Our authorities thank management for their continued support of Papua New Guinea (PNG) during 2005 and welcome the frank exchange of views between senior ministers and officials with the mission team. The Treasurer and Minister for Finance has commented on the balanced assessment in the Article IV report and the constructive nature of the Fund’s engagement in PNG. We also thank staff for the selected issues paper that particularly points to the drivers of productivity and growth, and their implications for the medium-term outlook.

Improved economic performance in PNG has been further consolidated in 2005, with good prospects for 2006. The recovery is against a backdrop of strong commodity prices that have boosted the petroleum and minerals sectors. But the wider nature of the recovery demonstrates the continuation of macroeconomic stability brought about through strong economic policy leadership from the Somare Government since its election in 2002.

To ensure ongoing progress in implementing sustainable macroeconomic policies and structural reforms, the Government has put in place two overarching frameworks for policy formulation and implementation.

• Medium Term Fiscal Strategy (MTFS) maps out an affordable and sustainable path of public spending. It aims to reduce the budget deficit progressively to balance by 2008, and progressively reduce public debt to GDP.

• Medium Term Development Strategy (MTDS) provides the overarching development strategy and specifies the broad policy framework in which the Government’s Agenda for Recovery and Growth will be implemented over the medium-term. It identifies broad spending priorities to guide public expenditure management and redirects spending to “priority areas”, including transport infrastructure maintenance, law and justice, basic education, and preventative health, including HIV/AIDS.

Fundamental to economic stability and improving conditions for a stable private investment environment, has been political stability. As set out in the staff report, the Somare Government is likely to be the first PNG government since independence in 1975 to complete a full five-year term, with elections due in 2007. A range of measures, including the introduction of the Political Parties and Integrity Act, has enhanced political stability. Moreover, additional resources have been injected into the Electoral Commission in the 2006 Budget to ensure preparations for an orderly and well-managed political process in 2007, including the implementation of the preferential voting system to further strengthen political stability.

In assessing this latest Article IV consultation with PNG, Executive Directors will no doubt reflect carefully on the ongoing Fund relationship with PNG. The PNG Government deserves due recognition for the degree to which they have sought a seachange in policy direction since 2002. But they also recognize that there is still much more to be done. As the Treasurer and Minister for Finance set out in his 2006 Budget Speech to Parliament:

• “We cannot be complacent. Despite the impressive recovery, our economy is still fragile. If our reform efforts falter now we will give up all of the hard-won gains that we have made.”

Of particular concern will be navigating macroeconomic policy, especially containing fiscal risks, ahead of the 2007 election. Again, my authorities are well aware of the dangers, as clearly acknowledged in the Budget Speech, particularly that if fiscal discipline under the MTFS is not maintained, then the economy and living standards will be damaged.

Improving Economic Performance

Economic performance has continued to improve since 2002, with lower inflation and interest rates, an improving investment trend, more employment, a stable exchange rate and a stronger external position. GDP is expected to have grown by 3.0 percent in 2005, from 2.9 percent in 2004, while non-mining GDP is expected to have grown by 3.5 percent in 2005, driven mainly by growth in the construction, agriculture, forestry and fisheries sectors.

Inflation has fallen from almost 20 percent in 2003 to 1.7 percent in 2005 (though through the year inflation to December 2005 was somewhat higher). Interest rates have fallen sharply, with market rates currently under 5 percent.

Latest available data indicates that international reserves increased to K2,396 million (US$774 million) at the end of 2005, from K2,061 million (US$639 million) in 2004, and is sufficient to cover 4.7 months of total imports and 9.0 months of non-mineral imports.

The balance of payments recorded a surplus of 2.9 percent of GDP in 2005, from a surplus of 2.4 percent of GDP in 2004.

Private sector employment increased by 2.8 percent in the year to September 2005, driven by increased activities in the manufacturing, minerals and construction sectors, following a decline of 0.4 percent in 2004. Private sector employment is expected to continue to increase, given the expected growth of total GDP in 2006 and over the medium-term.

