Papua New Guinea
2008 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Papua New Guinea

This 2008 Article IV Consultation highlights that GDP per capita for Papua New Guinea remains low. An unattractive investment environment, primarily owing to weak infrastructure, problems with governance, and high crime curtails development. Executive Directors have commended the authorities for saving the bulk of recent windfall mineral revenues and repaying public debt to improve the external debt position. They have also acknowledged the authorities’ policy of slowing exchange rate depreciation to moderate inflationary pressures.

Abstract

This 2008 Article IV Consultation highlights that GDP per capita for Papua New Guinea remains low. An unattractive investment environment, primarily owing to weak infrastructure, problems with governance, and high crime curtails development. Executive Directors have commended the authorities for saving the bulk of recent windfall mineral revenues and repaying public debt to improve the external debt position. They have also acknowledged the authorities’ policy of slowing exchange rate depreciation to moderate inflationary pressures.

I. Macroeconomic Backdrop

A. Context

1. Macroeconomic performance has improved, but Papua New Guinea remains a poor country highly exposed to commodity price fluctuations. Buoyed by commodity export revenues, GDP growth performance has improved notably in the last several years. Until recently, inflation has remained low, thanks to favorable terms-of-trade and improved macroeconomic management. However, GDP per capita remains low and improvements in living standards have lagged other low-income countries in the region. An unattractive investment environment, due primarily to weak infrastructure, problems with governance, and high crime, constrains more rapid growth of the nonmineral sector. The economy remains highly vulnerable to swings in commodity prices owing to their importance in both export and public revenue.

Figure 1.
Figure 1.

Papua New Guinea: Macro Performance

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

Sources: Papua New Guinea authorities; and Fund staff calculations.

B. Current Economic Setting

2. Papua New Guinea experienced high growth and a pick-up in inflation in 2008. Real GDP grew by 6.5 percent in 2007, on the back of strong growth in the nonmineral sector (7.3 percent), especially in construction and communications. Leading indicators, including employment rates and retail sales, suggest that activity continued to expand rapidly in 2008. After remaining in the low single digits during 2004–07, CPI inflation accelerated in late-2007, reaching nearly 13.5 percent (y/y) in September 2008. Although this mainly reflects rising food and energy prices, there are some limited indicators of broad-based inflation pressures.

Figure 2.
Figure 2.

Papua New Guinea: Prolonged Expansion Driven by Favorable Terms of Trade

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

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

3. The fiscal position had strengthened until recently. In the last few years, the fiscal balance has consistently overperformed, with the mineral windfall largely saved and public debt reduced. However, reliance on mineral revenue has increased and the nonmineral deficit has remained high. For 2008, the estimated fiscal surplus is 4.5 percent of GDP, down from 8 percent in 2007. The projected narrowing of the fiscal surplus in 2008 reflected a large drop in mineral revenues, which more than offset lower-than-expected development expenditure. The 2009 budget balance envisages a reversal, turning from surplus into deficit given the expected drop in mineral revenues and higher planned expenditure.

Figure 3.
Figure 3.

Papua New Guinea: Fiscal Performance Has Strengthened Until 2008

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

Sources: Papua New Guinea authorities; and Fund staff calculations.

4. The policy interest rate was increased during the second half of the year, but monetary conditions remain accommodative. Since June 2008, the policy rate was increased four times by a total of 200 basis points, to its current rate of 8 percent. However, high inflation has reduced real lending rates. Despite some sterilization, the large increase in foreign reserves through August contributed to an easing in credit conditions. Credit growth accelerated to 41 percent (y/y) in December 2008 from 34 percent (y/y) at end-2007.

Figure 4.
Figure 4.

Papua New Guinea: The Monetary Stance Remains Accomodative

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

Sources: Bank of Papua New Guinea; International Financial Statistics, and Fund staff calculations.

5. To date, spillovers from the global financial market turmoil have been limited. Banks are very liquid and largely isolated from international capital markets (Box 1). The stock market has weakened since June, in line with other stock markets in the region.

The Global Financial Turmoil: The Impact on Papua New Guinea1

The exposure of Papua New Guinea’s financial sector to global financial markets is minimal and spillovers from the current turmoil have so far been limited. Total financial sector assets represent roughly 85 percent of GDP, with commercial banks dominating the sector. Three large banks hold about 70 percent of total financial sector assets. The nationally owned Bank of South Pacific is the largest, holding 50 percent of bank assets.

uA01fig01

Financial Sector Assets

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

Sources: Bank of Papua New Guinea; and Fund staff calculations.
uA01fig02

Banking Sector Assets, November 2008

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

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

Banks are not vulnerable to international credit markets developments as their balance sheets are funded primarily by domestic currency deposits and are highly liquid. Deposits comprise approximately 80 percent of bank liabilities, with foreign currency deposits representing about 10 percent. About 60 percent of total banking sector assets are liquid. Lending, which represent 35 percent of bank assets, is directed primarily to the business sector. While only 1.3 percent of loans are currently classified as non-performing, banks maintain high provisioning against default.

uA01fig03

Bank Liabilities, November 2008

(In millions of kina)

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

Sources: Bank of Papua New Guinea; Bloomberg; and Fund staff calculations.
uA01fig04

Bank Assets, November 2008

(In millions of kina)

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

Sources: Bank of Papua New Guinea; Bloomberg; and Fund staff calculations.

