Papua New Guinea: 2005 Article IV Consultation—Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Papua New Guinea

Papua New Guinea’s 2005 Article IV Consultation reports that the economy continues to perform well as the recovery maintains its momentum and the authorities adhere to disciplined fiscal and monetary policies. The central government budget has been estimated to be once more in surplus in 2005, as mining and petroleum revenue remain strong and overall expenditure is kept in check, resulting in a further reduction in public sector debt. Monetary policy has achieved a favorable combination of relatively low interest rates and inflation.

Abstract

Papua New Guinea’s 2005 Article IV Consultation reports that the economy continues to perform well as the recovery maintains its momentum and the authorities adhere to disciplined fiscal and monetary policies. The central government budget has been estimated to be once more in surplus in 2005, as mining and petroleum revenue remain strong and overall expenditure is kept in check, resulting in a further reduction in public sector debt. Monetary policy has achieved a favorable combination of relatively low interest rates and inflation.

I. Introduction

1. From the mid-1990s until the early years of 2000, Papua New Guinea’s economic and social performance had been poor (Figures 1–4). Real GDP was broadly unchanged since the early 1990s and per capita income little higher than at the time of independence in 1975, as political instability and a rapid succession of governments hampered the implementation of appropriate economic policies (Box 1). Private activity was stagnant, poverty increased and social indicators, already among the worst for comparable countries, further deteriorated.

uA01fig01

Per capita GDP

(1990=100)

Citation: IMF Staff Country Reports 2006, 099; 10.5089/9781451831702.002.A001

Gross Domestic Product per Capita and Human Development Indicators (HDI) in Papua New Guinea and Comparator Countries 1/

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Sources: UN Human Development Report, 2005; IMF World Economic Outlook.

Country groups are based on WEO groups, unless specified.

Rank out of 177 countries. Country groups are averages of member rankings.

Fiji, Kiribati, Maldives, Samoa, Solomon, Tonga, and Vanuatu.

2. The current government, led by Prime Minister Sir Michael Somare, has made strides in addressing the economic challenges that it inherited upon taking office in 2002. It progressively tightened fiscal policy, in tandem with supportive monetary policy, in a bid to support growth while putting the economy on a more stable footing for the future. As a result, and aided by improving global commodity price developments, the country’s economic position has improved and macroeconomic stability has been restored. Real GDP growth turned positive in 2003, after contracting in the previous three years, and inflation dropped sharply. The government additionally set out a medium-term development strategy focusing on economic reform needed to boost growth to a higher sustainable level (Box 2).

3. The political environment has stabilized in advance of parliamentary elections in 2007. Prime Minister Somare is likely to complete a full five-year term through 2007, the first time for any government since independence. Installation of an autonomous government on Bougainville Island in June 2005 appears to have quieted the 15-year conflict there.

Challenges to Growth

Papua New Guinea has experienced volatile growth since 1960, with GDP increasing at an average annual rate of 5½ percent during 1960–75, then falling to 2.3 percent during 1976–2004. A growth accounting exercise for 1960–2004 finds that the growth slowdown during 1976–2004 may be largely explained by a significant slowing of capital inputs and TFP growth.1/ Investment has been trending downward, except for spikes during periods of mineral boom The performance during 1996–2004 was even more disappointing, with trend TFP contributing negatively to GDP growth.

Sources of Growth, 1965-2004

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Sources: NSO, IFS, and staff estimates.

More recently Papua New Guinea has met many of the theoretical requisites for stronger growth, including a more stable political and macroeconomic environment and an open trade regime, but a longer track record may be needed to change global perceptions.

Available information suggests that other structural factors leading to low total factor productivity may still underlie the poor growth performance by providing a drag on the economy. The rugged terrain raises the cost of transportation infrastructure, which remains weak: less than 4 percent of roads and of airport runways are paved. In addition, adult literacy is low (66 percent). More generally, governance and law and order issues continue to be disincentives to investment. Addressing these weaknesses should yield considerable gains for growth.

Political Risk Points By Component

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Source, ICRG, 2005. First 3 columns ranked 0-6, 2nd 3 columns ranked 0-12; the lower the number, the higher the risk.
1/Assuming a Cobb-Douglas production function with shares of labor and capital of 67 and 33 percent respectively, total factor productivity (TFP) is derived as a residual.

