Papua New Guinea
2007 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion for Papua New Guinea

Papua New Guinea’s economic performance has strengthened since the last Article IV Consultation. The country has significant underlying vulnerabilities. The economy is exposed to commodity price shocks, and mineral production is expected to decline over the medium to longer term. However, macroeconomic vulnerabilities have intensified, in particular, the potential for higher unproductive fiscal spending to raise demand pressures and spur inflation. Prudent fiscal policies are welcomed. Implementation of the multi-donor technical assistance plan is encouraged. The authorities are encouraged to accelerate the structural reforms and improve infrastructure.

Abstract

Papua New Guinea’s economic performance has strengthened since the last Article IV Consultation. The country has significant underlying vulnerabilities. The economy is exposed to commodity price shocks, and mineral production is expected to decline over the medium to longer term. However, macroeconomic vulnerabilities have intensified, in particular, the potential for higher unproductive fiscal spending to raise demand pressures and spur inflation. Prudent fiscal policies are welcomed. Implementation of the multi-donor technical assistance plan is encouraged. The authorities are encouraged to accelerate the structural reforms and improve infrastructure.

I. Introduction

A. Background

1. Papua New Guinea’s economic performance has strengthened since the last Article IV consultation. Supported by a combination of prudent fiscal and monetary policies and high global prices for key mineral export commodities, growth has accelerated over the past five years with increasing momentum from the nonmineral sector since the recession ended in 2003. Inflation has remained in the low single digits, and international reserves are at a record high.

2. Still, the country remains poor with significant underlying vulnerabilities. There has been little improvement in development indicators (Figure 1), and urban unemployment is estimated at around 40 percent. The economy is exposed to commodity price shocks, and mineral production is expected to decline over the medium to longer term (Box 1). An unattractive investment environment, including weak infrastructure and governance, constrains more rapid and sustained growth of the nonmineral sector (Box 2). Papua New Guinea’s recent growth performance is an improvement relative to the past; however, it is unlikely to be sustained and falls short of that needed to reduce poverty, raise development, and close the performance gap with respect to comparator countries over time.

Figure 1.
Figure 1.

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

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

Source: World Bank, World Development Indicators database, April 2007.1/ Progress is measured against a linear projection between the 1990 level and the MDG. Data points may not be available for each intervening year.
uA01fig01

PNG: GDP per Capita at PPP Exchange Rates, 1970–2012

(In percent of comparators)

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

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

3. The political environment has stabilized. Prime Minister Somare has returned for an unprecedented second-consecutive term following the mid-2007 parliamentary elections. After several years of inactivity following differences of opinion with the authorities on forestry sector governance, the World Bank has recently re-engaged with new project lending.

B. The Current Economic Setting

4. The near-term macroeconomic prospects are positive (Figure 2 and Table 1).

  • Buoyant growth of over 6 percent is estimated for 2007, based on robust mineral and nonmineral growth. The pickup reflects the combination of several one-off factors, including a strong rebound in mineral and agriculture production following drought in 2006, and expansion in telecommunications and mining-related construction. Strong nonmineral activity should continue in 2008, with some easing.

  • Annual average CPI inflation is estimated at under 2 percent in 2007.

  • Positive debt dynamics and some repayment lowered the public debt-to-GDP ratio to about 35 percent at end-2007, down sharply from a peak of 77 percent in 2002 (Figure 3 and Table 2).

  • Large foreign exchange inflows related to buoyant mineral exports boosted official reserves to over $2 billion at end-2007, equivalent to about 5 months of goods and services imports, and kept the current account balance in surplus (Figure 4 and Table 3).

  • Monetary aggregates continue to grow rapidly, although at a decelerated pace (Figure 5 and Table 4). Low inflation and real interest rates, and improved financial intermediation have contributed to a decline in broad money velocity.

  • The kina continued to appreciate against the U.S. dollar, 7 percent over the year to November. On a nominal and real effective basis, it depreciated by about 4 and 5 percent, respectively, over the year through September.

