Papua New Guinea
Selected Issues and Statistical Appendix
Author: International Monetary Fund
Publication Date:
12 Mar 2008
eISBN:
9781451831740
Language:
English
Keywords:
ISCR; CR; exchange rate; rate; repo rate; interest rate; inflation in Papua New Guinea; world inflation; CPI basket; PNG's inflation; macroeconomic variable; Monetary base; Oil prices; Consumer price indexes; kina appreciation
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This paper analyzes the workings and effectiveness of the monetary transmission mechanism in Papua New Guinea. The paper is organized as follows: it describes the current institutional structure in Papua New Guinea; interest rate is discussed; the evidence from vector autoregression analysis on the relationship between monetary policy variables and output and prices is considered; finally, implications are included. The Bank of Papua New Guinea (BPNG) uses a reserve money framework to conduct monetary policy operations. A macroeconomic balance approach estimates the REER, which simultaneously achieves internal and external balance.

Abstract

This paper analyzes the workings and effectiveness of the monetary transmission mechanism in Papua New Guinea. The paper is organized as follows: it describes the current institutional structure in Papua New Guinea; interest rate is discussed; the evidence from vector autoregression analysis on the relationship between monetary policy variables and output and prices is considered; finally, implications are included. The Bank of Papua New Guinea (BPNG) uses a reserve money framework to conduct monetary policy operations. A macroeconomic balance approach estimates the REER, which simultaneously achieves internal and external balance.

I. Sources of Inflation in Papua New Guinea1

A. Introduction

1. Since 2004, Papua New Guinea’s inflation has been low, compared to its historical level and peer countries’ inflation, in spite of rapid broad money growth and increased government expenditure. This chapter examines the possible explanations for this puzzle by analyzing the sources of inflation in Papua New Guinea. The results from the empirical analysis indicate that kina exchange rate movements are the most important determinant of inflation in Papua New Guinea, and correspondingly, appreciation of the kina has contributed to the low inflation. Changes in broad money growth, government expenditure, and oil prices also have had an impact on inflation. In particular, the findings suggest that recent rapid broad money growth, increased government expenditure, and higher oil prices could increase inflationary pressure in the near future. Cross-country analysis suggests that similar relationships between inflation and the above economic variables hold in Papua New Guinea’s peer countries as well. This analysis accordingly indicates that low inflation in Papua New Guinea compared to its peer countries was mainly caused by kina appreciation, in addition to relatively low, though increasing, government expenditure growth.

2. The structure of the remainder of this chapter is as follows: Section B reviews recent developments in inflation in Papua New Guinea and the economic environments surrounding it; Section C presents an empirical analysis of the relationship between inflation and different macroeconomic variables; Section D considers cross-county inflation analyses; and Section E presents the conclusions.

B. Inflation and the Economic Environment

3. Papua New Guinea’s inflation declined sharply in 2003 and has remained in low single digits since 2004.2

uA01fig1

CPI and NEER

(in percent, y/y change)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

4. Inflation historically has had a strong negative correlation with foreign exchange rate movements. The country experienced high inflation in line with depreciation of the kina exchange rate in 1995–96 (following the change in the foreign exchange regime from a pegged regime to an independent float), 1998–2000, and 2001–03. Since 2004, with the roughly unchanged or somewhat appreciated kina exchange rate, inflation has been low.

5. Movements in headline inflation are mainly explained by tradable goods, which account for 77 percent of the CPI basket.3 Therefore, despite relatively large price increases in nontradable goods from 2006, headline inflation has been subdued.4 Given that most tradable goods are imported, changes in the exchange rate and prices abroad have an impact on PNG’s domestic goods prices. Further disaggregation of headline CPI indicates that for tradable goods, food has been a key source of underlying inflationary pressure. Prices of “transport/ communication” and “rent, council charges, and fuel/power” have increased since 2006, mainly pushed by high oil prices, but overall these were offset by lower prices of “drinks, tobacco, and betel nut” and “household equipment/operations,” resulting in lower headline inflation.

uA01fig2

Inflation

(in percent, y/y change)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

uA01fig3

CPI Inflation

(in percent, y/y change, contribution)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

6. Papua New Guinea’s monetary conditions have remained roughly unchanged since mid-2004. The policy rate of the Bank of Papua New Guinea (BPNG), the Kina Facility Rate (KFR), decreased from mid-2003 to September 2005 following a year of tightening in 2002. Since September 2005, the KFR has been unchanged at 6 percent, a historically low level, while several of Papua New Guinea’s partner countries began raising policy rates in 2002–04. The staff’s nominal monetary condition index (MCI) suggests that monetary conditions in Papua New Guinea have been roughly unchanged at the most relaxed level in the last 10 years from 2003 through 2006.5 However, in real terms, monetary conditions tightened in 2003 in line with the REER appreciation, resulting from the spike in inflation, and has roughly unchanged since then.

uA01fig4

Policy Rates

(In percent)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

uA01fig5

Monetary Condition Index (MCI)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

Note: A linear combination of interest rates and foreign exchange rates.A positive number indicates tightness relative to the base (end-1996).