The Medium-Term Development Strategy

The April 2005 Medium-Term Development Strategy (MTDS) sets out the government’s development priorities for 2005-2010, which are consistent with their Millennium Development Goals. The MTDS aims at: (i) establishing good governance; (ii) promoting export-driven growth in agriculture, forestry, fisheries and tourism; and (iii) accelerating rural development and poverty reduction. These goals are to be met through:

  • public sector reform through improved accountability, reduced costs, more efficient service delivery, and fiscal sustainability;

  • a more favorable climate for private sector business through improved law and justice, expanded telecommunications, development of human resources, and upgraded transportation infrastructure; and

  • redirecting public expenditure toward the “priority areas” of rural and transportation infrastructure, basic education, law and justice, and preventive health care programs, including HIV/AIDS prevention.

Achievement of the fiscal strategy is dependent on firm implementation of the Public Sector Reform Program and Public Expenditure Review and Rationalization (PERR) to secure savings in lower-priority budgetary expenditure that can be redirected to priority areas.

The financing of the MTDS was mapped out by the Minister of Finance and Treasury in a mediumterm macroeconomic framework. Growth is expected to rise gradually, reflecting a recovery in the agricultural and mining sectors. Inflation should remain modest, as prudent fiscal and monetary policies are maintained and the exchange rate is assumed to be broadly stable. Continued fiscal restraint is expected to contribute to a further decline in the public debt level.

4. Australia and Papua New Guinea have reached tentative agreement to revive a streamlined Enhanced Cooperation Package (ECP). Under the 2003 ECP, Australia provided personnel to improve the functioning of the judicial system and the police force, and to assist the finance and treasury departments in improving their budget management, financial control, and procurement procedures. The ECP was suspended in May 2005 after the Supreme Court ruled that the immunity granted to the Australian federal police was unconstitutional. Under the revived proposal, the ECP will shift from a focus on strengthening law and order to improving governance and reducing corruption. The 30 officials serving as economic advisors to the government will remain in place.

5. The direction of the authorities’ economic policies has been in line with Fund advice. A medium-term strategy to foster faster real GDP growth on a sustained basis in order to raise living standards and alleviate poverty has been formulated and launched. The medium-term fiscal position has improved with further consolidation and debt reduction, as urged by Executive Directors. The authorities have maintained the flexible exchange rate regime, as recommended, noting that it has been essential in maintaining low inflation while supporting the economic recovery. With regard to structural reform, the outcome has been mixed. The public wage bill remains high, though some progress has been made in switching expenditure resources to priority areas. A controversial proposal in 2004 to borrow externally on commercial terms was set aside. However, advancement on other longstanding structural problems needed to promote private sector activity was slower than envisaged, including addressing weaknesses in governance, law and order, infrastructure, and investment regulations.

II. The Current Economic Setting

6. The economy is performing well as the recovery maintains its momentum, the external position remains healthy, and inflation is low. Real GDP rose by about 3 percent in 2004, in line with the previous year, and a similar rate of growth is expected for 2005 (Table 1). The mining and agricultural sectors were the initial drivers behind the recovery, boosted by an upswing in commodity prices and improved weather. Fiscal and monetary discipline, together with exchange rate appreciation, led to a sharp reduction in average CPI inflation in 2004 to around 2 percent from 14.7 percent in the preceding year, and inflation is estimated to average 1 percent in 2005. The external accounts are expected to be in surplus in 2005, buoyed by high commodity prices for minerals and oil, but also reflecting the start of oil refinery operations and increased non-mineral export volume.

Table 1.

Papua New Guinea: Selected Economic Indicators, 2001–06

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

Based on new official national account estimates (1998 prices).

Measured from below-the-line in the fiscal accounts. Staff projections for 2005-06.

Includes changes in check float.

Figures for 2005 are as of end-October.

Includes central government, Bank of Papua New Guinea, and statutory authorities.

7. The government continued to consolidate the fiscal position in 2005, with the projected outcome for the year stronger than budgeted (Table 2). High mineral and nonmineral revenue (buoyed by continued high commodity prices and stronger than expected growth), and lower than expected expenditure (including on interest payments) generated net savings for the year of about 5 percentage points of GDP. Under the authorities’ revised budget, about half of the savings was used to reduce the stock of domestic arrears and increase spending in priority areas. Another 2.5 percent of GDP of savings were set aside for a future equity acquisition in the Highlands-Queensland gas pipeline project and recorded as an expenditure. As a result, the authorities estimated a budget deficit of 0.6 percent compared to the original budget projection of a deficit of 0.9 percent of GDP. Adjusting for the funds set aside but not actually spent in 2005, the staff estimates the budget balance to be in a surplus of about 2.7 percent of GDP.1 The improved fiscal outcome resulted in a further reduction in total public sector debt, about half of which is external debt, to 49 percent of GDP in 2005 from 72 percent in 2002.

Table 2.

