) since the early 1980s although the debt-to-GDP ratio has risen more sharply since the mid-1990s as the effect on GDP of price, exchange rate, and economic growth changes has not been offset by debt amortization payments. These trends are discussed in more detail below.

Figure II.1
Figure II.1

Evolution of External Debt

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

3. The construction and subsequent production at new mines (or oil fields) has major implications for the composition of balance of payments as well as the debt stock. Projects are operated and financed largely by foreign investors, with the government often participating as an equity shareholder. Because the operation is financed mainly by foreign capital, capital inflows increase in the project’s construction phase to finance the importation of material and equipment and domestic expenditures on goods and services (with the main impact on the construction, transportation, and manufacturing subsectors). These large-scale inflows are mirrored by a large current account deterioration, leaving the overall balance of payments largely unaffected. As the production phase commences, capital inflows decline as does expenditure on imports and domestic goods and services. At the same time, production boosts export volumes, but factor income payments also increase, reflecting the payment of interest on loans used to finance the project and dividends on foreign-owned equity.

4. Large-scale capital inflows for the construction phase of projects have tended to be accompanied by substantial foreign direct investment, although it is difficult to discern a clear pattern. For instance, during Ok Tedi’s construction, debt-creating flows outpaced foreign direct investment, but this pattern was less clear for projects constructed during in the 1990s. Data limitations hinder a fuller examination of these financing flows. Inconsistencies between balance of payments data on projected amortization flows during 2003–08 (received directly from mining companies) and estimates of the current level of private debt stocks indicate that a substantial proportion of past private capital flows may have been misclassified as nondebt creating flows, and/or that a proportion of private flows has by-passed balance of payments statistics altogether.2

5. Five phases can be distinguished in the period reviewed here: (i) the initial sharp increase in private and public external debt (1979–85) associated, respectively, with largescale investment needs of the Ok Tedi mine and a sharp increase in fiscal deficits in the early 1980s; (ii) a rapid decline of external debt levels (1986–88) as fiscal consolidation coincided with large Ok Tedi debt repayments; (iii) a renewed increase in both private and public debt (1989–92) related to investments in the Misima and Porgera mine and the Kutubu oil field, as well as multilateral and bilateral assistance to deal with the economic fallout of the Bougainville crisis; (iv) a decline in private external debt (1993–97) as loan repayments for completed mineral projects outweighed new investments and; (v) a renewed increase in public debt ratios as a share in GDP (1998–2002) largely driven by the effect on economic growth from the Asia crisis, and adverse debt dynamics due to the exchange rate depreciation. These trends are described in more detail below.

Private external debt

6. Private external debt levels increased sharply in the period 1979–85, primarily due to construction work for the Ok Tedi mining project.3 Large imports, together with deteriorating terms of trade, led to a sharp increase in the current account deficit from around 11 percent of GDP in 1980 to 21 percent of GDP in 1981, and the current account deficit ratio stayed in double digits until Ok Tedi was completed in 1984. The private loans needed to finance these imports led to a tenfold increase in U.S. dollar debt by end-1985 (from $93 million in 1979 to $1.02 billion in 1985). Eighty percent of this increase is estimated to have been related to the mine.

Figure II.2
Figure II.2

Mining Activities as Determinants of Private Capital Flow

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

7. After Ok-Tedi commenced operations, external debt levels stabilized as private loan repayments broadly offset investments for new mineral projects. In addition, owing largely to the conversion of $286 million of private debt to equity in the Ok Tedi mine, the ratio of private external debt to GDP declined from its 1985 peak of 46 percent of GDP to 27 percent of GDP in 1988. This development was, however, short-lived. Capital inflows associated with new mineral projects, in particular the Misima gold mine that opened in 1989, the much larger Porgera gold mine that opened in 1990, and the Kutubu oil field in 1992, put private debt levels back on an upward trajectory. At the same time, the external position weakened after the closure of the Panguna copper mine (BCL) in 1998 due to a secessionist rebellion on the island of Bougainville. A devaluation of the kina in 1990 increased the value of the debt stock further in relation to GDP, and reached 63 percent of GDP in 1992.