7. Monetary aggregate growth began accelerating in 2004, as high prices for Papua New Guinea’s key commodity exports increased net foreign asset inflows. The BPNG intervened in the foreign exchange market to smooth exchange rate movements and avoid excessive appreciation of the kina against the U.S. dollar. It sterilized excess liquidity mainly by issuing central bank bills to maintain reserve money within its target growth rate. Net domestic asset growth began accelerating in 2005, driven by the recovery in private credit, which was in turn fueled by sound economic conditions, low interest rates, and improved financial intermediation. However, since 2006, net domestic asset growth has been near zero, as continued private credit growth has been offset by rising government deposits at the BPNG.

uA01fig6

Broad Money Growth

(12-month percent change)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

uA01fig7

Changes in Net Foreign and Net Domestic Assets of Central Bank

(12-month changes scaled by lagged reserve money level)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

Sources: IMF, International Financial Statistics; and Fund staff estimates.

C. Empirical Analysis

8. A Vector Error Correction Model (VECR) is used to examine the statistical relationships between CPI inflation and the exchange rate (NEER), broad money, government expenditure, inflation in Papua New Guinea’s major trading partners, and oil prices.6 This study uses simple econometric models that include exchange rate (NEER) and either broad money or government expenditure as endogenous explanatory variables. Model A includes broad money, while Model B includes government expenditure. Results from the exercises are as follows:

  • CPI and NEER are negatively correlated. A 1 percent appreciation in the kina is associated with a 0.87 percent decrease in CPI for Model A and 0.59 percent for Model B.7

  • CPI is positively correlated with broad money and central government expenditure. A 1 percent increase in broad money is associated with a 0.23 percent increase in CPI while a 1 percent increase in central government expenditures is associated with 0.42 percent increase in inflation.8 9

  • Inflation is positively correlated with a lagged oil prices. A 1 percent increase in oil price change in a period before is associated with 0.05 percent increase in an inflation change for Model A and 0.06 percent increase for Model B.

  • Inflation is positively correlated with the world inflation. Model A suggests a 1 percent increase in inflation in Papua New Guinea’s major trading partners is associated with 1.37 percent increase in an inflation change. However, this variable is not statistically significant for Model B.

  • Error correction terms suggest that deviations from the equilibrium level are adjusted by 24 percent per quarter for Model A and 29 percent for Model B, meaning it takes about 12 months to adjust full deviations for Model A and 9 months for Model B.

Results of VECM

article image

1/ Quarterly data for 1995 1Q-2006 4Q are used for estimations.

2/ Coefficients with ***, **, and * are statistically significant at 1, 5, and 10 percent criteria respectively.

3/ Figures in parentheses are standard errors.

9. As the econometric analyses show, the nominal exchange rate (NEER) is the most important determinant of CPI in Papua New Guinea, followed by government expenditure and broad money. The correlation coefficients of CPI components and economic variables suggest that broad money is highly correlated with nontradable goods such as rent, council charges, and fuel/power and miscellaneous, while NEER has a high correlation with tradable goods such as food; drinks, tobacco, and betel nut; clothing and footwear; and household equipment and operations.10 Meanwhile, government expenditure is highly correlated with CPI components across the board.

Correlation Coefficients of CPI components and Economic Variables

article image

1/ Correlation coefficients larger than 0.90 in an absolute value are highlighted.

2/ Sample period is for 1996 4Q-2006 4Q.

D. Cross-Country Analysis

10. Cross-country analysis for twenty countries including Papua New Guinea and its peers suggests that the relationships between inflation and NEER movements, broad money growth, and central government expenditure growth that are observed in Papua New Guinea hold across the board.11 The coefficient of inflation and NEER for twenty countries including Papua New Guinea is -0.80, indicating a 1 percent appreciation in NEER is associated with 0.80 percent decrease in inflation. Meanwhile, the coefficient of inflation and central government expenditure is 0.42, indicating a 1 percent increase in central government expenditure is associated with 0.42 percent increase in inflation. Similarly, the coefficient of inflation and broad money growth is 0.41, indicating a 1 percent increase in broad money growth is associated with 0.41 percent increase in inflation.

uA01fig10
1/ Correlation Coefficients are calculated by the cross-country data on PNG and its peer countries. The sample period is 1996-2006.2/ Government expenditures for Mongolia is for “general government.”

