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.


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.

III. Papua New Guinea: Export Performance and Competitiveness1

A. Introduction

1. Export performance is a key factor driving both economic growth and stability in a small open economy like Papua New Guinea. Accordingly, this paper reviews a broad set of indicators of export competitiveness, including estimation of the equilibrium real effective exchange rate (REER) using different methodologies. The REER appears to be broadly in equilibrium at present. However, other indicators suggest Papua New Guinea faces structural competitiveness problems, including a weak business environment, poor physical and knowledge infrastrucuture, land tenure issues, crime, and weak governance, which hamper overall export competitiveness. Looking forward, Papua New Guinea would benefit from accelerating the structural reforms necessary to improve the investment environment for the nonmineral economy.

2. The remainder of this chapter is structured as follows: Section B reviews Papua New Guinea’s export performance over the last decade. Section C considers different measurements of price competitiveness and Section D estimates the equilibrium real effective exchange rate. Section E assesses structural competitiveness in Papua New Guinea. Finally, the conclusions are presented in Section F.

B. Export Performance

3. Since 1995, Papua New Guinea’s export performance has been lackluster, notwithstanding large mineral discoveries during the 1980s and early 1990s. Mineral export volumes have generally been on a declining trend reflecting depletion of proven reserves (especially for petroleum) and until recently a lack of new investment in exploration activities. Nonmineral export volumes have increased somewhat, mainly because of increased palm oil acreages, logging, and production of copra oil. Despite this increase, nonmineral export values have declined significantly because of lower average prices during the review period. Analysis of the causes of this poor export performance is particularly important because growth in Papua New Guinea is closely linked to exports. Indeed, real GDP growth has been generally modest, averaging about 1 percent annually for the period 1995–2006. Some salient developments are summarized below.

  • Export values grew at an average rate of about 5.3 percent for the period 1995–2006. Mineral exports performed somewhat better (growth rate of about 7.3 percent) than nonmineral exports (growth rate of about 3.3 percent).

  • The average export growth rates masked very high year-to-year fluctuations in virtually all the products, with an overall coefficient of variation of 18. At least 95 percent of Papua New Guinea’s exports are commodities, with raw minerals accounting for about 80 percent of total exports.

  • Both price and volume trends affected the observed trend in values. For the period 1995–2006, average export volumes grew by only about -0.8 percent per annum. Mineral export volumes grew by -1 percent, while nonmineral exports volumes grew by 1 percent. Strong export volume growth was observed mainly in palm oil, and to some extent, in tea, copper and cocoa.

  • Mineral exports were negatively affected by declining oil reserves, the closure in 1989 of the large Bougainville copper mine, and the virtual cessation of mining exploration activities and sharp decline in oil sector exploration until the recent up tick in global mining and oil prices. Petroleum export volumes declined by 7.7 percent on average during 1995–2006. This was partially offset by increased production at the Ok Ted copper mine.

  • Overall average export prices increased by about 7.2 percent per annum in U.S. dollar terms during 1995–2006. Mineral price trends were generally favorable over the period under study. Average mineral prices increased by 11 percent, while nonmineral prices increased by about 1.5 percent. Prior to 2002, poor price trends were observed virtually across the board with the exception of oil.

Papua New Guinea: Export Values, 1995 - 2006

(Annual growth)

article image
Sources: Country authority; and Fund staff calculations.

4. Papua New Guinea’s export growth can be decomposed into three broad factors: global demand, product and markets, and competitiveness.

Global Demand

  • Part of export growth can be attributed to rising international demand; i.e., the stronger global import demand is for a particular product, the stronger would export value growth for that product be. This has been the main influence on export value growth in Papua New Guinea. Rising mineral prices have increased the share of mineral exports in total exports from 70 percent during 1991–99 to 77 percent in 2000–06 despite declining export volumes.


Commodity Price Movements

(Index 1995=100)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Source: IMF, World Economic Outlook.

Export Value

(In millions of US dollar)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Source: Country authority.

