Papua new Guinea: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
13 Mar 2006
eISBN:
9781451831719
Language:
English
Keywords:
ISCR; CR; GDP; mineral revenue; government; revenue reaction; revenue volatility; upward volatility; mineral revenue windfall; fiscal policy stance; Fiscal sustainability
Download PDF (395.3 KB)

This Selected Issues paper on Papua New Guinea reports that although economic cycles have generally paralleled the many mineral sector booms and busts, the downward trend in growth rates may reflect other factors. Papua New Guinea’s economy is dominated by a large labor-intensive agricultural sector and a capital-intensive oil and minerals sector. The formal sector consists of enclave extractive industries, cash crop production, and a small, import-substituting manufacturing sector. The importance of the agriculture sector is about the same as at independence, reflecting structural impediments that have deterred more rapid growth.

Abstract

This Selected Issues paper on Papua New Guinea reports that although economic cycles have generally paralleled the many mineral sector booms and busts, the downward trend in growth rates may reflect other factors. Papua New Guinea’s economy is dominated by a large labor-intensive agricultural sector and a capital-intensive oil and minerals sector. The formal sector consists of enclave extractive industries, cash crop production, and a small, import-substituting manufacturing sector. The importance of the agriculture sector is about the same as at independence, reflecting structural impediments that have deterred more rapid growth.

III. Fiscal Policy in a Resource-Rich Country1

A. Introduction

1. Countries rich in mineral resources face short- and long-term challenges in formulating fiscal policy arising from the fact that mineral revenue is volatile in the short-term and exhaustible in the long term. As a result, fiscal authorities in these countries need to define policies to: (a) avoid the significant macroeconomic and fiscal costs associated with short-term variations in the fiscal stance; and (b) determine the optimal use of mineral revenue over time that maximizes welfare while guaranteeing the long-term sustainability of fiscal policy.

2. To address these challenges, fiscal authorities should assess their fiscal stance focusing on non-mineral balances. In the short term, they should avoid unintended fluctuations in the overall non-mineral balance. In the long term, they should identify the level of non-mineral primary balance that maximizes welfare and guarantees fiscal sustainability over time.

3. This note briefly reviews the main challenges that resource-rich countries face in formulating fiscal policy, considers policy options available to address these challenges, and investigates appropriate indicators to assess the fiscal stance. Against this framework, it then examines fiscal policy performance in Papua New Guinea in recent years.2

B. Fiscal Policy in Resource-Rich Countries: Challenges, Policy Options, and Indicators

What challenges do resource-rich countries face in formulating fiscal policy?

4. Countries rich in mineral resources face challenges in formulating fiscal policy that arise from the fact that mineral revenue is extremely volatile in the short-term and exhaustible over time.

The challenge with the short-term volatility of mineral revenue

5. Short-term volatility in mineral revenue may lead to volatility in public expenditure and in the non-mineral fiscal balance, eventually causing substantial macroeconomic and fiscal costs.3

6. Large and unpredictable changes in expenditure, and in the non-mineral deficit, can entail different types ofmacroeconomic costs.

  • A rising non-mineral deficit financed with mineral revenue may create pressures toward a real appreciation of the domestic currency if not appropriately sterilized (Dutch disease). This would have negative effects on the competitiveness of the non-mineral sector of the economy, potentially reducing private investment and damaging economic growth.

  • A rising non-mineral deficit could also put pressure on domestic demand with undesired consequence on inflation, and the external non-mineral current account, setting the stage for macroeconomic imbalances.

Similar considerations apply in the case of a rapidly expanding mineral sector. In this case, there could be an overshooting of the real exchange rate because of large investment projects (and significant foreign exchange inflows) and broader wealth effects.

7. Short-term fluctuations in government expenditure financed with mineral revenue windfalls also entailfiscal costs.

  • The sudden creation of spending programs, following a surge in mineral revenue, can exceed the government’s planning, implementation, and management capacity, making difficult to prevent wasteful spending.

  • Expansions in spending programs during good times may lock in place a powerful hysteresis effect, making it difficult to streamline expenditure in bad times, and setting the stage for serious macroeconomic imbalances. At the same time, sharp expenditure reductions in the face of lowering mineral revenue may lead to social instability, discouraging private investment and reducing growth prospects.

  • In the case where public expenditure has increased rapidly for some time, the marginal value of additional expenditure is likely to be in question and this may lead to suboptimal and inefficiently high levels of expenditure.

Indeed, depending on the macro and political economy situation, a country may well benefit instead from using revenue to lower public debt or keeping mineral revenue in the form of financial assets.

The challenge with long-term exhaustibility of mineral revenue

8. Over the long-term, mineral revenue is exhausted, and this poses the problem of how much revenue to consume at each point in time. The risk is that consuming too much at the present results in suboptimal choices from a welfare point of view and either the need for substantial fiscal adjustment or potentially explosive debt dynamics in the post-mineral period.