List of PNG’s Peer Countries

article image

1/ Peer countries are selected based on the size of impact of changes in commodity exports on current account balances, foreign exchange regimes, and income levels.

11. Papua New Guinea’s inflation has been low compared to its peer countries, while broad money has grown more rapidly than its peer countries since 2005. Lower inflation in Papua New Guinea has reflected higher appreciation of the exchange rate and lower increases in government expenditure compared to peer countries.12

uA01fig11

PNG's inflation has been lower than its peer countries since 2004…

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

uA01fig12

while PNG's broad money grew more rapidly than its peer countries since 2005.

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

uA01fig13

Appreciation in the kina…

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

uA01fig14

along with lower government expenditures in PNG have contributed lower inflation in PNG.

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A001

E. Conclusions and Policy Implications

12. The analyses in this chapter suggest that changes in the exchange rate are the most important determinant of inflation in Papua New Guinea, followed by government expenditure, broad money, and international oil prices. In addition, the BPNG’s proactive stance to absorb excess liquidity through open market operations as well as the low volatility in the kina might have contributed to the low inflation. However, looking ahead, the recent rapid broad money growth, increased government expenditure, and increased international oil prices could increase inflationary pressures. The results from the empirical analysis indicate that the current equilibrium inflation rate ranges from 5–8 percent. Given the increased inflationary pressures, the BPNG should be prepared to tighten monetary conditions as necessary to counter such pressures. At the same time, given current conditions, it remains appropriate for the BPNG to continue the current exchange rate policy of leaning against the wind to prevent too rapid exchange rate appreciation against the U.S. dollar, and sterilizing the resulting reserve accumulation to help contain inflation, while also balancing concerns regarding the inflationary impact of nominal depreciation on a trade-weighted basis.

Annex: Technical Appendix

A Vector Error Correction Model (VECM), which can capture both long-run and short-run relationships for an empirical analysis, is used in the paper. The data set for the estimation is on a quarterly basis, of which CPI data are seasonally adjusted by the Census X-12 while quarterly government expenditure data are calculated by interpolating the annual data in a quadratic-match average way. Independent variables are foreign exchange rate (NEER), broad money, central government expenditure, oil prices, and inflation in Papua New Guinea’s major trading partners (import value weighted average of CPI in Australia, Japan, New Zealand, the United States, and developing countries). Oil prices and inflation in Papua New Guinea’s major trading partners are assumed to be exogenous variables given Papua New Guinea is a small and open economy (price taker).

Model A

Longrun(EC):log(CPI)=αlog⁡(NEER)+βlog⁡(BroadMoney)+ConstantVECM:Δlog⁡(CPIt)=−γECt−1+∑ηΔlog⁡(CPI)t−1/t−4)+∑λΔlog⁡(BroadMoneyt−1/t−4)+∑πΔlog⁡(Oilpricest/t−3)+ψΔlog(WorldCPIt)+Constant

Model B

Longrun(EC):log(CPI)=αlog⁡(NEER)+χlog⁡(GovernmentExpenditures)+ConstantVECM: Δlog⁡(CPIt)=−γECt−1+∑ηΔlog⁡(CPIt−1/t−3)+∑νΔlog⁡(GovernmentExpenditurest−1/t−3)+∑πΔlog⁡(Oilpricest/t−3)+ψΔlog⁡(WorldCPIt)+Constant

As unit root tests, Augmented Dickey-Fuller (ADF) and Phillips-Peron (PP) tests are applied. Existence of I (1) process for all variables except for NEER were supported by both tests while I (1) process for NEER is supported only by PP tests. Existence of at least one cointegration among the variables for both model A and B was suggested by the cointegration tests. Expected signs for correlation coefficients are as follows:

Long-run Relationship (endogenous variables)

  • Exchange rate: appreciation (depreciation) of the kina NEER expects to lower the inflation (a < 0).

  • Broad money: increase in broad money expects to increase inflation (β > 0).

  • Government expenditure: increase in government expenditures expects to increase inflation (χ > 0).

VECM (short-run relationship/exogenous variables)

  • Oil prices: increase in oil prices (with time lags) expect to increase inflation (π>0).