The outlook for 2006 and over the medium-term looks promising, with growth of 3.5 percent expected in 2006 and is broad based across all sectors. There are a number of promising resource projects coming into construction, notably the PNG to Australia Gas Project followed by the Ramu Nickel Mine, which are expected to contribute strongly to growth.

Enhanced Fiscal Discipline

The fiscal position also continues the steady reduction in the deficit levels that the Government announced in 2002, as part of its MTFS and medium-term debt reduction strategy.

The fiscal outturn for 2005 is likely to be 0.6 percent of GDP or even better, compared with the original projected deficit of 0.9 percent of GDP. This outcome is due to continued disciplined expenditure management and improved revenue performance. This will be the third year in succession that the fiscal outturn has been in line with, or better than, the MTFS. For 2006, the budgeted deficit of 0.6 percent is again in line with the MTFS.

As noted by the staff, savings from lower interest payments have been re-allocated to reducing arrears and other outstanding obligations, and to priority spending areas identified in the MTDS. My authorities have also successfully restricted windfall revenue gains from temporary increases in commodity prices from being transmitted into an unsustainable increase in recurrent expenditure. The Government has set aside K400 million ($US128.0 million) to part fund the Government’s minority equity share in the PNG to Australia Gas Project, which it sees as an important asset that will deliver a stream of revenue for many years in the future. This action reduces the Government’s borrowing requirements to finance its share of the gas project. My authorities have also reaffirmed their intention not to contract non-concessional loans to finance its equity share. The Government is working closely with the ADB to secure ADB financing for the remaining equity in the project.

Significant improvements in fiscal management have contributed to a further reduction in total public sector debt to 49 percent of GDP in 2005, from an unsustainable level of 72 percent in 2002. Total public sector debt is budgeted to fall to 46 percent of GDP in 2006. As set out in the staff report, the Government has recently developed a medium-term strategy for debt management. In line with this strategy, PNG has been seeking to lengthen the maturity of its debt portfolio. While it has noted the Fund’s caution on this issue and intends to avoid any inordinate rise in interest costs, the Government has been seeking to manage interest rate and rollover risks associated with the still relatively short maturity structure of its domestic debt portfolio. My authorities acknowledge the staff’s debt sustainability analysis and agree with the need to continue prudent macroeconomic policies and reforms. They also recognize the downside risks, including those highlighted by the staff, which could curtail the outlook for fiscal and debt sustainability.

In his 2006 Budget Speech, the Minister for Finance and Treasury assured that the Government would continue to provide policy stability by working within the parameters of the MTFS and MTDS, which the Government has followed in recent years and will continue to follow. In fact, the Minister acknowledges that if macroeconomic management slips, and the reform efforts falter, then the outlook for 2006 and the future years will also be gloomy.

Reforms in the fiscal area have been ongoing as well, although the process has been slow. Financial controllers and internal audit units are now established in large spending agencies, including Defence, Police, Health and Education, to strengthen expenditure control and financial discipline. My authorities agree with the staff that more needs to be done to improve governance and accountability to strengthen public expenditure management.

Monetary Policy and Financial Sector Supervision

Monetary policy has eased substantially over the past two years, in line with lower inflation and inflationary expectations. The accommodative policy stance is being supported by the Government’s prudent fiscal management and favorable external conditions, which strengthened the exchange rate position and curbed price pressures.

The stable macroeconomic and political conditions, as well as high liquidity have caused private sector credit to pick up for the first time in four years, increasing by around 20 percent in 2005 from a low base.

The Bank of Papua New Guinea (BPNG) has reaffirmed its commitment that monetary policy will remain accommodative while inflation pressures remain subdued. Money market interest rates have been below BPNG’s official indicator rate for a considerable period, so liquidity conditions will have to be managed closely by the Bank going forward. The Government will also need to support this through a continuation of prudent fiscal policy, and acceleration of ongoing structural reforms to increase productivity.