  • The financial sector appears sound, based on backward-looking indicators. Reflecting the improved growth prospects and low interest rates, credit growth continues to be strong, though decelerating (Figure 5 and Table 4). Financial sector assets have grown to 71 percent of GDP at June 2007, from 45 percent at end-2003.

  • Reflecting the improved fiscal and external situation, Standard & Poor’s upgraded Papua New Guinea’s credit rating to ‘B+’ on its foreign currency long-term debt and ‘BB-’ on its local currency rating (Table 6).

Figure 2.
Figure 2.

Papua New Guinea: Real Sector Developments

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

Sources: PNG authorities; IMF, World Economic Outlook; UN, Human Development Report 2007/08; and Fund staff estimates.
Table 1.

Papua New Guinea: Selected Economic Indicators, 2003–08

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

September figures for interest rate and exchange rates.

Based on new official national account estimates (1998 prices).

Measured from above the line in the fiscal accounts.

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 3.
Figure 3.

Papua New Guinea: External Sector Developments

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

Sources: PNG authorities; IMF World Economic Outlook and Information Notice System; and Fund staff estimates.
Table 2.

Papua New Guinea: Summary of Central Government Operations, 2004–08

(In percent of GDP)

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

Includes the November 2007 Supplementary budget.

Since 2005, this includes transfers to Bougainville.

The 2005–08 government budgets classify earmarked funds that are transferred to government trust funds as expenditure. Under the staff’s cash presentation, these funds are reclassified on a cash accounting basis (consistent with Government Finance Statistics), and expenditure is counted as occuring only when money is disbursed from the trust funds.

In 2006 and 2007, includes budget expenditure for all loan prepayments.

Figure 4.
Figure 4.

Papua New Guinea: Fiscal Sector Developments

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

Sources: Papua New Guinea authority; IMF, World Economic Outlook; and Fund staff estimates.
Table 3.

Papua New Guinea: Balance of Payments, 2003–08

(In millions of U. S. dollars)

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

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

Figure 5-A.
Figure 5-A.

Papua New Guinea: Monetary Developments

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

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

Papua New Guinea: Monetary Developments

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

Sources: IMF, International Financial Statistics and World Economic Outlook; Papua New Guinea authority; and Fund staff calculations.
Table 4.

Papua New Guinea: Summary Accounts of the Banking System, 2004–08

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

Papua New Guinea: Medium-Term Scenario, 2004–13

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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. Movements in gross debt stocks reflect an initial accumulation and then drawdown of government deposits.

WEO for projections.

Table 6.

Papua New Guinea: Indicators of External Vulnerability, 2002–07

(In percent of GDP, unless otherwise indicated)

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

End of period.

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

Figures for 2007 are as of September.

Covers only banking system short-term external debt.

Initial rating of B1 (stable) in January 1999.

Initial rating of B+ (stable) in January 1999. The rating was upgraded to B+ in September 2007.

Papua New Guinea: Mining-Sector Role Waning Over Medium Term

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Sources: PNG authorities; and Fund staff estimates.

Is Papua New Guinea’s Nonmineral Sector Competitive?

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Sources: PNG authorities; IMF Information Notice System, Direction of Trade Statistics, and World Economic Outlook database; and Fund staff estimates.

Papua New Guinea maintains one of the least restrictive trade regimes in the region. However, domestic structural rigidities, including weak and costly basic utilities and poor transportation, communication, and electric power infrastructure, low skills and literacy, high crime, and weak governance continue to hamper competitiveness and growth, particularly of the core nonmineral sector.

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Sources: World Bank, World Development Indicators; and 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 www.worldbank.org.

Coverage varies depending on data availability.

Although Papua New Guinea’s ranking in the World Bank’s ease-of-doing business database compares relatively favorably with others in the region, enforcing contracts, dealing with licenses, and getting credit are relatively more cumbersome.

Doing Business: Papua New Guinea and Comparators 1/

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Source: World Bank, Doing Business Indicators, 2008.