  • Foreign inflation: increased inflation abroad expects to increase PNG’s inflation (ψ <0)

References

  • Douglas K. Pearce, Sara A. Reiter, 1985, “Regression Strategies When Multicollinearity Is a Problem: A Methodological Note,” Journal of Accounting Research, Vol. 23, No. 1.

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  • Neil R. Ericsson, Eilev S. Jansen, Neva A. Kerbeshian, and Ragnar Nymoen, 1998, “Interpreting a Monetary Conditions Index in Economic Policy,” BIS Conference Papers, Volume 6, pp. 237 –254, Bank for International Settlements, Basle, Switzerland.

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  • Sampson Thomas, Jeffrey Yabom, Williamina Nindim, and Jacob Marambini, 2006, “Exchange rate pass-through in Papua New Guinea,” Pacific Economic Bulletin, Volume 21, No 1, Asia Pacific Press.

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1

Prepared by Aiko Mineshima. This chapter is based on a presentation delivered at the Bank of Papua New Guinea in Port Moresby in November 2007 and benefits from comments received at that time.

2

The quality of CPI data for Papua New Guinea is poor: for example, the weights are outdated (based on a 1975–76 Household Income and Expenditure Survey), and prices on dwelling rentals, which compose about 3.9 percent of the headline CPI basket, have not been collected since 1991 and are therefore held constant.

3

Tradable goods include: food; drinks, tobacco, and betel nut; clothing and footwear; household equipment; and motor vehicles.

4

Nontradable goods include: rents, council charges, and fuel/power; transport and communication; and miscellaneous.

5

The monetary condition index (MCI) is a weighted average of changes in the effective exchange rate and interest rates relative to a base period (in this case, end-1996). Reflecting the relative influence on monetary conditions, the weights for Papua New Guinea are 75 percent for the NEER and 25 percent for the interest rate. As Papua New Guinea is a small, open economy with a shallow financial market, the impact of exchange rate movements on monetary conditions is more significant than in more developed economies.

6

Productivity (GDP gap or real GDP per capita) could be an explanatory variable of inflation. However, both the GDP gap and real GDP per capita do not work well for Papua New Guinea; the sign for the GDP gap is opposite to the our expectation, while NEER becomes statistically insignificant when real GDP per capita is included in the model. These results could be related to the poor quality of national accounts data. Nonetheless, given indications that productivity has not improved in recent years, inflationary pressure could be further increased if other conditions are unchanged.

7

Thomas and al. (2006) estimated the exchange rate pass-through to underlying inflation by using OLS. The result shows the pass-through effect is approximately 50–60 percent.

8

Including both broad money and government expenditures in a model causes multicollearity problem (the correlation coefficient of broad money growth and government expenditures is about 0.9). Other studies have shown that dropping one of correlated variables is the best way to solve this problem; Pearce and Reiter (1985) discusses the well-known two-stage strategy.

9

Private credit, related to broad money, could be an explanatory variable of inflation. However, the econometric model becomes divergent if private credit is used instead of broad money.

10

“Miscellaneous” includes medical and health care, entertainment, cultural goods and services, and other goods.

11

Peer countries are selected based on the size of impact of changes in commodity exports on current account balances, foreign exchange regimes, and income levels.

12

Looking at levels rather than growth rates, government expenditure and broad money as a share of nominal GDP have been higher for PNG than for its peer countries: the average of government expenditure as a share of nominal GDP for 1996-2006 is 31 percent for PNG and 23 percent for its peers, while the average of broad money as a share of nominal GDP for 1996–2006 is 34 percent for PNG and 21 percent for its peers.

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Cover IMF Staff Country Reports
Papua New Guinea: Selected Issues and Statistical Appendix
Author: International Monetary Fund
Volume/Issue:
Volume 2008: Issue 093
Publisher:
International Monetary Fund
ISBN:
9781451831740
ISSN:
1934-7685
Pages:
100
DOI:
https://doi.org/10.5089/9781451831740.002

CPI and NEER

(in percent, y/y change)

Inflation

(in percent, y/y change)

CPI Inflation

(in percent, y/y change, contribution)

Policy Rates

(In percent)

Monetary Condition Index (MCI)

Broad Money Growth

(12-month percent change)

Changes in Net Foreign and Net Domestic Assets of Central Bank

(12-month changes scaled by lagged reserve money level)

PNG's inflation has been lower than its peer countries since 2004…

while PNG's broad money grew more rapidly than its peer countries since 2005.

Appreciation in the kina…

along with lower government expenditures in PNG have contributed lower inflation in PNG.