Product and Market

5. While Papua New Guinea’s share of the world exports market has been improving in value terms since 2002 with the rise in commodity prices, it has been declining in volume terms over the past decade. Over a longer-term, an increase in market share could be expected if Papua New Guinea’s exports mainly comprised products for which world demand is growing more rapidly than the global average. However, against the background of a commodity demand boom, while world trade volumes increased by around 7.1 percent per annum over the period 1995–2006, over the same period, Papua New Guinea’s export volume growth averaged around -0.8 percent per annum. As a result, the share of country’s goods in world exports has made significant losses since the mid-1995 in volume terms. Although nonmineral export volume has increased recently, the increase has been less than the world’s increase.

  • The range of Papua New Guinea’s exports is limited and has been relatively unchanged over the years. Exports consist mainly of commodities, including minerals and fuel, wood products, and agricultural products. Other areas, such as manufactured products, contribute little.

  • Export performance can also be affected by changes in the demand for exports across regions such that an increase in global market share would be expected if a country’s exports were destined for markets that grow more rapidly than the global average. However, Australia remains Papua New Guinea’s main trading partner—reflecting historical ties, rather than the fast growing emerging economies to the north.


World Export Market Share

(Index 1995 =100)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Sources: IMF, Direction of Trade Statistics; and Fund staff estimates.

Volume Export Market Share


Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Sources: IMF, World Economic Outlook; and Fund staff calculations.

Papua New Guinea: Exports Composition and Growth

(In percent, annual average)

article image
Sources: Bank of Papua New Guinea and Fund staff calculations.

PNG Exports by Main Partners

(In percent of total exports)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Source: IMF, Direction of Trade Statistics.

C. Assessing Competitiveness: Wage and Cost Indicators

Labor costs

6. Wage costs are an important component in the total costs of producing exports; unfortunately, poor data availability bar a thorough analysis on these grounds in Papua new Guinea. Unit labor costs in the traded sector relative to the main trading partners, expressed in a common currency, are generally accepted as a useful proxy for cost competitiveness. However, the latest data collected for Papua New Guinea dates from the mid-1990s. A study by Duncan and Lawson (1997) found that Papua New Guinea’s unit labor costs were high compared to competitor countries, such as Malaysia, Indonesia, and the Philippines. For the period 1970–1994, unit labor costs for Malaysia and the Philippines averaged 40 percent of those of the United States, and those of the Indonesia averaged 0 percent, 2 while Papua New Guinea averaged 80–100 percent. Duncan and Lawson show that the main reason for the high unit labor costs in Papua New Guinea was poor productivity performance. Available data since the Duncan and Lawson study was completed suggest there has likely been no improvement in productivity, since the mid-1990s.3


Labor Productivity

(GDP US$ per employment)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Sources: IMF, World Economic Outlook; World Bank, World Development Indicators; and Fund staff estimates.

Real Effective Exchange Rates

7. Real effective exchange rate (REER) indicators suggest that price competitiveness has remained roughly unchanged over the past decade. The REER has remained largely stable since the August 1994 devaluation (depreciation by about 0.37 percent for the period January 1995–July 2007), as appreciation on a nominal effective exchange rate basis was offset by relatively lower domestic inflation.


Real Effective Exchange Rates

(2000 = 100)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Source: IMF, Information Notice System.

8. Pair wise correlation analysis shows no evidence of an inter-relationship between the REER and export performance in Papua New Guinea. Granger causality tests seem to indicate no causality between exports and the REER.4 Nonetheless, it would be premature to conclude that changes in the REER would not affect export performance.

  • First, it is likely that the limited impact of the exchange rate on export performance reflects the duality between the mineral sector and the nonmineral sector. The mining industry has largely operated at world prices as an enclave with few linkages to the rest of the economy.

  • Second, the results are consistent with the view that export growth has generally been a result of discovery of new minerals and, to some extent, the extension of cultivated areas (e.g., palm oil and copra), rather than the emergence of nontraditional exports. Thus, export volumes would have been little affected by foreign currency-denominated prices (see Mlachila 2002).

9. Other research has found that a real depreciation in Papua New Guinea has a positive impact on the nonmineral sector, for example, by opening up new markets.5

D. Assessing Competitiveness: REER Estimates

10. This section seeks answers to the question of whether the REER is in line with macroeconomic fundamentals. As estimates of equilibrium real effective exchange rates (EREERs) tend to be quite sensitive to the methodology used, especially in countries like Papua New Guinea with severe data limitations, this study uses three different approaches: the purchasing power parity approach (PPP), the macroeconomic balance approach, and the behavioral equilibrium exchange rate (BEER) approach.