9. In conclusion, governments in countries rich in mineral resources face a double challenge. They need to define a fiscal policy to: (a) absorb the macroeconomic and fiscal costs deriving from the short-term volatility of mineral revenue; and (b) determine how to use mineral revenue over time to maximize social welfare while guaranteeing long-term fiscal sustainability.

What are the policy options available to address these challenges?

10. Different policy options are available to address the short- and the long-term challenges posed by the dependence on mineral revenue.

11. In the short term, there are strong arguments for smoothing the public expenditure path and reducing fluctuations in the non-mineral fiscal balance. This policy would reduce the macroeconomic and fiscal costs associated with mineral revenue volatility. In this respect, a key policy objective should be to pursue fiscal strategies aimed at breaking the pro-cyclical response of expenditure to volatile mineral revenue. This can be achieved by eliminating expansionary fiscal policy biases during mineral booms and targeting prudent non-mineral fiscal balances. By reducing fluctuations in public expenditure and in the non-mineral fiscal balance, the government would contribute to a more stable evolution of aggregate demand, while maintaining the quality and efficiency of its spending programs. A smoothing policy would also satisfy a precautionary motive underlying fiscal policy in resource-rich countries. Specifically, caution in expenditure planning would reduce the country’s exposure to unexpected adverse mineral and financing shocks.

12. In the case of a rapidly expanding mineral sector, there could be a strong justification for a countercyclical non-mineral fiscal policy. Sudden mineral booms may lead to surges in domestic demand with pressure on the currency and inflation. In these cases, a clearly countercyclical non-mineral fiscal policy would play an important stabilization function.

13. In the long term, fiscal policy should aim at smoothing consumption over time to maximize intertemporal welfare and guarantee long-term fiscal sustainability by targeting the primary non-mineral balance. Revenue coming from mineral resources should first be partly saved (e.g., by repaying public debt or acquiring financial wealth) and then used after the depletion of mineral resources. In this respect, fiscal policy should be targeted at accumulating substantial net assets during the period of mineral production to sustain the non-mineral deficit in the post mineral period. Formally, this outcome can be achieved by targeting an appropriate level of primary non-mineral balance.4

Indicators to assess the fiscal stance in resource-rich countries

14. In assessing the fiscal performance in resource-rich countries, non-mineral fiscal balances play a critical role to integrate the standard analysis based on overall fiscal balances.5

15. The non-mineral balance is a good indicator of the government demand on the economy. An increase in government expenditures financed by higher mineral revenue would be reflected in a larger non-mineral fiscal balance, but would not be picked up by the overall balance, as this would be fully financed. The non-mineral balance also provides a clearer picture of the government’s fiscal policy stance and its adjustment efforts. Indeed, differently from the overall balance, the non-mineral balance is an aggregate largely under the control of fiscal authorities. In this respect, it reflects better the government’s actual adjustment efforts. Many mineral-rich countries use the non-mineral balance as a leading indicator of the fiscal stance. For example, in Norway, budget documents and fiscal policy discussions prominently focus on the concept of non-oil balance. This focus has the additional advantage of making the use of mineral revenue more transparent.

16. In mineral-rich countries, the overall fiscal balance is still an important measure of the budget financial requirements and vulnerability. The overall balance underpins the gross financing needs of the government’s fiscal operations, and helps to identify possible financing problems and vulnerabilities.

C. How is Papua New Guinea Managing Fiscal Policy and Mineral Revenue?

17. Over the last four years, the fiscal policy stance in Papua New Guinea has improved substantially. As a result of the government’s effort of reducing fiscal deficits, non-mineral fiscal balances have improved significantly and have been very little correlated to the volatile pattern of mineral revenue. This has reduced the risk of having a pro-cyclical fiscal policy associated with mineral revenue performance, certainly contributing to recent macroeconomic stability.

The fiscal stance in Papua New Guinea

18. Since 2002, both the non-mineral overall and the primary balances have improved (Table 1). This is a remarkable result as it occurred against a background of relatively volatile mineral revenue that reached a minimum of about 15 percent of total revenue in 2002 and a maximum of about 29 percent of total revenue in 2005.6

Table III.1.

Papua New Guinea: Non-Mineral Balance (Central Government)

(In percent of GDP)

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Source: Authorities data and Staff estimates

19. The fiscal stance has not been influenced by the volatility of mineral revenue. The non-mineral overall and primary balances have been little correlated to mineral revenue, over the last few years (Table 2). This result was achieved in the context of the government’s medium-term fiscal framework and debt reduction strategy that helped to isolate expenditure patterns from mineral revenue’s upward volatility. The mirror image of this achievement is that the overall fiscal balance is significantly correlated to mineral revenue, as the latter was used to improve the overall fiscal balance.

Table III.2.

Papua New Guinea: Correlation with Mineral Revenue

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Source: Authorities data and Staff estimates

How have unexpected mineral revenue windfalls been used?