8. The opening of the Kutubu oil field in 1992 completed a period of heavy private external borrowing. The large export proceeds generated by the mineral and petroleum projects were used to repay loan obligations. Economic activity accelerated sharply with the development of the Porgera gold mine (1990) and the Kutubu oil field (1992) and current account surpluses ranged between 11–16 percent of GDP. By 1996, the level of external private debt declined to 35 percent of GDP. The trend decline in private sector debt was temporarily reversed in 1997 as high capital inflows resumed to construct the Lihir gold project–one of the largest gold mines outside of South Africa–and for the development of the Gobe oil project. However, in the absence of major new mineral projects and limited private foreign borrowing by the rest of the economy, private sector debt soon fell again reaching 18 percent of GDP by end-2002, its lowest level since the early 1980s.

Figure II.3
Figure II.3

Private External Debt

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

Public external debt

9. Fiscal deficits in the early 1980s led to a sharp increase in public debt levels. A rapid increase in expenditure coupled with lower proceeds from the Panguna mine (Bougainville Copper Limited), at that stage the only operative mine in Papua New Guinea, led to a quadrupling of the fiscal deficit to levels around 6 percent of GDP between 1981–83.4 Total public debt increased from 19 percent in 1980 to 50 percent of GDP in 1985, notwithstanding efforts to curtail expenditure. Moreover, the public debt service ratio (as a percent of exports of goods and services) doubled from 4 percent of exports of goods and services in 1980 to 8 percent in 1985, due largely to the increasing reliance on foreign commercial loans. Bilateral official debt during this period was relatively limited as most financial assistance extended by governments was provided in the form of grants.

10. In the mid-1980s, with the fiscal deficit under control, the government was able to sharply reduce its external commercial debt. By 1990, public external debt had declined to 25 percent of GDP and about three quarters of the public debt outstanding was either from official bilateral or multilateral sources, compared to less than half in at the end of 1985.

Figure II.4.
Figure II.4.

Composition of Public External Debt

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

11. Net inflows from bilateral and multilateral concessional sources increased sharply in 1990, following the economic deterioration following the closure of the Bougainville copper mine, and a sustained decline in world prices for the country’s major agricultural products. Public debt levels increased by 10 percent of GDP in 1990 (to 35 percent of GDP), but declined thereafter to around 25 percent of GDP, as real GDP increased or new mines came on line.

12. Since 1997, public sector external debt has increased steadily in U.S. dollar terms, in line with net foreign financing for the budget, from around $1.3 billion to $1.45 billion. However, public sector external debt as a share of GDP has increased much more sharply from 27 percent in 1997 to 54 percent by end-2002. The rapid increase is largely attributable to the 30 percent real depreciation of the exchange rate since 1997 and the contraction in real GDP during this period. In particular, after 1997 Papua New Guinea’s economy was adversely affected by a severe drought, reduced agricultural output while the low river levels temporarily halted exports from the country’s largest gold and copper mine. These supply problems were exacerbated by the Asia crisis, which reduced demand for Papua New Guinea’s exports and led to a sharp decline in commodity prices. The decline in activity and exports led to an increase in the fiscal deficit that was financed mainly by borrowing from the central bank. This led to substantial losses of international reserves (falling to two weeks of imports), a sharp acceleration in inflation, and a protracted nominal effective depreciation of the kina.

Figure II.5.
Figure II.5.

Public Debt to GDP

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

13. The deficit was constrained during a Fund-supported reform program in 2000 and 2001 and the BPNG entered into an $80 million (nonconcessional) swap arrangement with Australia (equivalent to 2.3 percent of GDP) that was later converted into a government-to-government bilateral loan. However, in December 2001, after the expiry of the arrangement with the Fund, the deficit increased again in part due to unbudgeted domestic expenditures, and the government contracted a $55 million loan on nonconcessional terms to fund a nontransparent public sector Yumi-Yet bridges project that had not been included in the 2002 budget. At 54 percent of GDP, the level of public sector external debt is now a significant concern.

B. Present Structure of External Debt

14. At end-2002, total external debt consisted predominantly of central government debt, as the private debt share has progressively declined since the early 1990s. Central government external debt accounts for 69 percent of total external debt; central bank external debt amounts to 6 percent of the total (consisting almost entirely of liabilities to the Fund) and the remainder, 25 percent, is taken up by the private sector.