Purchasing Power Parity Approach

11. Assessing real exchange rate misalignment under the Purchasing Power Parity (PPP) approach involves a comparison of prices of a basket of goods produced by the home country with those of a comparable basket abroad and calculating the exchange rate that would equate them. Assuming the Balassa-Samuelson hypothesis holds, a country’s prices should become relatively higher as the country becomes relatively richer. The real exchange rate calculated on a PPP basis—measured as the ratio of the domestic price level to international prices—is currently below what would be predicted given Papua New Guinea’s relative income. However, the deviation is small compared to other countries.

Macroeconomic Balance Approach

12. Macroeconomic Balance approach estimates the REER that simultaneously achieves internal and external balance. To this end, the fundamental equilibrium exchange rate (FEER) is defined as the exchange rate that will equate the current account to the structural savings/investment balance in the medium term. The estimation process comprises the following three steps:

  • estimating an equilibrium relationship between current account balances and a set of fundamentals;

  • computing an equilibrium current account (current account norm) from these relationships as a function of the levels of fundamentals projected to prevail in the medium term; and

  • calculating the REER adjustment that would close the gap between the estimated current account norm and the underlying current account balance (the current account projection for 2012).

13. The fundamental variables used for the model are the following: demographic variables affecting the saving rate (old dependency ratio and population growth rate), initial net foreign assets (share of nominal GDP), fiscal balance (share of nominal GDP), relative income (PPP-based per-capita income relative to Australian data), relative real interest rate (relative to Australian data), and mineral exports (share of nominal GDP).

Macroeconomic Balance Approach: Current Account Regression

article image
Note: A *, ** indicates significance at the 10, 5 percent level.

14. Given the estimated import/exports elasticities to exchange rate movements, the REER would need to appreciate by 0.4 percent to close the gap between the underlying current account balance (-2.5 percent) and the current account norm (3.1 percent).6 7

Behavioral Equilibrium Exchange Rate Approach

15. This approach estimates the EREER by identifying structural determinants using a behavioral exchange rate model. Clark and McDonald (1998, 2000) popularized the behavioral equilibrium exchange rate (BEER) approach as a modeling strategy designed to seek a long run relationship between observed real exchange rates and a set of fundamental determinants derived from a theoretical real exchange rate model. An attractive feature of the model is that the real exchange rate is required to be in equilibrium only in terms of its value given by the appropriate set of explanatory variables over a specific sample period. This allows representation of the equilibrium real exchange rate in terms of the dynamic structure that generates the data on the real exchange rate and its fundamental determinants, even though the variables themselves are derived from a long run structural model.8

16. The paper uses a vector error correction model to estimate the BEER. The following model is estimated using Johansen’s co-integration and error correction techniques.9


where the notation used is defined in Box 1. The figure below shows the behavior of the key fundamental variables since 1994. The analysis shows that commodity price movements, productivity, real interest rates differentials vis-à-vis trading-partner countries, the size of the fiscal balance, net foreign assets position, and the debt service ratio explain much of the long-run behavior of the real effective exchange rate.

The results of the estimation are summarized in the table below and show that:

  • An increase in the terms of trade of 1 percent is associated with a depreciation of 0.16 percent in the real effective exchange rate.

  • An increase in real interest rate differential of one percentage point is associated with an appreciation of 0.01 percent in the real effective exchange rate.

  • An increase in real GDP per capita relative to trading partners of 1 percent is associated with an appreciation of 0.10 percent in the real effective exchange rate.

  • An improvement in the fiscal balance of 1 percentage point of GDP is associated with an appreciation of the real effective exchange rate of around 1.4 percent.

  • An improvement in the debt service ratio of 1 percentage point is associated with an appreciation of the real effective exchange rate of around 0.4 percent.

Selected Results of the Vector Error Correction Estimates Sample period: 1995Q2-2006Q4 1/

article image

t-statistics in square brackets.

The implied half-life of the shock to real exchange rate is calculated as follows: the time (T) required to dissipate x percent (in this case, 50 percent) of a shock is determined according to T=(1-x)/θ, where θ is the coefficient of the error-correction term and T is the required number of periods (quarters).