Papua New Guinea: Summary of Central Government Operations, 2001–06

(In percent of GDP)

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

In 2006, expenditures are above budget ceilings as they include projected saving from interest payments.

In 2005, the authorities treat savings for a future acquisition of an equity participations in the PNG gas project as an expenditure. Under IMF’s GFS standards, these are treated as savings below the line. These savings are then used in 2006 and the transaction is registered below the line under nonbanks domestic financing. A memo item shows IMF staff projections according to the authorities’ treatment.

8. As monetary policy has been relaxed in line with the tightening of fiscal policy, credit to the private sector revived while inflation remains low (Table 3). In the absence of inflationary or exchange rate pressure, the central bank progressively lowered the signaling Kina Facility Rate from a 16 percent peak in July 2003 to 6 percent in September 2005. Broad money is expected to rise by about 15 percent in 2005, reflecting increased net foreign assets. In response to lower interest rates, abundant liquidity and more stable economic and political conditions, private sector credit picked up for the first time in four years, increasing by about 20 percent from a low base.

Table 3.

Papua New Guinea: Summary Accounts of the Banking System, 2001-06

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

9. Over the past two years, the kina has remained roughly unchanged on a real effective exchange rate basis, while external reserves have increased. The kina appreciated against the U.S. dollar by about 15 percent in nominal terms during this period, mainly reflecting strong export receipts along with a gradual restoration of confidence in economic management. Gross international reserves are expected to close 2005 at 5.5 months of non-mineral imports (Table 4). External competitiveness appears adequate, given increased non-mineral export volume and a relatively stable share of Papua New Guinea’s exports in total world exports. In addition, Papua New Guinea’s aggregate ranking (64 out of 155 countries globally) in the World Bank’s ease of doing business database compares relatively favorably overall with others in the region.

Table 4.

Papua New Guinea: Balance of Payments, 2001-06

(In millions of U. S. dollars)

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

Public external debt includes central government, central bank external debt, and statutory authorities.

Doing Business: Papua New Guinea and Comparators

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Source: World Bank, 2005.

10. The authorities have taken steps to improve public sector efficiency and the investment environment, but overall progress in implementing structural reform has been slow. Positive steps have been made through the adoption of stricter controls on recurrent public expenditure. However, advancement of the broader reform of the public sector was slow, particularly in revenue administration and provincial government operations. Movement on infrastructure investment and land reform also was limited and privatization stalled. The financial system overall remains healthy. The financial condition of the government-owned Rural Development Bank has improved somewhat, but it remains to be seen whether sufficient measures are in place to avoid a return to past financial difficulties. Political analysts continue to give poor marks to Papua New Guinea regarding corruption and quality of the bureaucracy, although the country’s ratings are comparable to others in the region (Box 1). Relations with the World Bank are strained over governance questions in connection with loans for forestry management.

III. Policy Discussions: Growth and Structural Reform

11. The consultation discussions focused on the policies needed to maintain the current stable macroeconomic environment while moving the economy to a higher sustainable growth path and reducing poverty. To meet this objective, the authorities have adopted a Medium-Term Development Strategy (MTDS) that targets improved governance, stronger export-driven growth, and accelerated rural development. The mission endorsed this strategy, which is based on: (a) an improvement in the outlook for medium-term fiscal sustainability through public sector reform (Box 3), (b) a continuation of the current low inflation by maintaining an appropriate monetary stance, and (c) a more vigorous effort on reform to remove longstanding impediments to private sector development and growth, including by redirecting public spending toward infrastructure, law and order, education, and health. However, the discussions also looked at the scope for additional steps, including measures to strengthen non-mineral revenue and improve the environment for private sector activity, to help ensure success in achieving the MTDS’s objectives.

A. Medium-Term Outlook: Prospects and Risks

12. The macroeconomic outlook is positive provided that the authorities continue their prudent fiscal and monetary policies and progress more rapidly on their structural reform agenda (Table 5). Growth is expected to rise gradually to about 4.5 percent by 2010, as private activity responds to improved macroeconomic policies and structural reform and new mineral projects come on line only toward the end of the forecast period (Box 4). Sustained real growth on this order would represent a break from past poor performance; given the current rate of population growth, the annual real per capita growth rates would be over 2 percent. A more rapid rate of economic growth would require a stronger effort to address structural factors impeding growth. Inflation should remain subdued below 4 percent annually.

Table 5.

Papua New Guinea: Medium-Term Scenario, 2001–10

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Sources: Department of Treasury; Bank of Papua New Guinea; and Fund staff estimates and projections.

Central government operations only.

Measured on a below-the-line basis.

Includes changes in check float.