15. The share of private borrowing in the total external debt stock has been in almost continuous decline since its peak of 69 percent in 1992, and at 25 percent now takes up roughly the same share in total external debt as in the early 1980s. Barring major new mineral projects, the trend decline in private external debt is projected to fall to 5½ percent of GDP by 2008, compared with 18 percent of GDP at end-2002, at which stage it would comprise 10 percent of the total external debt stock.

Figure II.6.
Figure II.6.

The Composition of Total External Debt. (end 2002)

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

Source: Data provided by Papua New Guinea methodic and Food staff Reports

16. The bulk (97 percent) of Papua New Guinea’s public external debt consists of borrowing from official sources, both bilateral and multilateral. The main creditors are the Asian Development Bank, the World Bank and Japan, in roughly even proportions.5 Following the government’s policy since the mid-1980s of avoiding further commercial borrowing, commercial debt declined from a peak of 39 percent of total public debt in the early 1980s. This share of commercial debt is projected to increase to 5 percent in 2008, because of the Yumi-Yet bridges project which was contracted at end-2001 on nonconcessional terms. Roughly half of Papua New Guinea’s external public debt is denominated in U.S. dollars, a third in Japanese yen, and the remainder in other foreign currencies.

Figure II.7.
Figure II.7.

Debt-Service Ratio

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

Figure II.8.
Figure II.8.

The Currency Composition of External Public Debt

(In percent of total)

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

17. The public debt-service ratio has fallen somewhat from its peak of 11 percent in the early 1990s, and now hovers at around 7–8 percent of exports of goods and services. Total (public and private) debt service has come down from its peak of 35 percent of exports of goods and services in 1993 to 18 percent of at end-2002. As explained above, this ratio is an imperfect indicator of Papua New Guinea’s ability to meet debt service payments due to the self-financing nature of mineral and petroleum projects. In any event, Papua New Guinea’s economy is extremely open (exports amount to roughly 65 percent of GDP), enhancing its ability to generate foreign exchange earnings for debt-service.

C. External Debt Projections

18. The staff has prepared an external debt scenario assuming the pursuit of prudent macroeconomic policies and wide-ranging structural reforms to boost nonmineral economic growth rates. Achieving the macroeconomic objectives under this scenario will require significant efforts, especially with respect to nominal GDP growth and containing the fiscal deficit.6 The main assumptions are as follows:

  • A gradually rising nonmineral GDP growth rate from roughly 2½ percent in 2003 to 3½ percent of GDP by 2008. Total GDP growth is, however, volatile due to the contraction in mineral output in the medium term.

  • A decline in the central government deficit to 2 percent of GDP in 2003 and an average of 1 percent of GDP thereafter.

  • A nominal external interest rate of between 4½-5½ percent (around its current average level), and a constant real exchange rate.

Figure II.9.
Figure II.9.

Public External Debt, 1997–2008

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

19. Under this scenario, external public debt declines from 54 percent of GDP in 2002 to around 40 percent of GDP by the end of 2008, primarily due to net repayments and positive GDP growth. The decline in private debt levels is, however, somewhat of a mixed blessing as it signals lack of foreign interest in pursuing new mineral projects at this time.7 While there are some smaller projects on the horizon (e.g., the Napa Napa oil refinery and, possibly, Ramu Nickel) no major mineral projects are currently anticipated that would reverse the downward trend in the stock of private external debt. The main possible exception to this is the Queensland Gas Pipeline which in scope would rival, if not surpass, previous major mining projects but achieving the requisite number of buyer contracts has so far proven an elusive task. The stock of total external debt declines from around 72½ percent of GDP at end-2002 to 51 percent of GDP in 2008. Public debt service increases somewhat in the short term, from 7½ percent of exports of goods and nonfactor services (GNFS) in 2002 to 10 percent of GNFS in 2005, but declines thereafter to an estimated 6½ percent of GNFS. The projections do not include new IDA or PRGF loans from the Bank and the Fund. To the extent such loans are forthcoming, and start to replace the existing higher cost multilateral portion of the public debt stock, the net present value of public debt will decline further.

Figure II.10.
Figure II.10.