The foreign currency deposits most vulnerable to withdrawal from Papua New Guinea amount to 5 percent of bank assets and are held by the two Australian subsidiaries. Although no guarantee is provided on these deposits, by either the domestic or Australian authorities, there has been no shift of these deposits toward the parent banks that now enjoy a full deposit guarantee in Australia.

Spillovers from international markets have been observed in the equity market. As of end-2008, the Kina Securities Index was about 40 percent below its peak in June, a similar decline witnessed in most other equity markets around the world.

uA01fig05

Stock Market Index

(2001=100)

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

Source: International Financial Statistics.
1Selected Issues Paper “The Global Financial Turmoil: The Impact on Papua New Guinea’s Financial Sector.”

6. Until recently, effective exchange rates have remained stable, but commodity price vulnerability lingers. Both the real and nominal effective exchange rates have been stable since 2003 through mid-August 2008, while improved terms-of-trade delivered a sequence of current account surpluses. Preliminary data up to the third quarter of 2008 suggest that the current account surplus widened further, propelled by the global commodity boom, although this trend may have been reversed during the last quarter of the year with the decline in commodity export prices. Current account surpluses reduced external debt to about 27 percent of GDP at end-2008. Official foreign exchange reserves rose to US$2.7 billion in early August, reflecting large commodity-price-related revenue inflows. In the second half of 2008, reserves were drawn down to about US$2 billion resisting depreciation pressures in the kina/U.S. dollar rate owing to falling commodity prices. Consequently, the real effective exchange rate has appreciated since August, primarily because of the depreciation in the Australian dollar against the U.S. dollar.

Figure 5.
Figure 5.

Papua New Guinea: The External Position Has Strengthened

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

Sources: Bank of Papua New Guinea; Bloomberg; and Fund staff calculations.

II. Policy Discussions

7. In the near-term, the challenge is to cope with a rapidly deteriorating external environment while ensuring that the accumulated mineral windfall is used effectively to support sustainable growth. In the medium term, the priority is to strengthen the private nonmineral sector to help close the development gap with regional peers and reduce external vulnerability. Accordingly, discussions focused on:

  • managing the accumulated fiscal surpluses ensuring that the mineral windfall is directed toward achieving more broad-based growth;

  • guarding against persistently high inflation; and

  • assessing financial sector stability.

A. Outlook

8. In line with global developments, staff and the authorities agreed that activity is slowing. Staff project growth to ease to under 4 percent in 2009 from an estimated 7 percent in 2008, with a slowdown in both the nonmineral and minerals sectors. The authorities were slightly more optimistic, expecting the positive sentiment associated with the prospective LNG project (Box 4) to stimulate the nonmineral sector through higher investment.1 Staff expect inflation to ease quickly, as commodity-price declines feed through. The Bank of Papua New Guinea (BPNG) officials noted that domestic price pressures may add some persistence, despite declining food and energy prices, given the boost to confidence from the LNG project and increased public spending envisaged in the 2009 budget.2

Papua New Guinea: Macroeconomic Framework, 2008–13

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Sources: Papua New Guinea authorities; and Fund staff projections.

9. There was broad agreement that downside risks dominate, albeit with some mitigating factors. Given the risk of further deterioration in the global economy, the outlook remains highly vulnerable to additional weakening in the terms of trade and further softening in external demand. On the upside, expectations that the LNG project will move forward may have a larger-than-expected positive impact on domestic demand.

B. Fiscal Policy—Managing Mineral Wealth

10. Staff commended the authorities for adopting the Medium-Term Fiscal Strategy (MTFS) (Box 2). The framework reduces the exposure of the budget to the volatility of mineral revenues with a rule constraining the nonmineral deficit to be no more than 8 percent of GDP. The ongoing-spending nonmineral deficit cannot exceed 4 percent of GDP—the assessed structural ratio of mineral revenue to GDP. However, the strategy also allows for additional public investment of up to 4 percent of GDP from accumulated past surpluses, provided it is directed toward achieving Medium-Term Development Strategy (MTDS) goals.