Fiscal Reform to Meet Growth Objectives

A key component of the authorities’ medium-term development strategy to raise growth and reduce poverty is the Public Sector Reform Program. Key elements include:

  • “Right-sizing” the public sector to shift the government’s focus to core business and improve service delivery; a draft plan and recommendations for overhauling the government’s structure has been submitted to the cabinet.

  • Introducing public expenditure reform to free resources for priority expenditure, including a gradual reduction in the size of civil service by 10 percent by 2007.

  • Improving accountability and compliance by strengthening monitoring and audit systems.

  • Continuing the privatization program.

  • Strengthening the performance of provincial and local governments.

A detailed action plan for public expenditure reform was provided under the 2004 World Bank-led Public Expenditure Review and Rationalization (PERR), including:

  • Steps to reduce the size of the civil service, including through introduction of a new payroll system.

  • Strengthening budget systems, including through greater transparency and remedial action for breaches of agreed budgets.

  • Detailing expenditure prioritization at an agency or sector level.

  • Improving health and education spending.

An August 2005 PERR review found that progress had been made in improved debt management, greater budget transparency, and higher health and education spending. At the same time, greater efforts were needed in areas such as:

  • Securing control of expenditure, including the payroll.

  • Benchmarking existing processes to identify next steps needed and monitor progress.

  • Further strengthening transparency and accountability.

  • Strengthening leadership and management.

  • Improving capacity of managers and individual staff.

Prospects for the Mining Sector

The mining sector (including petroleum) dominates Papua New Guinea’s economy. Recent positive developments regarding projects already underway, partly related to current strong world prices, suggest a brighter outlook than previously expected. In addition, new mining exploration applications rose sharply in 2004-05 in response to higher world commodity prices and tax incentives introduced in 2003.

Queensland-Highlands Gas Project: The project calls for the construction of a 2,655 km gas pipeline from the Highlands to northern Australia. After being stalled for many years owing to the failure to secure sufficient customer sales contracts, a critical mass of preliminary purchase agreements have now been signed. The front-end engineering and design phase is nearing completion and financing is being arranged. Initial gas deliveries are targeted for 2009, if all goes to schedule, and the revenue accruing to the government is expected to offset declining oil sector proceeds.

Oil (25 percent exports): Oil production declined in recent years, and current reserves are expected to be exhausted by 2012. However, the largest producer, InterOil, has announced new bids for oil and gas exploration.

Gold and silver (30 percent exports): Although gold output is in decline, prospects have recently been brightened with the start of two new gold mines in 2005 and the key Hidden Valley and other smaller projects beginning production by 2008.

Copper (17 percent exports), nickel and other minerals: Annual production of the declining Ok Tedi copper mine now is expected to be higher and last longer than previously envisaged. The prospective Ramu nickel/cobalt deposit could also contribute to higher mineral output in the longer run.

Selected Mineral Sector Indicators, 1992-2010

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Source: PNG authorities and staff estimates.

13. The medium-term outlook and success in improving development indicators is subject to significant downside risks. These largely relate to continued uncertainties regarding the nickel and gas projects, to commodity price volatility, and to prospects for the continuation of current macroeconomic and structural policies. The delay or suspension of the large mineral projects would sharply curtail the outlook for the fiscal position and the external sector. Also, a reduction by 5 percent in the prices of Papua New Guinea’s main commodity exports would reduce government revenue by about 0.3 percent of GDP each year. Other potential downside risks include weak execution of the reform agenda, particularly ahead of the 2007 elections. The downside risks support a continuation of the authorities’ conservative approach to fiscal policy. If more favorable conditions were to materialize instead, an acceleration of spending toward priority areas would be possible, provided implementation capacity is not over taxed.

14. The staff’s analysis of debt sustainability underscores the need to continue prudent macroeconomic policies and reforms (Annex VI). The updated debt sustainability analysis using the low-income country framework suggests that the public sector debt outlook is particularly vulnerable to changes in real GDP growth. A return to the low levels of real GDP growth experienced in the recent past would increase projected debt-to-GDP ratios by 4 percentage points of GDP in 2010. The authorities acknowledged these risks, and noted that their debt strategy, which monitors the Fund’s debt sustainability indicators, is designed to reduce these vulnerabilities.