Macroeconomic Determinants of the Exchange Rate

  • Terms of trade (LTOT): The impact of the terms of trade on the real exchange rate is theoretically ambiguous.1 Changes in terms of trade entail changes in domestic prices of importables, and as a result, generate inter-temporal and intra-temporal substitution effects as well as income effects. This makes the net effect on the equilibrium real exchange rate (ERER) ambiguous (Edwards 1989, 1994).

  • The real interest rate (RID): An increase in a country’s real interest rate relative to its trading partners tends to appreciate the ERER. For an economy that is highly open to international capital markets, a higher domestic real interest relative to that of its trading partners creates opportunities for capital inflows.

  • Productivity growth differential (LYPD): An increase in productivity relative to other countries leads to an improvement in the current account, thereby appreciating the real exchange rate. Given lack of data availability in Papua New Guinea, we employ real GDP per capita with respect to trading partner countries as a proxy for the Balassa-Samuelson effect.

  • Trade policy (Open). Permanently higher levels of trade taxes (i.e., reducing the openness of the economy) lead to ERER appreciation. Consumption becomes more expensive with the increase in the relative price of importables, while also creating excess demand of both exportables and nontraded goods. The excess demand in the nontradable goods sector permits an appreciation of the ERER.

  • Net capital inflows (LNFAGDP). Net capital inflows (as a percentage of GDP) are used as a proxy for capital controls. In models of ERER determination, a permanent increase in net capital inflows (interpreted as a reduction in the tax on foreign borrowing) leads to an appreciation of the ERER.

  • Fiscal policy (FIS): Fiscal policy has an ambiguous effect on the equilibrium real exchange rate: the direction of its quantitative influence depends on the sectoral composition of the change in government expenditure.

  • The debt service ratio (DSR). If the debt service ratio falls permanently, this will improve the sustainability of the current account and thus lead to an appreciation of the ERER. If a country is a net debtor, an increase in the debt burden will deteriorate its current account. The real exchange rate will depreciate and make correction of current account imbalances possible. If a country is a net creditor, higher interest income from loans will lead to a current account surplus and the real exchange rate will appreciate.

1/ See MacDonald and Ricci (2003).

17. The level of the exchange rate appears to be in line with fundamentals. The equilibrium real exchange rate (ERER) was obtained by imposing the coefficients of the long-run equation on the permanent values of the fundamentals using Hodrick-Prescott (HP) and Christiano-Fitzerald (CF) filters.

  • Relative to its equilibrium values (HP and CF), the actual exchange rate was mostly undervalued by a small margin during 1994–2007. There were three periods of significant undervaluation during 1995, 1998–2000, and 2001–02, and three brief periods of small to moderate overvaluation in 1997, 2000, and 2005.

  • The first resulted from the use of a nominal exchange rate anchor that was not supported by a consistent fiscal policy in the period prior to 1994. It also reflected broad inconsistencies in the conduct of macroeconomic policies and in the fundamental variables.

  • By end-2006, the actual RER was somewhat more depreciated than the estimated equilibrium exchange rate. The increase in the ERER is due to various factors. The increase in the terms of trade contributed to kina depreciation as income effects dominated substitution effects. However, the improvement in the fiscal balance, increase in net foreign assets, and small increase in the real interest rate differential partly offset these terms of trade effects.


Actual and Equilibrium Real Effective Exchange Rate, 1994Q1 - 2007Q3

(Index 2000=100)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

E. Assessing Competitiveness: Structural Indicators

18. While it appears that price competitiveness is broadly appropriate in Papua New Guinea, structural factors are also important determinants of competitiveness. The structural factors include the business environment (including entrepreneurship, tax regime, regulations, access to finance, and governance), physical and knowledge infrastructure, law and order, land policy, and trade policy. These elements are important determinants of current and future productivity, which is one of the factors that influence competitiveness. One indication of Papua New Guinea’s relative structural competitiveness is the comparatively low level of foreign direct investment relative to other resource rich countries in Asia and low income countries globally. Foreign direct investment is particularly low outside of the mineral sector.


Foreign Direct Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Source: IMF, World Economic Outlook.

PNG: Foreign Direct Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Sources: PNG authorities; and Fund staff estimates.

