Papua New Guinea: 2006 Article IV Consultation—Staff Report; and Public Information Notice on the Executive Board Discussion for Papua New Guinea

This 2006 Article IV Consultation highlights that Papua New Guinea is enjoying its fourth year of recovery and macroeconomic stability, but major challenges lie ahead. Sound macroeconomic policies over the past several years have reduced fiscal vulnerabilities, lowered inflation, spurred business confidence, and boosted growth. High prices for key export commodities have strengthened the fiscal and external positions. However, progress toward achieving the country’s Medium-Term Development Strategy objectives or Millennium Development Goals has been limited. Recent developments and the near-term outlook remain favorable.

Abstract

This 2006 Article IV Consultation highlights that Papua New Guinea is enjoying its fourth year of recovery and macroeconomic stability, but major challenges lie ahead. Sound macroeconomic policies over the past several years have reduced fiscal vulnerabilities, lowered inflation, spurred business confidence, and boosted growth. High prices for key export commodities have strengthened the fiscal and external positions. However, progress toward achieving the country’s Medium-Term Development Strategy objectives or Millennium Development Goals has been limited. Recent developments and the near-term outlook remain favorable.

I. Introduction

1. Papua New Guinea is enjoying its fourth year of recovery and macroeconomic stability, but major challenges lie ahead. Sound macroeconomic policies over the past several years have reduced fiscal vulnerabilities, lowered inflation, spurred business confidence, and boosted growth. High prices for key export commodities (petroleum, copper, and gold) have strengthened the fiscal and external positions. However, progress toward achieving the country’s Medium-Term Development Strategy (MTDS) objectives or Millennium Development Goals (MDGs) has been limited (Box 1, Table 1, and Figure 1). In particular, structural reforms needed to stimulate activity in the nonmineral economy have stalled in advance of the June 2007 general elections.

Table 1.

Papua New Guinea: Millennium Development Goals Progress, 1990 - 2004

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Source: World Development Indicators database, September 2006.

Figures in italics refer to periods other than those specified.

Figure 1.
Figure 1.

Papua New Guinea: Progress Toward Selected Millennium Development Goals 1/

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Source: World Bank, World Development Indicators database, September 2006.1/ Progress is measured against a linear projection between the 1990 level and the MDG. Data points may not be available for each intervening year.

2. Reflecting past years of political instability and weak economic management, per capita income is little improved since independence in 1975. As a result of earlier election-year fiscal policy excesses, the current government faced a near crisis situation when it took office in 2002; its efforts during its initial years mainly—and successfully—focused on stabilizing the fiscal situation and promoting economic recovery. However, underlying development needs in Papua New Guinea still remain to be fully addressed. The dominance of the natural resource sector has hindered the development of nonmineral sectors of the economy. Poor infrastructure, weak governance, and an unattractive business environment have constrained more rapid growth. Although recent growth rates have been strong relative to the past, the growth performance gap relative to comparator countries is widening. Poverty and unemployment remain high as the economy is unable to absorb a rapidly growing labor force.1

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Papua New Guinea: Per Capita GDP as Share of Developing Asia and Pacific Islands Countries, 1970-2007

(in percent)

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Source: IMF, World Economic Outlook; and Fund staff estimates.

3. Recent developments have introduced new uncertainty to the outlook as the midyear parliamentary elections draw closer. Frequent cabinet changes over the past year, including in key economic ministries, have complicated macroeconomic policy-making. The PNG-Queensland gas pipeline project, originally expected to start construction in late 2006, was put on hold following a recent reassessment by foreign partners.

Medium-Term Development Strategy

The April 2005 Medium-Term Development Strategy (MTDS) sets out the government’s development priorities for 2005–10, consistent with their Millennium Development Goals. The MTDS objectives are to: (i) establish good governance; (ii) promote export-driven growth in agriculture, forestry, fisheries, and tourism; and (iii) accelerate rural development and poverty reduction, through:

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

  • a more favorable climate for private sector activity 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 for HIV/AIDs.

Almost two years after the strategy’s inception, progress has stalled in many areas. An important advance has been in shifting a larger share of budgeted expenditure toward infrastructure and human capital. However, the MTDS’s objectives remain valid and a point of reference for the public.

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II. Background

A. The Economic Setting

4. Recent developments and the near-term outlook remain favorable (Tables 25 and Figures 27). High commodity prices and expanding mineral production should contribute to continued growth and fiscal and external surpluses (Box 2).