As set out in the staff report, the regulatory and supervisory framework for the central bank, commercial banks, non-bank financial institutions, superannuation funds and life insurance companies have been strengthened, resulting in improved financial sector soundness. Much of financial sector reform has been completed, with steps now being taken to complete the overall reform agenda, including the implementation of the Fund’s technical assistance recommendations on financial sector supervision.

The Government has also stepped in to revive the deteriorating Rural Development Bank (RDB), declared insolvent in July 2004 because of poor management and weak governance. In an effort to improve the governance arrangement, new legislation has been submitted to the Parliament for approval in early 2006. The new legislation intends to allow the RDB to operate on commercial grounds, while maintaining its core objective of providing banking service for the rural sector. The RDB is likely to come under the prudential supervision of BPNG, if licensed to operate as an authorized bank. Given the RDB is now likely to have wider commercial operations, the authorities will need to keep these new arrangements under close review given the governance risks.

Structural Reform and Private Sector Development

As set out in both the MTFS and the MTDS, the Government considers improving the climate for private sector investment to be a first order priority. While favourable commodity prices are boosting the petroleum and minerals sectors, it is imperative to widen development potential in other sectors such as agriculture, tourism and services, if economic gains are to translate into employment gains across the regions and the community more generally. The three elements of the Government’s strategy to support private sector development and growth are:

• A stable investment climate.

• An efficient, effective and affordable public sector.

• Creating a competitive and dynamic private sector.

As already noted, political stability is fundamental for a stable investment climate. This needs to be maintained throughout the 2007 election processes. Setting out clear plans under the MTFS and MTDS are also essential ingredients that the Government is following. The benefits of this framework have resulted in low inflation and interest rates, a stable exchange rate, steady economic growth, improving investment trends and employment creation.

In terms of a more efficient public sector, the report of the Rightsizing review calls for a more streamlined public service concentrating on declining core government functions, and detailing where changes need to be made. Implementation will be difficult, but the Government will take forward some of these reforms in 2006. Given the importance of the benefits of achieving a more efficient public service and reallocating resources to MTDS priorities, it will be important for the Government to push ahead with these reforms.

My authorities agree with the Fund’s advice that accelerated implementation of the MTDS is needed to address remaining structural shortcomings in the public sector hampering the private sector. In the 2006 Budget, the Government has increased resources going to priority areas, including for the rehabilitation and maintenance of roads, law and order, primary education and health. The roll-out of the District Services Improvement Program will also be important across the regions for improving infrastructure for commerce and agricultural development. In all these areas, it will be crucial to achieve appropriate implementation, monitoring and reporting against budget appropriations and development plans.

The third element of the Government’s strategy is creating a competitive and dynamic private sector, where the Government is addressing various areas that impede business.

There have been improvements in the performance of larger public enterprises, but more needs to be done, particularly on the corporate governance arrangements and the regulatory framework within which they operate. In particular, the Government will be asking the Independent Competition and Consumer Commission (ICCC) to examine the regulatory changes needed for the transition to a more competitive telecommunications market when the telecommunications monopoly expires in 2007.

The Government will also be looking at options to improve the services provided to business and consumers by other (public and private) utility providers. Competition within coastal shipping will be examined by the ICCC to assess the merits of strengthening competition and regulatory control. Regulatory impediments around air transport will also be reviewed with a view to increasing competition and reducing air transport costs.

My authorities will continue to implement the recent review of PNG’s investment regime with a view to streamlining investment regulations and processes to remove unnecessary impediments to investment. In addition, the National Working Group on Business Impediments has made substantial inroads into removing red tape and bureaucratic bottlenecks that impede private sector development. The BPNG has also liberalized foreign exchange controls in June 2005 to support private sector investment.