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

Simple average of countries in the region.

uA01fig04

Real GDP Growth, 1997–2008

(In percent)

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

Sources: PNG authority; and Fund staff estimates.
uA01fig05

Contribution to GDP Growth in Non-mineral Sector

(In percent, y/y)

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

Sources: PNG authorities; and Fund staff estimates.

5. At the same time, policy challenges to improving and sustaining the recent strong performance have intensified.

  • Annual average inflation is expected to trend upward toward the middle single digits over 2008, with pass-through of rising petroleum prices, some kina depreciation on an NEER basis, and higher demand pressure from increased budget spending.

  • Overall fiscal surpluses will continue through 2007–08. High mineral revenue inflows, combined with restraint of recurrent costs and implementation capacity constraints, helped boost fiscal savings since 2002 relative to comparators. However, the nonmineral deficit, measured on a cash basis, is now likely to further worsen as mineral revenue eases and spending increases.

  • Progress on the structural reform agenda set out under the Medium-Term Development Strategy (MTDS) has stalled over the past year, particularly with respect to public sector reform. 1

  • Constraints to private activity remain formidable, including unreliable services from basic utilities, poor transportation infrastructure, high crime, low public sector capacity to provide services, unclear licensing and regulation policies, weak human capacity, delays in work-visas, and land tenure issues. For these reasons, foreign and domestic investment outside of the enclave mineral sector is low.

  • As a result, competitiveness of the nonmineral sector has not improved over the recent period, resulting in little or no increase in nonmineral export volumes (Box 2). Agricultural exports, the largest share of nonmineral exports, were additionally affected by bad weather in 2005–06.

uA01fig06

Resource Revenue Spending 2002–07 1

(In percent)

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

Sources: IMF, World Economic Outlook; IMF country reports; and Fund staff estimates.1 Defined as the ratio of the increase in non-resource fiscal deficit (in 2002–2007) to the increase in resource revenues.
uA01fig07

Fiscal Balances and Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2008, 098; 10.5089/9781451831757.002.A001

Sources: PNG authorities and Fund staff estimates.

Papua New Guinea: Summary of Central Government Operations, 2006–08

(in percent of GDP)

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

Includes November 2007 Supplementary Budget.

The 2005–08 government budgets classify earmarked funds that are transferred to government trust funds as expenditure. Under the staff’s cash presentation, these funds are reclassified on a cash balances basis (consistent with Government Finance Statistics), and expenditure is counted as occuring only when money is disbursed from the trust funds.

Measured from above the line.

Authorities’ Response to Recent Fund Policy Advice

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C. Medium-Term Outlook: Prospects and Risks

6. In the absence of a change to current policy trends, the staff and authorities agreed that the outlook is for a return to moderate growth over the medium term, with increased downside risks (Table 5).

  • The baseline projection expects growth to average about 3.5 percent over the medium term, mainly reflecting the onset of production at new mines. Nonmineral growth is expected to decelerate from current peaks to trend growth rates in the absence of structural reform. Inflation should remain in the middle single digits.

  • This scenario assumes: (i) current fiscal policy continues to be implemented relatively well, with higher but not excessive fiscal spending in the near term and with the ability to ensure reasonable expenditure quality, (ii) monetary policy continues to contain inflation, and (iii) limited structural reforms are undertaken.

  • Regarding external prospects, the medium-term outlook assumes that (i) mineral exports and revenue inflows decline from their current peak, based on government production estimates, (ii) the exchange rate continues to be managed flexibly, and (iii) the external current account position deteriorates in line with the decline in mineral exports and with no improvement in nonmineral exports in the absence of reform to improve the investment climate.

  • However, significant macroeconomic and external vulnerabilities remain. In particular, there is potential for higher unproductive fiscal spending to raise demand pressures and spur inflation. Additional downside risks include a weaker global economy leading to lower commodity prices, and no action or a reversal of progress on the structural reform agenda, both of which would adversely affect growth and the external accounts. 2 Upside risks include global developments leading to sustained higher commodity prices, further crowding-in of private activity from the increase in public investment, and additional production from existing or new gas and mining projects. 3

  • The baseline nonmineral GDP growth rate needs to roughly double over a sustained period to meet the objectives of reduced poverty, significant job creation, and higher development. Given Papua New Guinea’s resources, these higher growth rates could be realized if a fiscal-monetary policy mix is pursued that maintains macroeconomic stability, mineral revenues are used productively, and structural reforms are undertaken to remove rigidities constraining private activity so that productivity and investment are raised and sustained.