B. Maintaining Macroeconomic and Financial Stability

Fiscal policy: continuing fiscal prudence and accelerating fiscal reform

15. The government’s medium-term fiscal strategy (MTFS) aims at keeping the central government’s budget close to balance and progressively reducing public debt relative to GDP. Within this framework, the government’s 2006 budget targets an overall deficit of 0.6 percent of GDP. The mission supported the government’s fiscal objectives, and views them as achievable and appropriate as they would imply a gradual reduction in the nonmineral overall and primary balances and in the debt-to-GDP ratio between 2006 and 2010. However, the mission noted that risks to the medium-term strategy may derive from commodity price and mineral revenue volatility, pressure for slower reform and unprioritized spending ahead of the 2007 parliamentary elections, and financing participation in the Queensland-Highlands gas pipeline project. To ensure that the consolidation to date is safeguarded and medium-term sustainable fiscal balance is achieved, the mission encouraged an acceleration and intensification of the public sector reform outlined in the MTDS (Boxes 2 and 3).

uA01fig06

Non-Mineral Tax Revenue to GDP, 2002 - 2004

Citation: IMF Staff Country Reports 2006, 099; 10.5089/9781451831702.002.A001

1/ 2003

16. The government introduced a tax policy package with the 2006 budget aimed at encouraging investment and complemented by improvements in revenue collection. The negative revenue impact of the tax package is estimated at about 0.5 percent of GDP in 2006, mainly resulting from a progressive reduction in personal income tax rates and an increase in the exemption threshold (text table). At the same time, initiatives to improve tax collection include upgrading audit capacity to assist in arrears recovery, particularly from large taxpayers. The mission viewed the tax package as a step toward an investment-friendly tax system, but recommended that the revenue loss from the tax package and previously scheduled tax cuts (including under the ongoing tariff reform) be offset by additional revenue-enhancing measures to guarantee the integrity of the non-mineral tax base and support the MTDS. In particular, the mission pointed to PFTAC technical assistance recommendations that could achieve this objective, such as through the creation of a large taxpayer unit and the introduction of a presumptive tax regime for small businesses. The authorities agreed with the need to safeguard the non-mineral revenue base through improved tax administration and were receptive to the PFTAC proposals, although they raised concerns that limited capacity could stymie effective implementation of reforms. They also pointed to the possibility of raising goods and service tax (GST) rates if needed in the future.

FY2006-07 Main Tax Policy Measures 1/

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Permanent measures introduced in the 2006 budget.

17. In line with the MTDS, the authorities view expenditure re-orientation toward development areas as a first priority. The mission welcomed the shift in 2006 budget expenditure toward infrastructure, the increase in education and health spending, as well as the improvements in the integrated payroll system that will continue to help control salary expenditure. However, overall progress has been slow on expenditure reprioritization. While large cuts were made in payrolls in nonpriority areas in 2004 and 2005, these were offset by hiring in priority areas (including teachers and health workers). As a result, overall public employment has remained broadly unchanged and the wage bill will remain large. Against this background, the mission argued in favor of more front-loaded retrenchment instead of the current gradual employment reduction plan, and accelerated time-bound execution of the forthcoming recommendations from the “right-sizing” initiative’s to streamline the government’s structure and refocus it on core business. The authorities recognized that little progress had been made to date in reducing the wage bill, although it had been contained as a share of total expenditure and no new wage increase was budgeted for 2006, and that redoubled efforts were needed. These were expected to follow from the “right-sizing” recommendations, including plans for retrenchment in nonpriority areas.

18. The authorities have made progress in improving expenditure management and plan to further strengthen budget preparation and financial and reporting systems under their Public Expenditure Review and Rationalization (PERR) program. The current monthly cash budget system and the introduction of financial controllers have helped to keep spending within ceilings and limit the accumulation of new domestic arrears, although unauthorized expenditure reallocations across spending items continue to occur. The government has also made progress on trust accounts, including reducing the number by half since 2004, and tagging another 350 for closure.2 To capitalize on recent progress, the mission suggested introducing a time-bound plan to close the remaining trust accounts not subject to standard financial management controls. In addition, as statutory authorities do not follow basic accountability procedures, the mission suggested that their budget operations should be subject to standard expenditure reporting obligations.

19. The mission noted that should mineral revenue remain strong, maintaining the 2006 budget deficit target would imply an increase in expenditure and a deterioration in the non-mineral balance. The mission advocated using any savings in 2006 to finance some increase in priority infrastructure or social spending, as long as the capacity to implement the spending effectively is not overtaxed. The bulk of any additional revenue should be used to reduce government debt, which would provide a continuing flow of resources in the form of lower interest payments and a hedge against the risks discussed above. Over the longer term, as budget dependence on mineral revenue could increase as the large gas and mineral projects underway come on line, the government should strengthen the current fiscal framework to address the impact of mineral revenue volatility on expenditure policy.