  • The recovery is expected to gain steam in 2007, with growth rising to over 4 percent, as new mines begin production and increased government spending stimulates activity in the nonmineral sector.

  • Inflation, estimated at 3.5 percent on average in 2006, is expected to rise slightly in 2007 as fiscal spending increases pressure on prices, but remain consistent with the Bank of Papua New Guinea’s (BPNG) 4 percent medium-term inflation objective.

  • The current account surplus should narrow in 2007 as the value of mineral exports begins to decline with lower prices expected for key exports. Official external reserves should increase to about $1.6 billion (4 months of goods and services imports).

  • After a steep rise in the kina’s value in 2003-05, it appreciated by 3 percent against the U.S. dollar and 6 percent on a real effective basis in 2006.

  • An overall fiscal surplus is expected for the third successive year in 2007, although the underlying nonmineral deficit would further widen due to higher spending and lower nonmineral tax revenue (largely reflecting the phased reduction in the personal income tax). The 2006-07 budgets provide for large spending increases mainly for development expenditure (over three quarters of the total increase), much of it one-off, and smaller allotments for public enterprise investment, natural disaster victims, and domestic arrears clearance. Given weak implementation capacity and the late timing of the 2006 supplementary budgets, the spending outcome is expected to be significantly less than appropriated. The remaining amounts would be deposited in trust fund accounts for future spending.

  • Repayment of 0.5 percent of GDP of external debt in 2006 to the Asian Development Bank (AsDB) combined with positive debt dynamics (real GDP growth, kina appreciation, and low interest rates) should contribute to a public sector debt-to-GDP ratio of 40 percent in 2007.

Table 2.

Papua New Guinea: Selected Economic Indicators, 2002–07

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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.

Includes changes in check float.

Includes central government, central bank external debt, and statutory authorities.

Table 3.

Papua New Guinea: Summary of Central Government Operations, 2003–07

(In percent of GDP)

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

Supplementary budget passed in August 2006, plus November appropriation bill.

Since 2005, this includes transfers to Bougainville.

In 2005-06, 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.

In 2006, includes budget expenditure for loan repayment.

Table 4.

Papua New Guinea: Summary Accounts of the Banking System, 2002-07

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

Papua New Guinea: Balance of Payments, 2002-07

(In millions of U.S. dollars)

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

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

Figure 2.
Figure 2.

Papua New Guinea: Real Sector Developments

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: Papua New Guinea authorities; IMF, World Economic Outlook; UN, Human Development Report, 2006; and Fund staff estimates.
Figure 3.
Figure 3.

Papua New Guinea: External Sector Developments

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: Papua New Guinea authorities; IMF World Economic Outlook and Information Notice System ; and Fund staff estimates.
Figure 4.
Figure 4.

Papua New Guinea: Fiscal Sector Developments

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: Papua New Guinea authorities; IMF World Economic Outlook ; and Fund staff estimates.
Figure 5-A.
Figure 5-A.

Papua New Guinea: Monetary Developments

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: IMF, Monetary and Financial Statistics ; Bloomberg; Papua New Guinea authorities; and Fund staff calculations.
Figure 5-B.
Figure 5-B.

Papua New Guinea: Monetary Developments

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: IMF, International Financial Statistics ; Papua New Guinea authorities; and Fund staff calculations.
Figure 6.
Figure 6.

Papua New Guinea: Regional and Global Comparators, 2004-06

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: IMF, World Economic Outlook ; Papua New Guinea authorities; and Fund staff calculations.
Figure 7.
Figure 7.

Papua New Guinea: Regional and Global Comparators

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

1/ Mineral revenue.Sources: Country authorities; and Oil & Gas Journal.

Role of the Mining Sector in Papua New Guinea

The mining sector (including petroleum and natural gas) dominates Papua New Guinea’s economy. Once considered a sector in decline, the recent surge in mineral prices has spurred investment in existing mines to expand production and in new exploration as reflected in a sharp rise in mineral exploration applications. The outlook hinges on whether planned projects come on stream before expected declines in mineral prices dampen activity once more.

Gold and silver (27 percent of exports): The largest mine (Lihir) is expanding output with new investment, a second sizeable mine (Kainantu) recently began operations, and several new small mines should start production over the next 2–3 years. The life of another large mine (Porgera) will likely be longer than previously expected.