The New Medium-Term Fiscal Strategy

In July 2008, the Government approved a new MTFS for the period 2008–12. Under this strategy, the nonmineral fiscal deficit is constrained to fall within a range of 4 to 8 percent of GDP. This range has been chosen based on the following principles:

  • Ongoing spending (including recurrent and development spending) should be kept in line with “normal revenues”. Normal revenues are defined as the sum of nonmineral revenues and normal mineral revenues—the mineral revenues that would be expected without a commodity-price boom, about 4 percent of GDP. Ongoing spending is limited to the sum of normal mineral revenues and nonmineral revenues.

  • Mineral revenues above 4 percent of GDP should be used for “one-off” expenditures, debt reduction (30 percent) and additional public investment (70 percent). Amounts not used for debt reduction accumulate in trust accounts to be drawn down over time. In any year, no more that 4 percent of GDP can be spent from the trust accounts on additional public investment.

The estimate of normal mineral revenues is based on the average from the pre-boom years of 1999–2003 and the expected performance in 2010–12 based on planned production and IMF commodity price forecasts. Every two years, the government will reassess the appropriateness of the 4 percent of GDP estimate of normal mineral revenues.

11. The new MTFS will significantly strengthen the fiscal framework, but staff emphasized that it would benefit from some fine tuning. The framework still contains the potential for procyclicality by allowing greater investment spending in the event of more buoyant mineral revenues. To reduce the risk of procyclicality, staff advised that the cyclical position of the economy be used explicitly to determine the amount of excess mineral revenue to be spent each year. The authorities saw merit in this recommendation.

12. On the 2009 budget, staff agreed that some fiscal loosening was appropriate given the external environment, but expressed concerns about the magnitude (Box 3). Provided inflation eases as expected and spare capacity is available, cyclical conditions could accommodate increased public investment expenditure. Although the magnitude of the 2009 deficit is expected to fall within MTFS limits, the fiscal stance will be too expansionary given the cyclical position of the economy and aiming for a balanced budget on staff’s definition would be more prudent. Further, given the revenue outlook, the level of public spending in the budget cannot be maintained without undermining debt sustainability.

The 2009 Budget

The 2009 fiscal stance is expansionary. The fiscal balance is expected to deteriorate to -2 percent of GDP from an expected surplus of 4.5 percent of GDP in 2008, reflecting a large drop in mineral revenues and higher expenditure.

The budget may underestimate the increase in expenditure:1

  • First, District Service Improvement Program (DSIP) expenditure may turn out to be higher. The 2009 budget allocates 356 million kina (1.8 percent of GDP) to be directed to districts and provinces and financed with accumulated surpluses held in trust accounts. This is in addition to the 890 million kina (4.2 percent of GDP) allocated in the 2007–08 budgets to the DSIP, of which only 0.2 percent of GDP had been spent as of end-September 2008. Given the recent easing of the constraints on spending from DSIP trust accounts (i.e., removal of restrictions on type and timing of expenditures), the total envelope to be spent under the DSIP could amount to 6 percent of GDP in 2009.

  • Second, the budget does not factor in the increase in the minimum wage introduced in February. The total increase in the minimum wage is 170 percent. It will be phased in over 40 weeks, starting mid-February through mid-October.

Summary of Central Government Operations

(In percent of GDP)

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Sources: PNG authorities and Fund staff projections and estimates.

The 2009 budget records as revenue $600 million kina previously accumulated in trust accounts. Under the IMF presentation, this amount is recorded as positive financing.

District Service Improvement Program.

Additional priority spending.

Stock.

1Staff projections on expenditure for the 2009 are based on historical underspending in development due to implementation constraints.

13. Staff noted that the use of trust funds in the 2009 budget was not fully consistent with the MTFS and questioned the efficacy of some planned public spending. A portion of the allocation of spending to provinces and districts will be financed with accumulated windfall revenue. Because there are no mechanisms to ensure that these resources will be directed toward public investment in MTDS priority areas, this is inconsistent with the MTFS. Given the outlook for commodity prices and thus the limited prospects for additional windfall revenues in the coming years, staff stressed the importance of safeguarding the accumulated revenues and using them effectively to achieve development needs. Additionally, the lack of capacity to prioritize and manage projects, and the near absence of reporting and accountability in local governments raises concerns about the efficiency of such spending.

14. The authorities were mindful about the importance of maintaining medium-term sustainability, but pointed to political pressures to spend. In particular, the country’s acute development needs alongside the large accumulated trust funds have generated demands to visibly increase spending at the local level, hence the increase in District Service Improvement Program (DSIP) spending. However, given the outlook for mineral revenues both in the short and the medium term, they acknowledged the risk to fiscal sustainability, particularly in light of the DSA analysis presented by staff.