19. Survey-based indicators of the business environment suggest structural impediments to external competitiveness exist. Although Papua New Guinea’s ranking in the World Bank’s ease-of-doing-business database compares relatively favorably with other countries in the region, key areas rank poorly. These include enforcing contracts, dealing with licenses, getting credit, and trading across borders. Another disincentive to investment is high political risks due to corruption, bureaucracy quality, and ethnic tensions. The World Bank’s CPIA index and Transparency International both rank Papua New Guinea poorly on these issues.10 In addition, the evolution of rankings indicates that the structural reforms undertaken to date have yet to improve competitiveness in a meaningful way.

Selected Countries: Doing Business 2006-07 1/

article image

Economies are ranked on their ease of doing business, from 1-178, with first place being the best.

Source: World Bank, Doing Business, 2008.

Corruption Perception Index, 2006

article image
Source: Transparancy International, 2006.

From 1 to 163 with first place being the best.

Relates to perceptions of the degree of corruption as seen by business people and country analysts, and ranges between 10 (highly clean) and 0 (highly corrupt).

Nominally, with 5 percent probability the score is above this range and with another 5 percent it is below. However, particularly when only few sources are available, an unbiased estimate of the mean coverage probability is lower than the nominal value of 90%.

Twelve surveys and expert assessments were used and at least three were required for a country to be included in the CPI.

APD Resource-rich Low-income Countries: Governance Indicators 1/

article image
Sources: World Bank, Kaufamm, Krayy and Mastruzzi (2005).

The World Bank Country Policy and Institutional Assessment rates eligible countries against 16 criteria grouped in four clusters: (a) economic management; (b) structural policies; (c) policies for social inclusion and equity; and (d) public sector management and institutions. Scores range from 1-6, with higher scores reflecting better performance. Other indicators range between ±2.5, with higher positive outcomes reflecting better outcomes. See

Coverage varies depending on data availability.

20. Papua New Guinea suffers from infrastructure bottlenecks, even when compared to other low income countries. Due to its mountainous terrain, most of the country is impassable, as evidenced by its low proportion of paved roads (less than 5 percent). Access to telecommunications is limited and unit costs are high. At the same time, Papua New Guinea also has low social indicators, indicating a weak knowledge infrastructure. Given the very high annual population growth rate, the country faces considerable challenges in education, especially to increase its school enrolment and retention ratios. In the health sector, a key challenge is to increase access to primary health care facilities, and to reduce the prevalence of communicable diseases.

APD Resource-rich Low-income Countries: Indicators of Human and Physical Capital

article image
Source: World Bank, World Development Indicators.

21. Papua New Guinea’s law and order problems and related security costs also have an adverse impact on the business environment. In addition to direct costs of security, estimated at 3 percent of total business cost on average, there are indirect costs. Security concerns constrain the geographical area in which a company can operate. Overall labor costs are increased to compensate employees for the added personal insecurity, especially for imported labor. Security concerns also generally lead to reduced intensity of capital equipment usage as during certain hours, for example, at night. Finally, security issues occupy management’s time, thereby reducing overall productivity.

22. The lack of transferable land titles is considered another structural impediment, with about 97 percent of the land communally owned. Arguments for land reform include: the traditional tenure system reduces the incentive for landholders to invest in their land since the cost of improvement is privately borne by the landholder while the benefits are socialized; the inability to use land as collateral makes it difficult for landholders to borrow money to finance new investments; and the lack of well-defined property rights over land can divert resources into activities focused on rent-seeking rather than wealth creation. Efforts to modernize land tenure by establishing a national land registry system have met with little success to date due to popular opposition, although there have been some successful individual ventures. For example, in some oil palm estates clearly demonstrable benefits (e.g., royalties, jobs, social services) have encouraged some tribes to lease their land, contributing to a considerable increase in the exports of palm oil.

23. Given its high level of trade openness, Papua New Guinea appropriately maintains one of the least restrictive trade regimes in the region. It fares well relative to comparator countries in terms of both the trade restrictiveness index as well as average import tariffs, which are little over 5 percent, following a recently completed tariff reform.11 The government is currently conducting an overall review of its trade policy.