Public External Debt, 1997–2008

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

D. Sensitivity Analysis

20. Stress tests suggest that, even with policies along the lines described above, Papua New Guinea’s external debt remains highly vulnerable to shocks, and a number of stress tests would push the debt ratios to precarious levels. Detailed results are summarized in Table II. 1, at the end of this chapter.8

Table II.1.

Papua New Guinea: External Debt Sustain ability Framework, 1992–2008

(In percent of GDP, unless otherwise indicated)

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Derived as [r−g−ρ(l+g) + δa (l+r)]/(l+g+ρ+gρ) times previous period debt stock, with r = nominal effective interest rate onexternal debt; ρ = change in domestic GDP deflator in U.S. dollar terms, g = real GDP growth rate, e = nominal appreciation (increase in dollar value of domestic currency), and a = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [−ρ(l+g) + εα(l+r)]/(1+g+ρ+gρ) times previous period debt stock, ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end of previous period.

  • Under the first stress test, external nominal interest rates are assumed to be two standard deviations above their historical levels during 2003 and 2004, after which they return to baseline levels. This has virtually no impact on the debt ratio relative to the baseline path, as the low standard deviation associated with relatively stable levels of annual external interest payments in the past roughly matches the slight projected increase in interest payments under the baseline.

Figure II.11.
Figure II.11.

External Debt Sustainability—Stress Tests

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

  • The second stress test scenario is one where real GDP growth is assumed to deteriorate by 5 percent annually in both 2003 and 2004. This has a substantial impact on the debt ratio increasing it by 10 percent of GDP over the baseline by 2004. The higher debt stock at the end of 2004 increases interest payments, resulting in a more modest decline in the debt ratio in the period 2005–08 relative to the baseline.

  • The third stress test assumes that the noninterest current account deficit is more deleterious by two standard deviations in 2003 and 2004. This would have the effect of raising the external debt ratio to roughly 84 percent by the end of 2004—almost 24 percentage points above the baseline—although a gradual decline in the debt path would subsequently set in. The debt-to-GDP ratio would decline to 79 percent of GDP in 2008, still somewhat above the level in the first year in which the shock was applied. It should be noted, however, that these results are driven by the mechanics of the exercise and likely overstate the effects of a current account shock. In particular, absent new mineral projects there are no obvious sources of financing for higher nonmineral current account deficits, implying that any shocks would likely be met with a combination of import compression and relative price changes, and only in part by new debt creating flows.

  • The fourth stress test entails a combination of shocks, to account for the possibility that when shocks do occur, economic variables can deteriorate in tandem. In particular, a simultaneous one standard deviation shock (applied in both 2003 and 2004) to the nominal interest rate, the GDP growth rate, and the noninterest current account, coupled with a 15 percent depreciation of the real exchange rate, would raise the debt ratio to 86 percent of GDP in 2003 and further to 94 percent of GDP in 2004 where it remains for the balance of the projection period. The relative size of the shocks is shown in Figure II.12.

  • The final standardized stress test consists of a one-off depreciation in the real exchange rate of 30 percent in 2003 (similar to the exchange rate shock in 1998). This shock demonstrates the extreme vulnerability of the debt-to-GDP ratio to exchange rate movements, raising the debt ratio to 93 percent in 2003, although the debt ratio declined thereafter.

Figure II.12.
Figure II.12.

Impact of Permanent One-Standard Deviation Shocks on Debt-to-GDP Ratio in 2003

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

21. The pertinence of the stress tests is underlined by what have turned out to be overly optimistic projections in Article IV reports during 1999–2001. Both the 1999 Article IV report and the request for a Stand-By Arrangement in 2000 projected that the public external debt ratio would fall to under 30 percent of GDP by 2002. In the latter document, this was predicated on economic growth of 4½ percent in 2000, a fiscal deficit target of 1½ percent, inflation of around 5 percent and a recovery in gross reserves to 3½ months of imports. In the event, real GDP contracted in both 2000 and 2001, the budget deficit target in 2001 was overshot and inflation was twice as high as projected. Most importantly, however, the exchange rate declined substantially, leading to a declining value of GDP in U.S. dollar terms (price and exchange rate changes add a combined 20 percent of GDP to the public external debt ratio). As a result, the public external debt ratio rose to 54 percent of GDP by 2002.

Figure II.13.
Figure II.13.