20. The government has developed new guidelines for debt management that aim to reduce costs and risks. The strategy is based on limiting acquisition of new debt to either domestic or concessional sources and lengthening the maturity. The mission cautioned on lengthening the maturity of government debt at high cost at a time when domestic interest rates were coming down. It noted in particular that the recent oversubscriptions of longer-term maturity (and more costly) Inscribed Stocks auctions had resulted in yields well below coupon rates. The authorities viewed these developments as reflecting the limited options for longer-term investment in a liquid market. Nonetheless, they indicated that they planned to proceed cautiously in order to avoid an inordinate rise in interest costs. The mission also emphasized the importance of avoiding the contracting of new external debt on commercial terms, and expressed concern about possible growing implicit contingent liabilities given state-owned enterprises’ borrowing plans.

21. The government is attentive to the need to strengthen financing and monitoring of sub-national governments’ activities. Sub-national governments manage resources amounting to about 20-25 percent of central government’s total expenditures, but are not subject to basic control and reporting standards, while service delivery in rural areas remains poor. The authorities acknowledged these concerns and noted their intention to proceed quickly to clarify the legal framework underlying sub-national governments’ activities and responsibilities, reform financing arrangements and the system of grants, and enforce a reporting system for sub-national governments spending and debt. In addition, the district service improvement program places local governments under the direct monitoring of the central government treasury by creating small treasury offices in each district. The mission welcomed these plans, and in particular noted the need to subject the district support grants, which are outside budget oversight, to standard public expenditure controls and scrutiny pending eventual elimination.

22. The mission cautioned regarding the prospective contracting of additional debt to finance equity investment in the new gas pipeline. Although the details of the transaction have not been finalized, early indications are that the government would finance a share of the pipeline during 2006–07. The authorities viewed the gas pipeline project as essential to the economy’s future and saw their participation as necessary for its finalization. However, they acknowledged the risks associated with an equity investment, and intended to minimize any increase in debt.

Monetary policy and exchange rate policy: anchoring low inflation and maintaining competitiveness

23. The central bank reaffirmed its commitment to the objective of maintaining low inflation. The authorities and the mission agreed that if fiscal policy remains prudent and the current cautious monetary policy stance continues, inflation should remain subdued over the medium term. However, as the combination of high excess reserves and low interest rates have begun to revive credit growth, the mission cautioned the authorities about further easing. Notwithstanding the apparent absence of inflationary pressure, the authorities recognized that the current high liquidity held risks and noted that additional measures were under consideration to supplement open market operations if needed, including levying mineral taxes in kina. The authorities also plan to develop a secondary market for government securities to assist in effective monetary policy implementation.

24. The authorities and the mission agreed that the current floating exchange rate arrangement remains appropriate, as it has helped to promote adjustments to economic shocks and allowed the authorities to pursue an independent monetary policy. In the last two years, the appreciation of the kina against the U.S. dollar helped bring down inflation and ease the external debt service burden, without an apparent loss in competitiveness. The authorities reaffirmed their commitment to the floating exchange rate and indicated that their policy remained to intervene only to smooth volatility in the market.

25. The authorities relaxed foreign exchange controls on a range of capital transactions in June 2005. They noted that an initial assessment indicated that the impact on the foreign exchange market had been minimal, notwithstanding negative interest rate differentials with foreign partners. The authorities indicated that additional actions to eliminate foreign exchange restrictions were under consideration.

26. The central bank has made good progress in developing its monetary policy framework over the past year. To bring a more medium-term focus to monetary policy, the forecasting horizon was extended to three years with the assistance of an MFD expert. The mission welcomed plans to further develop the central bank’s inflation forecasting capacity and understanding of the monetary transmission mechanism, along with better coordination with the Treasury on liquidity and debt management policies. Communication with the public through the semi-annual Monetary Policy Statement has improved, helping to promote confidence in the central bank and its policy regime, in addition to increasing public accountability. The mission also drew attention to the need to implement the recommendations of the recent STA mission on monetary statistics, in particular to address weaknesses in the accounts of the central government at the central bank.

Private sector development through institution and capacity building: structural reforms needed to reduce vulnerabilities and foster economic growth

27. As noted in the MTDS, removing longstanding impediments to private investment are essential to achieving higher growth and more rapid job creation. The mission welcomed steps taken recently to improve the environment for private activity, including the relaxation of restrictions on visa and work permits, greater resources for road maintenance, reduction of the tax burden, and an improved dialogue with the business community. Accelerated implementation of the MTDS is needed to address remaining structural shortcomings hampering the private sector. These include further improving telecommunication and transportation infrastructure (particularly in rural areas), strengthening law and order, improving governance, addressing land tenure issues, reviving an efficient “one-stop shop” for investment, strengthening contract enforcement through judicial and legal training, and increasing transparency in public procurement. These steps would also help to diversify the export base, reduce dependence on the mineral sector and vulnerability to world commodity market developments, and promote job creation, which in turn would help in improving the law and order climate.