Copper (27 percent of exports), nickel, and other minerals: Copper production from the Ok Tedi mine is expected to decline steadily from its recent highs, albeit over a longer timeframe than previously envisaged. The large Ramu nickel mine is expected to begin construction in 2007, with production commencing in 2010.

Oil (23 percent of exports): production volumes should remain flat during 2007–10, followed by a gradual decline thereafter.

Natural gas: Following the late–2006 discovery of natural gas in Papua New Guinea’s Gulf region, the largest producer, InterOil, has announced new exploration bids. However, the $5.3 billion PNG-Queensland Gas Pipeline Project tapping natural gas reserves located in Papua New Guinea’s Highlands region is now unlikely to materialize after the external partners’ recent negative reassessment of the project’s viability due to increasing costs. The government is considering alternative options for use of the Highland’s gas reserves and another project may be developed if prices remain high.

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Mineral Sector Indicators

(In percent)

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: PNG authorities; and Fund staff estimates.
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Mineral Revenue

(In percent)

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: PNG authorities; and Fund staff estimates.

Papua New Guinea: Summary of Central Government Operations, 2005–07

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

Includes supplementary budgets passed in August and November 2006.

In 2006, the budget treats savings for a future acquisition of an equity participation in the PNG gas project as an expenditure. Under IMF’s GFS standards, these are treated as expenditure for loan repayment.

Measured from above the line.

B. Medium-Term Outlook and Risks

5. The macroeconomic outlook should remain positive, if fiscal and monetary policies are maintained on their current path (Table 6 and Figure 8). Real GDP growth of about 4 percent is expected over the medium term, together with continued low inflation rates. Falling export prices should underlie narrowing external current account surpluses. The nonmineral fiscal deficit is expected to improve gradually after 2007, if one-off spending in the 2006–07 budgets is not carried over and the “right sizing” program to streamline the government is implemented.

Table 6.

Papua New Guinea: Medium-Term Scenario, 2003–11

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

Central government operations only.

Measured from below-the-line in the fiscal accounts.

Includes changes in check float.

Includes central government, central bank external debt, and statutory authorities.

Figure 8.
Figure 8.

Papua New Guinea: Outlook Indicators

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: IMF, World Economic Outlook; Papua New Guinea authorities; and Fund staff calculations.

6. The balance of risks is to the downside. Higher-than-expected election-related spending could lead to increasing price pressures; the resulting rise in interest rates as monetary policy is tightened could choke off economic growth. Still weak fiscal accountability, especially for many trust funds, also poses risks of higher or inefficient spending. A steeper-than-anticipated decline in world export commodity prices or postponement of large mineral projects would heighten the need for fiscal adjustment to allow room for essential development spending.2 Inaction or unwinding of previous progress on structural reform would dampen investor confidence. The further spread of HIV/AIDs—already one of the highest infection rates in the Asia-Pacific region—would have consequences for growth and human development. On the upside, rapid development of gas reserves could improve the longer-term outlook for growth.

7. A doubling of the baseline growth rates would be needed to significantly reduce poverty and unemployment. Stronger annual growth of 7–8 percent is within reach, but would require more effective use of Papua New Guinea’s mineral wealth, including a sustainable medium-term fiscal policy that efficiently delivers needed development expenditure, and decisive efforts on structural reform to encourage greater activity in the nonmineral sector. The resulting strengthened fiscal position would improve the debt sustainability outlook.

8. Papua New Guinea is at a moderate risk of debt distress, emphasizing the importance of continued prudent fiscal policy (Appendix I). The staffs debt sustainability analysis (DSA) using the low-income country framework suggests that the public sector debt outlook is particularly sensitive to changes in real GDP growth and to the exchange rate. The authorities are keenly aware of these risks. The objective of their debt strategy targeting a reduction in the debt-to-GDP ratio over the medium term is to reduce these vulnerabilities.

III. Policy Discussions

9. The discussions focused on the short-term policy mix that would preserve macroeconomic stability and provide a bridge to a higher growth path in the future. The authorities and the staff broadly agreed on the main challenges facing Papua New Guinea and on the policy priorities needed to address them. In particular, the authorities were committed to avoiding the election-related fiscal policy excesses that in the past resulted in significant setbacks to the economy. In addition, while the current monetary and exchange rate policy was appropriate, a tightened stance would be needed should fiscal-related demand pressure emerge. Looking forward, in line with the objectives of the MTDS and the MDGs, the authorities and staff agreed on the need for renewed attention to the structural reform agenda to encourage private sector activity and raise growth in the nonmineral sector.