Public Debt-to-GDP Projection in Fund Staff Reports

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

Source: IMF Staff Reports

E. Additional Stress Tests

22. Two additional stress tests were conducted to assess the vulnerability of Papua New Guinea’s external debt. The first simulates various oil price shocks. Oil exports in recent years comprised roughly 28 percent of total exports and the volatility of oil prices thus has a significant impact on the balance of payments.9 At current levels (the WEO baseline of $26½ per barrel in 2003 and thereafter declining to $21 per barrel), the staff is not projecting any financing gaps for 2003. However, a decline in the oil price to $20 per barrel in 2003 and the period thereafter would increase the total external debt ratio by 6½ percent of GDP in 2003, by 3 percent of GDP in 2003 and by smaller magnitudes thereafter. Conversely, a higher oil price would benefit Papua New Guinea. With an oil price of $35 per barrel throughout the projection period, the external debt ratio could fall to just 16 percent of GDP by 2008. The chart below illustrates the vulnerability to different oil price scenarios.

Figure II.14.
Figure II.14.

Oil Price Scenarios—Impact on Total External Debt

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

Figure II.15.
Figure II.15.

Effect of a One-Standard Deviation Shock to Copper and Gold Prices in 2003 and 2004

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

23. The second additional stress test consists of a simultaneous shock to gold and copper prices. Oil, gold and copper jointly comprise three-fourths of Papua New Guinea’s total exports. Applying a one-standard deviation shock to both gold and copper prices (implying a copper price that is 20 cents per pound lower, and a gold price that is $37.3 per oz lower than WEO projections in 2003) increases the debt-to-GDP by 5 percent of GDP by the end of 2004 and by 11 percent of GDP by 2008 (the debt ratio reaches a level of 55 percent of GDP compared to 44 percent of GDP in the baseline). Both the oil price stress tests and the shock to copper and gold prices imply that these price shocks are unlikely to create an unsustainable debt dynamic.

F. Conclusions

24. The sensitivity analysis undertaken in this chapter illustrates that the main threat to Papua New Guinea’s debt dynamics derives from changes in macroeconomic variables, not from exogenous shocks to the prices of its main export products. This underscores the importance of pursuing the government’s medium-term objectives with a fiscal deficit that averages 1 percent of GDP and stable inflation in the low single digits that contribute to the stability of the kina and of continued access to concessional financing. Indeed, the sharp rise in public external debt levels in recent years is testimony to the impact on the external debt stock of exchange rate, GDP deflator changes, and growth shocks. Avoiding these types of shocks will require not only sound macroeconomic policies but also sustained structural reforms to enhance competitiveness and improve the business climate. Finally, the private external debt stock, while high at times, has not posed particular difficulties in the past, primarily because it has been largely self-financed by the mineral companies whose balance sheets are not vulnerable to exchange rate fluctuations since both their assets and liabilities are denominated in foreign currency. It is expected to trend down over the medium term in the absence of new projects in the mining and petroleum sectors.

ANNEX II.I Private External Debt Projections—Estimation of Underreported Debt

1. As noted in the statistical appendix to the staff report, data on private external debt are particularly weak. Large errors and omissions started to emerge during the 1980s and 1990s, likely reflecting, in part, unrecorded overseas financing of imports, including by those companies involved in mineral and oil exploration. Lenders in many cases disburse funds directly to contractors, effectively bypassing the exchange record system.

2. Official data on private debt stocks are inconsistent with projected amortization flows reported by the mineral sector. Previous private debt estimates indicated a private debt stock of close to zero in 2001, but balance of payments data indicate forthcoming gross amortization flows of close to $1 billion in the period 2001–08 alone (on a net basis the private sector is expected to repay between $550–600 million). These balance of payments estimates for future debt amortization are taken directly from the private mineral companies.