28. A strengthening of the regulatory framework for the central bank, banks, and superannuation funds has improved financial sector soundness. Although a full set of indicators is not available, available data show nonperforming loans continue to be low and capital adequacy ratios remain above the minimum requirement. Steps are now needed to complete reforms, including the implementation of the recommendations of Fund technical assistance on financial sector supervision. Both the mission and the authorities agreed that the rise in lending to the private sector in 2005 was a welcome sign that the financial sector was providing support for growth. At the same time, the authorities promised to remain vigilant to possible emerging risks, particularly regarding sector concentration of bank credit. The authorities also indicated their intention to promptly implement the recently passed AML/CFT legislation and create a Financial Intelligence Unit.

Financial Sector Indicators

(In percent)

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Source: Bank Papua New Guinea.

September.

2005 is June.

29. The government acted to rehabilitate the Rural Development Bank (RDB) after its declared insolvency in July 2004. The deterioration of the RDB’s financial position in recent years had reflected poor loan management due to weak governance. The financial recovery plan for this bank: (a) replaced the previous board of directors and managing director, (b) temporarily stopped lending activity, (c) recapitalized the bank through a 0.3 percent of GDP injection, (d) cut staff by one third with assistance of a 5 million kina retrenchment grant, and (e) brought in experienced commercial lending officers to manage the bank’s portfolio. The mission urged the passage of new legislation, scheduled for submission to Parliament in early 2006, which would establish new corporate rules to ensure the RDB operates on commercial grounds and limits political interference.

30. The government reported that the larger public enterprises’ financial positions have improved under outside management, but they indicated that additional measures are needed to improve long-term prospects and the efficiency of these enterprises. Among such measures were the introduction of a competition and regulatory framework for each sector where public enterprises had a dominant or monopoly position. Also, prompt publication of financial statements for these enterprises would enhance transparency and governance. The mission noted that the establishment of a competition and regulatory framework would also provide a foundation for reviving the privatization program. It also welcomed the pass-through of increases in world oil prices to domestic petroleum product prices and the increases in the tariff structure for utilities, and stressed the need to keep prices in line with world prices or the costs of production. The authorities also observed that Telikom’s monopoly status would be reviewed in 2007 when its current contract expired. They indicated that privatization for some public enterprises in the future might be considered.

31. The mission encouraged the maintenance of the current open trade regime in Papua New Guinea, which is among the least restrictive in the region. The elimination of the copra marketing board, which helped stimulate copra exports in 2005, was also noted. A seven-year tariff reform launched in 1999 is expected to be completed in early 2006. The tariff structure will be compressed to four rates (zero, 30, 40, and 55 percent), resulting in a reduction in the average nominal import tariff. Papua New Guinea does not face major difficulties in accessing foreign markets.

32. The mission urged rapid action on the authorities’ plans under MTDS to improve governance through increased transparency and accountability. Governance remains an important issue to be addressed, as acknowledged by the authorities. The mission urged strengthening the transparency of fiscal operations by reinforcing the Office of the Auditor General through additional resources and better compliance from government entities to allow publication of the final audited accounts of the central and provincial governments within one year as provided for under the law. The authorities agreed that further strengthening of the auditing function required increased attention.

33. Data provision for surveillance purposes has improved and is generally adequate. Nevertheless, shortcomings in the quality, coverage, consistency, and timeliness of national accounts, balance of payments, and fiscal data still affect the monitoring of macroeconomic developments. Further strengthening of the statistical framework is needed including through rehabilitation of the National Statistics Office. The authorities agreed with this assessment and sought technical assistance from the Fund in improving the data base.

IV. Staff Appraisal

34. Since 2003, impressive progress has been made in reversing the difficult macroeconomic conditions present earlier this decade. Macroeconomic stability has been restored as the authorities adhered to disciplined fiscal and monetary policies against the background of improved commodity prices. The key challenge ahead is to sustain recent gains and move the economy to a higher growth path to reduce poverty. Implementation of the Medium-Term Development Strategy (MTDS), which the staff supports, will help meet this challenge. Achieving the medium-term fiscal objective of maintaining budget balance and supporting higher growth will require structural fiscal reform. Monetary policy, at the same time, should continue to focus on maintaining relatively low and stable inflation. In addition, further structural reform is needed to remove longstanding impediments to private investment and economic growth. The current favorable domestic and external economic environment provides a window of opportunity for moving forward on MTDS reforms.