7. The debt sustainability analysis (DSA) suggests that Papua New Guinea’s public debt burden faces a moderate risk of debt distress (Appendix I). 4 External debt sustainability is vulnerable to shocks that lower export growth below the baseline. The debt outlook is sensitive to a number of risk factors, including an escalation in public spending, declines in world mineral prices, and larger public sector borrowing—including by stateowned enterprises (SOEs). The authorities recognize these risks, and their debt strategy continues to bar new net debt.

II. Policy Issues

8. Against the background of temporarily high mineral revenue inflows and increased downside risks, the discussion focused on the agreed need for a fiscal and monetary policy mix that maintains macroeconomic stability. In particular, the authorities were keen to ensure that the current large fiscal surpluses were managed well to avoid inflationary pressures while still promoting growth. The monetary authorities emphasized their continued commitment to keeping inflation under control, notwithstanding expected additional price pressures. Given existing conditions, the staff and authorities agreed on the continued appropriateness of the current exchange rate level and regime. Against the background of the recent growth in the financial sector, the authorities further maintained their commitment to continue strengthening its supervisory and regulatory framework. The discussions also considered how structural reforms could capitalize on the current favorable domestic and external conditions to improve prospects for sustained higher nonmineral growth.

A. Fiscal Policy and Public Debt

9. Elements of the recent budgets are welcome; however, aspects of the underlying easing of the fiscal stance are a concern. The 2007 and 2008 budgets aimed to manage the temporarily large inflows of mineral revenue through a combination of higher development spending and debt repayment.

  • The one-off spending increases to meet priority infrastructure and social development needs aligned with the MTDS are appropriate. In addition, the staff welcomed the pre-payment of external debt and reduction in unfunded civil service pension liabilities. 5

  • However, staff cautioned about the potential scale of fiscal relaxation over the near term. A large amount of additional mineral revenue set aside in 2008 and earlier budgets is expected to be spent over 2008–12, which will result in the nonmineral deficit rising from 4.7 percent of GDP in 2005 to 8 percent by 2009. Given absorptive and implementation capacity constraints, the increased spending could add to domestic demand and price pressure, and lead to waste.

  • A large amount of spending has been allocated to projects outside the MTDS, of which the new spending directed to the provinces and districts raise particular concern, due to the lack of capacity to prioritize and deliver projects, weak financial controls, and near absence of reporting in local governments. 6

  • In addition, given the projected fall off in mineral revenue from 2008 onward, the new expenditure pattern raises the prospect of need for considerable and sustained fiscal consolidation over the medium term.

  • Consequently, the staff recommended containing the actual (cash) expenditure to more sustainable and stable levels, while ensuring that windfall mineral revenue is used for well-designed MTDS-prioritized development spending and debt reduction.

  • The authorities argued that high development needs and a legacy of under funding in the rural areas had driven the plans to increase spending for infrastructure in the provinces and districts. At the same time, they acknowledged the concerns raised and emphasized the intention to introduce new procedures that would improve oversight and strengthen subnational government capacity. As a result, the increase in spending to these areas would likely be phased over several years.

10. A new proposal to update the Medium-Term Fiscal Strategy (MTFS) appropriately emphasizes a stable and sustainable nonmineral fiscal balance (Box 3). The proposal builds on the existing strategy of overall budget balance and no new net debt accumulation by recommending using only “normal” mineral revenue for ongoing spending programs. Additional mineral revenue would be used for either public investment or debt reduction. The staff encouraged the authorities to formally approve this proposal to replace the current policy under the existing MTFS. It particularly welcomed the new emphasis on the nonmineral balance, as