3. For the purposes of the debt sustainability analysis in this chapter, official data on private external debt has been augmented with an estimate of this underreported private debt. The estimate is based on the assumption that the private sector amortization from 2003–08 is derived from loans with a maturity of ten years, and annual loan repayments following a grace period of five years—roughly consistent with a pattern seen for past mineral loan projects—leading to an implied historical disbursement path. In addition, it is assumed that beyond 2003 no further underreporting of private debt takes place, consistent with the practice of not forecasting errors and omissions. The projections thus generated raise the debt stock during the period 1992–2002 by amounts varying from $0.6–1.3 billion, as illustrated in the chart below.

uA01fig01

Estimate of Unreported Debt

Citation: IMF Staff Country Reports 2003, 176; 10.5089/9781451831658.002.A001

III. Recent Trends and Fiscal Sustainability1

1. After averaging around 1 percent of GDP during most of the 1980s, the budget deficit in Papua New Guinea increased and fluctuated widely during the 1990s.2 As a result, the deficit and central government debt as a share in GDP have steadily increased to levels that have raised questions concerning the sustainability of the medium-term fiscal outlook. In this chapter, the fiscal and debt trends during 1990–2002 are reviewed, and the current fiscal rigidities and vulnerabilities are discussed. The magnitude of the adjustment required to return to a sustainable fiscal outlook is also assessed. The main conclusions are as follows:

  • The fluctuation in the fiscal deficit as a share in GDP has mainly reflected variations in revenue, especially revenue from the mineral and petroleum sector. As a share in GDP, and abstracting from non-cash development spending provided directly by donors, domestic expenditure since the mid 1990s has been relatively stable despite the revenue fluctuations. Civil service wage expenditure has consistently been between 9–10 percent of GDP, despite frequent efforts to reduce such expenditures.

  • The debt-to-GDP ratio increased rapidly during the last five years. While the external debt stock measured in U.S. dollar terms has been fairly stable, as a share in GDP the deficit has increased sharply due to the real depreciation of the exchange rate and the prolonged contraction in real GDP. Domestic debt has been fairly constant as share in GDP during the last five years, although its maturity profile has progressively shortened.

  • On current policies, the budget deficit over the medium-term would increase from an estimated 3½ percent of GDP in 2003 to over 5 percent of GDP by 2008, mainly due to the expected trend decline in mineral and petroleum revenue that, in turn, reflects the absence of new exploration activity during the 1990s. The authorities have indicated their intention to offset these potential adverse developments.

  • The fiscal outlook is also vulnerable given the gross borrowing requirement that will approach 25 percent of GDP in 2003 and 2004, mainly due to the short maturity of domestic debt, and due to the high sensitivity of the debt-to-GDP ratio to potential domestic and external shocks.

  • An average fiscal deficit of around 1 percent of GDP over the medium-term would be necessary to bring the level of central government debt back to a more sustainable level. This would require a fiscal adjustment in the order of 3 percent of GDP over the medium term.

  • Achieving the required degree of adjustment will be challenging given, on the one hand, the need to increase social and productive expenditure and, on the other hand, the inflexibility of civil service expenditure and of provincial transfers.

  • The recently established Public Expenditure Rationalization Review can assist in identifying the appropriate medium-term expenditure priorities and choices to reach this medium-term deficit target, although revenue adjustments could also be considered.

A. Fiscal Trends During 1990–2002

2. During 1990–2002, the central government budget deficit fluctuated between 1 percent of GDP and 6 percent of GDP (Table III.1). These fluctuations largely reflected developments in the mineral and petroleum sector, and their effect on budgetary receipts, as existing mines closed and new ones opened. Excluding the post-Bougainville years in 1990-91, when mineral revenue fell to zero, revenue from the mineral and petroleum sector has fluctuated by 4½ percent of GDP (between 5–20 percent of total revenue). In contrast, during the last 10 years, all other non-grant revenue has varied by just 3 percent of GDP (Table III.2). However, abstracting from interest payments and from non-cash development projects directly provided by donors, since the mid 1990s domestic expenditure has remained within a narrow range of between 22–25 percent of GDP (Table III.3). The relative stability of domestic expenditure occurred despite frequent efforts to tighten expenditure controls and to reduce outlays, notably for the civil service. Consequently, given the rigidity in domestic expenditure in the face of changing revenue collections, the budget deficit has varied over a wide range.

Table III. 1.

Papua New Guinea: Central Government Budget, 1990–2002

(In percent of GDP)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.
Table III.2.

Papua New Guinea: Central Government Revenue, 1990–2002

(In percent of GDP)

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Sources: Data provided by the Papua New Guinea authorities; and staff estimates.
Table III.3.

Papua New Guinea: Central Government Expenditure, 1990–2002

(in. percent of GDP)

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