20. An interesting issue is to examine how the fiscal authorities have reacted in the past to unexpected mineral revenue windfalls. To do this, we need to define the concept of unexpected mineral revenue windfalls. Since commodity prices are believed to follow a random walk, the best predictor of mineral revenue in one year is the amount of mineral revenue collected the previous year. Therefore, we can use year-to-year changes in mineral revenue as a proxy for unexpected mineral revenue or windfalls. Once mineral revenue windfalls materialize, the government has three basic options. It may: (a) adjust the non-mineral revenue; (b) modify expenditure plans; and/or (c) allow changes in the overall fiscal balance. What course of action did the fiscal authorities in Papua New Guinea adopt in the face of changes in mineral revenue in past years?

21. Over the last few years, the fiscal authorities have not adopted a systematic approach as to how use mineral revenue windfalls. Revenue windfalls have indeed neither been systematically spent nor saved. For example, the increases in mineral revenue in 2003 and 2004 led to different policy reactions (Table 3). In 2003, the mineral revenue increase allowed a reduction in non-mineral revenue, and was associated with sharp reductions in expenditure, thus resulting in significant fiscal savings. In 2004, the policy response was different. The increase in mineral revenue was accompanied by an improvement in non-mineral revenue and very little adjustment on the expenditure side, leading to significant fiscal savings. If we look at the response to reductions in mineral revenue, the policy response is yet different. For example, in 2002 lower mineral revenue had little effect on non-mineral revenue and led to a reduction in expenditure and a worse overall fiscal balance. Underlying these differences is that starting in 2003, the authorities embarked on a significant fiscal adjustment plan that focused on reducing expenditure independently of revenue performance. This has broken the correlation between mineral revenue performance and expenditure.

Table III.3.

Papua New Guinea: Fiscal Response to Mineral revenue Shocks Non-Mineral Balance (Central Government)

(In percent of GDP)

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Source: Authorities data and Staff estimates.

A mineral revenue shock is defined as a variation in mineral related revenue from one year to the next.

Non-mineral revenue reaction is defined as a decrease in non-mineral revenue (a positive number indicates a decrease in non-mineral

Savings are defined as changes in the overall fiscal balance.

D. What Do We Conclude?

22. To date, Papua New Guinea is on the right track in dealing with the challenges that mineral-rich countries face in formulating fiscal policy. These challenges arise from the fact that mineral revenue is volatile in the short-term and exhaustible in the long term. As a result, fiscal authorities in these countries need to define a policy to: (a) avoid the significant macroeconomic a fiscal costs associated to short-term variations in the fiscal stance; and (b) determine the optimal use of mineral revenue over time that maximizes social welfare and guarantees the long-term sustainability of fiscal policy. To address these challenges, fiscal authorities should assess their fiscal stance focusing on non-mineral balances. In the short term, they should avoid unintended fluctuations in the overall non-mineral balance. In the long term, they should identify the level of non-mineral primary balance that maximizes welfare while guaranteeing fiscal sustainability over time. In Papua New Guinea’s case, by adopting a fiscal adjustment plan that reduces expenditure independently of revenue performance, the strategy effectively addresses the short-term challenge. For the longer term, a parallel debt policy of progressively reducing debt-to-GDP ratios over time has so far met the long-term challenge although significant increase in future mineral revenue may warrant some attention to the long-term dynamics of non-mineral balances.

STATISTICAL APPENDIX

Table 1.

Papua New Guinea: GDP by Sector at Current Market Prices, 2000-04

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Sources: Data through 2002 provided by the National Statistical Office; data for 2003-04 from the Treasury Department.
Table 2.

Papua New Guinea: GDP by Type of Expenditure at Current Market Prices, 2000-2004

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Sources: Data through 2002 provided by the National Statistical Office; data for 2003-04 from the Treasury Department.
Table 3.

Papua New Guinea: GDP by Type of Expenditure at Constant 1983 Prices, 2000-04

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Sources: Data through 2002 provided by the National Statistical Office; data for 2003-04 from the Treasury Department.
Table 4.

Papua New Guinea: Production of Major Commodities, 2000–04

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Sources: Data provided by the Papua New Guinea authorities, and Fund staff estimates.
Table 5.

Papua New Guinea: Employment by Sector, 2002–September 2005

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Source: Bank of Papua New Guinea, Quarterly Economic Bulletin.

Not included in overall index; excludes subcontractors.

Table 6.

Papua New Guinea: Consumer Price Index by Expenditure Group, 2000–September 2005

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Sources: Consumer Price Index, National Statistical Office; and Bank of Papua New Guinea’Quarterly Economic Bulletin.

Excluding food and goods and services subject to administered prices.

Weights are based on the 1977 expenditure survey.

Table 7a.

Papua New Guinea: Central Government Budget 2001–05

(In millions of kina)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.
Table 7b.

Papua New Guinea: Central Government Budget 2001–05

(In percent of GDP)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.
Table 8.

Papua New Guinea: Central Government Revenue and Grants 2001–05

(In millions of kina)

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates.
Table 9.

Papua New Guinea: Central Government Fiscal Financing 2001–05

(In millions of kina)

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

Papua New Guinea: Central Government Domestic Debt, 2001-September 2005

(In millions of kina; end of period)

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Sources: Data provided by the Bank of Papua New Guinea; and Department of Treasury.

Discount value.

Face value.