35. The re-orientation of government expenditure toward needed infrastructure and social spending under the MTDS is welcomed. The government is encouraged to follow through with plans to reduce public employment, particularly in non-core areas, and reduce the wage bill which continues to crowd out needed development expenditure. Accordingly, a more front-loaded retrenchment in government employment should be considered. The staff supports rapid implementation of the right-sizing initiative recommendations to streamline the government and refocus it on core activities.

36. The 2006 tax policy package improves incentives for private activity, and can be financed easily in an environment of mineral revenue windfalls. The authorities are cautioned about using such windfalls to finance permanent changes in the tax system, however. To support the Medium-Term Fiscal Strategy over the long term, the non-mineral revenue base should be strengthened through implementation of measures to improve tax administration, including the establishment of a large taxpayer unit.

37. Should mineral revenue remain high and surpluses emerge over the medium term, the government is urged to continue the practices followed in the recent past. Any windfall savings should be used to finance priority infrastructure or social spending, as long as it can be spent effectively, and to repay government debt. Conversely, should the risks to the medium-term outlook materialize, the authorities would need to consider steps to safeguard the MTFS.

38. Progress in expenditure and debt management has been made, but challenges remain to improve spending controls. The monthly cash budget system and the introduction of financial controllers were particularly welcomed. The staff encourages the authorities to extend standard financial management control to remaining trust accounts, to statutory authorities budgets, and to sub-national government operations including district support grants. The authorities are cautioned about the need to monitor growing contingent liabilities related to state-owned enterprises’ borrowing plans.

39. The central bank’s continuing focus on maintaining low inflation is welcome. Although inflationary pressure remains at bay, high liquidity in the banking system and low interest rates are encouraging rapid credit growth. The authorities are cautioned against further policy easing and encouraged in their efforts to strengthen and develop tools for effective monetary policy implementation. The current floating exchange rate arrangement has helped to promote adjustments to economic shocks and permits the authorities to pursue an independent monetary policy.

40. Progress has been made in strengthening the financial sector. Steps have been taken to rehabilitate the Rural Development Bank, but the authorities will need to do more, including establishing a legal framework to ensure the bank operates on commercial terms and is free from political interference to avoid a return to past difficulties.

41. Higher growth, employment creation, and poverty reduction over the longer term will depend on stronger private sector activity. The accelerated implementation of the remainder of the MTDS is needed to address structural impediments hampering the private sector. Greater competition in the public enterprise sector, including through opening the sector to competition and reviving the privatization program is needed. Governance remains weak, and rapid implementation is needed of plans to increase transparency and accountability, including through greater support of the Office of the Auditor General to allow timely publication of government accounts.

42. Data provision for surveillance purposes is generally adequate, but further strengthening is needed to address continued weaknesses. The authorities are urged to move rapidly to correct shortcomings in the quality, coverage, consistency, and timeliness of national accounts, balance of payments, and fiscal data that continue to affect the monitoring of macroeconomic developments.

43. The staff recommends that the next Article IV consultation be held on the standard 12-month cycle.

Figure 1.
Figure 1.

Papua New Guinea: Regional and Global Comparators

Citation: IMF Staff Country Reports 2006, 099; 10.5089/9781451831702.002.A001

Source: IMF, World Economic Outlook ; and Fund staff calculations.
Figure 2.
Figure 2.

Papua New Guinea: Regional and Global Comparators

Citation: IMF Staff Country Reports 2006, 099; 10.5089/9781451831702.002.A001

Source: Authorities; and British Petroleum Annual Report.
Figure 3.
Figure 3.

Papua New Guinea: Domestic Economic Indicators, 2000-2005

Citation: IMF Staff Country Reports 2006, 099; 10.5089/9781451831702.002.A001

Source: Data Provided by Papua New Guinea authorities; IMF, Information Notice System ; and Fund staff estimates.
Figure 4.
Figure 4.

Papua New Guinea: External Economic Indicators, 2000-2005

Citation: IMF Staff Country Reports 2006, 099; 10.5089/9781451831702.002.A001

Sources: Data provided by the Papua New Guinea authorities; IMF, Information Notice System and World Economic Outlook ; and Fund staff estimates.
Table 6.

Papua New Guinea: Indicators of External Vulnerability, 2000–05

(In percent of GDP, unless otherwise indicated)

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Sources: Department of Treasury; Bank of Papua New Guinea; and Fund staff estimates.

End of period.

Ex-post real rate.

Covers only banking system short-term external debt.

Initial rating of B1 (stable) in January 1999.

Initial rating of B+ (stable) in January 1999.