Measure of Trade Restrictiveness, 2007

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Source: Fund staff calculations.1/ Lower index number indicates lower restrictions

Trade Openness

(Exports and imports in percent of GDP)

Citation: IMF Staff Country Reports 2008, 093; 10.5089/9781451831740.002.A003

Sources: IMF, World Economic Outlook; and Fund staff calculations.

F. Conclusions and Policy Implications

24. While Papua New Guinea has enjoyed strengthened export performance in recent years, the improvement mainly reflects the significant rise in world commodity prices as exports remain concentrated in the mining and petroleum sectors. In volume terms, Papua New Guinea has seen a declining share in total global trade. Staff estimates indicate that the exchange rate is broadly in line with macroeconomic fundamentals at present. In contrast, comparisons of unit labor costs across countries suggest a cost competitiveness problem, though data availability limits a more thorough analysis and makes comparisons difficult. Available data also indicate a structural competitiveness problem.

25. Given volatility and scarcity of resources in the mineral sector, sustained improvement requires enhanced productivity growth and resource reallocation to the nonmineral sector. Foreign direct investment and domestic private investment are key to achieving the necessary economic transformation, but boosting investment will depend on the successful implementation of structural reforms aimed at improving the overall investment environment.

Technical Appendix

Johansen Vector Error Correction

In order to investigate the existence of a long-run, co-integrating, relationship between the real effective exchange rate and the variables discussed above, our study employs the Johansen (1995) maximum likelihood estimator, which corrects for autocorrelation and endogeneity parametrically using a vector error-correction mechanism (VECM) specification.12

The Johansen methodology can be described as follows. Define a vector:


and assume that the vector has a VAR representation of the form:


where η is a (n x 1) vector of deterministic variables, p is the lag length, and e is a (n x l) vector of white noise disturbances, with mean zero and covariance matrix Ξ, and Π is a (n x n) matrix of coefficients. Express 3 may be reparameterized into the so-called vector error correction mechanism (VECM) as:


where Δ denotes the first difference operator, Φ is a (n x n) a coefficient matrix j=1+ipΠj, and Π is a (n x n) matrix equal toi=1pΠj1 whose rank determines the number of co-integrating vectors. When specified in this VECM form, a vector autoregressive process has the advantage of providing information on both the long run relationships among the variables and their short run adjustment to such long run equilibrium relationships.

  • If Π is of full rank, n, or zero rank, Π = 0, no co-integration exists amongst the elements in long-run relationship (in these instances it would be appropriate to estimate the model in, respectively, levels or first differences).

  • If, Π is of reduced rank, r (where r<n), then there exist (n x r) matrices a and ß such that Π = α β´, where β is the matrix whose columns are the linearly independent co-integrating vectors, and the α matrix is interpreted as the adjustment matrix, indicating the speed with which the system responds to last period’s deviations from the co-integrating relationships.

Testing for co-integration therefore requires an estimate of the pie matrix Π = α β´. In the Johansen’s approach, this is achieved by estimating the pie matrix Π = a β´ from the unrestricted VAR model, and then testing whether the restrictions imposed Π by the reduced rank of matrix can be rejected by the data.13 This is tested using two types of tests advocated by Johansen. The first is the trace statistic, which allows one to perform a log likelihood ratio (LR) test for the null hypothesis that there exist r co-integrating vectors against the alternative of co-integrating vectors (where is the number of endogenous variables in the VAR).

The second is the maximum eigenvalue (max—λ) statistic. This is a log likelihood test that tests the null hypothesis that there is r co-integrating vectors against the alternative that there is co-integrating vectors. Asymptotic critical values for conducting these two tests have been provided by Johansen (1988), and also Osterwald-Lenum (1992).

An important advantage of the Johansen methodology in the current application is that the estimated coefficient—the p vector—can be used to prove a measure of the equilibrium real exchange rate and therefore a quantification of the gap between the prevailing real exchange rate and its equilibrium level. The methodology also derives estimates of the speed at which the real exchange rate converges to the equilibrium level.


  • Balassa, B., 1964, “The Purchasing-Power Parity Doctrine: A Reappraisal,” Journal of Political Economy, Vol. 72.