A. Maintaining Macroeconomic Stability

Monetary and Exchange Rate Policy

10. The staff views the current monetary policy stance as appropriate. The monetary and credit aggregates continue to rise at relatively rapid rates and liquidity in the banking system remains high. However, along with the continued appreciation of the kina, the BPNG has absorbed sufficient liquidity to keep inflation within the low single digits.

11. Looking ahead, both the staff and the authorities see risks for inflation in 2007 and the possible need for tightening the monetary stance. The most serious concern arises from the risk of unproductive election-related government spending. In addition, pressure could emerge from expected upward revisions in controlled prices (although these would likely have a temporary impact), and sustained large mineral revenue inflows. In that light, the authorities and the staff agreed that monetary policy should be tightened if signs of inflation pressure emerged.

12. The authorities reaffirmed their commitment to a floating exchange rate regime. The authorities generally limit intervention to smoothing out fluctuations within a relatively thin market buffeted by volatile foreign exchange flows related to the mineral sector. Recently, they have used the opportunity of the current favorable terms of trade to build reserves, while protecting the competitiveness of the nonmineral sector by resisting rapid appreciation of the kina against the U.S. dollar. The staff supported this pragmatic approach, given:

  • Mineral prices are not expected to remain at current highs, suggesting that the real exchange rate need not adjust upward permanently. The large current account surplus in 2006 is expected to dissipate over the medium term.

  • Foreign reserves have increased, but at 4 months of goods and services imports, they are not large relative to comparator countries (and are small relative to other natural resource exporters) (Box 3).

  • Competitiveness indicators are mixed, but point to either little change or some decline in nonmineral sector competitiveness in recent years (Box 4), presenting an additional challenge for the nonmineral economy where sustained economic and employment growth must come from over the longer term.

However, as the authorities have neither the resources nor the record of fiscal discipline needed to defend a fixed rate, should upward pressure be unexpectedly sustained or downward pressure materialize, the exchange rate should be allowed to move flexibly as needed.

Fiscal Policy

13. Against the background of pressures for increasing spending ahead of the 2007 elections, the 2006 and 2007 budgets sought to achieve a balanced budget while giving increasing weight to the development spending needed for future growth. The bulk of the higher spending is geared to development expenditure (especially infrastructure), and mainly one-off increases to emphasize the temporary nature of the current record mineral revenue inflows. A large import content in most of these projects and weak budget execution capacity limiting the speed at which such spending takes place, will result in a manageable impact on inflation and medium-term sustainability, if the budget is implemented as appropriated.

uA01fig04

The share of domestic-financed development expenditure is increasing sharply, although the total level remains stable.

Citation: IMF Staff Country Reports 2007, 111; 10.5089/9781451831726.002.A001

Sources: PNG authorities and Fund staff estimates.
  • The staff emphasized its concern that weak public expenditure management might result in leakages and nonpriority spending, which could lead to a build-up of demand and inflation pressure. In particular, the months ahead of the mid-2007 elections might lead to a further expenditure expansion, typical of previous election years. The authorities stressed that they did not wish to repeat the past mistake of pre-election spending excesses, particularly given the large size of revenues at stake. For this reason, the 2006-07 budgets had clearly-defined spending priorities of one-off development expenditure aligned closely with MTDS objectives.

Papua New Guinea: Reserve Adequacy and Costs of Carrying Reserves, 1980-2005 1/

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Sources: Papua New Guinea authorities, WEO, World Bank Development Indicators, and Fund staff estimates.1/ The comparator group includes Barbados, Fiji, Jamaica, Samoa, and Trinidad and Tobago.

Is Papua New Guinea Competitive?

Papua New Guinea’s ranking in the World Bank’s ease-of-doing-business database compares relatively favorably with others in the region.

Doing Business: Papua New Guinea and Comparators 1/

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Source: World Bank, Doing Business Indicators, 2006.

Economies are ranked on their ease of doing business, from 1-175, with first place being the best.

However, law and order and governance continue to be major disincentives to investment, along with other structural rigidities, including weak and costly basic utilities and transportation and communication infrastructure.

Political Risk Points by Component

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Source: International Country Risk Guide, October 2006.

First 3 columns ranked 0-6, 2nd 4 columns ranked 0-12; the lower the number, the higher the risk.

Infrastructure Indicators, 20041

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Source: World Bank, World Development Indicators.

Or latest available data.

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