  • Chen, Y., and K. Rogoff, 2002, “Commodity Currencies and Empirical Exchange Rate Puzzles,” IMF Working Paper No. 02/27 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Clark, p., and R. Mac Donald, 2000, “Filtering the BEER: A Permanent and Transitory Decomposition,” IMF Working Paper No. 00/144 (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Dickey, D., and W. Fuller, 1981, “Likelihood Ratio Statistics for Autoregressive Time Series with a Unit Root,” Econometrica, Vol. 49.

    • Search Google Scholar
    • Export Citation
  • Duncan, R., and T. Lawson, 1997, “Cost structures in Papua New Guinea”, Discussion Paper No. 69, Institute of National Affairs, Port Moresby.

    • Search Google Scholar
    • Export Citation
  • Edwards, S., 1989, Real Exchange Rates, Devaluation and Adjustment: Exchange Rate Policies in Developing Countries (Cambridge, Massachusetts: MIT Press).

    • Search Google Scholar
    • Export Citation
  • Edwards, S., 1994, “Real and Monetary Determinants of Real Exchange Rate Behavior: Theory and Evidence from Developing Countries,” in Estimating Equilibrium Exchange Rates, edited by J. Williamson (Washington: Institute for International Economics).

    • Search Google Scholar
    • Export Citation
  • Engle, R. F., and C. Granger, 1987, “Co-integration and Error Correction: Representation, Estimation and Testing,” Econometrica, Vol. 55.

    • Search Google Scholar
    • Export Citation
  • Faal, E., 2006, “Growth and Productivity in Papua New Guinea,” IMF Working Paper No. 06/113, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation
  • Hinkle, L., and P. Montiel, (eds), 1999, Exchange Rate Misalignment, Concept and Measurement for Developing Countries. (London: Oxford University Press).

    • Search Google Scholar
    • Export Citation
  • Kannapiran, C., 2000, Commodity Price Stabilisation: Macroeconomic Impacts and Policy Options, Agricultural Economics 23 (1), 17–30.

  • Mlachila, M, 2002, Selected Issues and Statistical Index, International Monetary Fund, Papua New Guinea.

  • MacDonald, R, and Ricci, L, 2003, “Estimation of the Equilibrium Real Exchange Rate for South Africa,” IMF Working Paper No. WP/03/44, (Washington: International Monetary Fund).

    • Search Google Scholar
    • Export Citation

Prepared by Ebrima Faal, Qaizar Hussain, Agnes Isnawangsih, and 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.


R. Duncan and T. Lawson. 1997. Cost Structures in Papua New Guinea. Port Moresby: Institute of National. Affairs, Discussion Paper No. 69:45.


Faal (2006) estimates that total factor productivity growth during 1980–2006 was zero.


The hypothesis that changes in export values do not Granger-cause changes in the REER is rejected at the 5 percent significance levels. P-values of 0.233 and 0.665 suggests that we cannot reject the hypothesis.


In a detailed study of the tree-crop sector in Papua New Guinea, Kannapiram (2000) argued that kina depreciation achieved the twin objectives of improving competitiveness and increasing profit margins, especially for coffee and oil palm production and exports.


The results should be treated with some caution given the limited data set and degrees of freedom.


Annual data for 1992–2006 are used for the econometric analyses and are shown in Table 1. Elasticity of exports/imports/current accounts with respect to the REER are assumed to be:

  • Exports: -0.46 (one percent appreciation in REER decreases exports in share of GDP by 0.46)

  • Imports: -0.62 (one percent appreciation in REER decreases imports in share of GDP by 0.62)

  • Current accounts: -0.46*(exports in share of GDP)-(-0.62)*(imports in share of GDP).


An important advantage over single-equation methods (such as the Engle-Granger method) is that this approach accounts for simultaneity and autocorrelation of the endogenous variables. The VECM also permits the inclusion of additional exogenous variables that may help explain the short-run behavior of the real exchange rate.


International comparisons of structural indicators are often based on survey evidence and, therefore, need to be interpreted with caution.


There are four major ad valorem tariff rates (0, 15, 25, 40) and some additional specific tariff rates (such as 70 percent on sugar and 20 percent on mackerel).


There are alternative ways of addressing serial correlation and endogeneity in a co-integrating framework, such as Phillips and Hansen (1990).


(Eviews 5.0 Users Guide, p. 724.)

Papua New Guinea: Selected Issues and Statistical Appendix
Author: International Monetary Fund