15. Staff advised that continued tax reform would help reduce budgetary dependence on mineral revenues. Strengthening tax administration and rationalizing corporate tax incentives would improve nonmineral revenue buoyancy and efficiency. A number of tax concessions have been granted in the past in many sectors resulting in a growing list of ad hoc concessions that undermine the tax base. The authorities stressed that incentives were necessary to stimulate growth, but committed to maintain the current tax base. In the future, granting tax concessions on an ad hoc basis will be avoided and future tax concessions will only be granted under the existing laws.

16. Discussions also focused on the implications for the medium-term fiscal position of the planned public investment in the LNG project (Box 4). The mission advised that budget plans be cautious because the government’s financial obligations associated with the project could put pressure on the country’s debt position. Also, the mission emphasized the importance of channeling the dividends from the public’s equity stake in the project through the budget to ensure that they are directed toward addressing development needs.

GDP Impact of the LNG Project

The peak impact of the LNG project is estimated to be an increase of 25 to 30 percent in GDP. Production is expected to commence in late 2013, with a maximum capacity of about 60 million barrels of oil equivalent. The 30-year project is estimated to increase GDP, through both direct and indirect channels, by about 15 to 20 percent. The impact during the 5-year construction phase will be relatively small. Accounting for the substantial income outflows, the project is expected to increase annual GNI by about 9 percent.

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Source: PNG Treasury.

mboe: million barrel of oil equivalent.

C. Monetary Policy—Guarding Against Persistently High Inflation

17. Staff noted that the current monetary stance was appropriate, but underlined the need for monetary policy to react quickly to changing circumstances. Although imported inflation will fall rapidly given declining commodity prices, policy needs to ensure that domestic pressures do not keep inflation too high. In particular, the fiscal stimulus in the pipeline for 2009 and still rapid credit growth may fuel nontradables inflation going forward. With real lending rates expected to rise as headline inflation declines, staff advised the central bank to keep its policy rate on hold until there is more certainty about how domestic inflation pressures will evolve. However, with risks to inflation assessed as lying on the downside, staff stressed that the central bank should be prepared to loosen quickly if leading indicators suggest that domestic demand will slow sharply or the inflation outlook improves.

18. The authorities agreed broadly with this assessment, although they considered it unlikely that they would need to loosen monetary policy in the near term. They noted that domestic capacity is stretched and confidence has been supported by increased certainty that the LNG project will proceed. In the absence of official data on property prices, they pointed to anecdotal evidence of rapidly rising real estate prices as an indicator of the extent of domestic demand pressures. Furthermore, they noted that the magnitude of the planned fiscal easing and the increase in the minimum wage had the potential to impart significant domestic inflation pressure.

19. Staff supported the transfer of part of the government’s trust accounts from private banks to the BPNG, and encouraged the quick transfer of the remaining accounts. Private sector credit growth, fueled by strong expansion in deposits, has added to domestic demand and further strained available resources. Staff reasoned that moving the public trust accounts to the BPNG was a cost-effective means of reducing liquidity and easing credit growth.3 The authorities agreed and noted that negotiations to transfer the remaining trust accounts were ongoing.

D. Financial Sector—Coping with the Financial Turmoil

20. There was agreement that the financial sector is insulated from the direct effects of the global financial market turmoil. With banks funded primarily via domestic deposits, the tight conditions in international capital markets are not affecting their liquidity.

21. Staff and the authorities saw asset quality as the greatest risk to financial stability. With export incomes expected to decline sharply owing to falling commodity prices, concerns about debt-servicing capabilities have risen, particularly in light of the rapid pace of credit growth over the last few years. It was noted that credit expansion has been largely to banks’ long-term customers, somewhat mitigating these concerns. The authorities noted that the downturn could slow credit growth as both credit demand and deposit growth ease. They also reported progress on credit monitoring, including the establishment of the credit and data bureau that provides data to inform credit decisions. Regarding staff’s concerns that the recent revival of the Development Bank could see funds directed by political interests generating hidden fiscal liabilities, the authorities noted that the Development Bank has remained both small and profitable.

22. To date, the superannuation funds have weathered the turmoil well. Despite significant holdings of mining, oil, and other equities that have dropped substantially in value, these funds were still expecting positive returns in 2008. This reflects continued strong performance of other domestic investments, particularly real estate.

23. Staff reiterated that the level of financial intermediation remains very low relative to peers—a constraint on private nonmineral sector growth. Credit to the private sector represents less than 20 percent of GDP, largely due to structural rigidities, including weak enforcement of contracts and credit rights. The authorities concurred and hoped that the Financial Sector Assessment Program (FSAP), tentatively scheduled for late-2009, would provide impetus for reform. They also confirmed their willingness to undertake a self-assessment of the financial sector prior to the FSAP.

E. Assessing the Equilibrium Real Exchange Rate and External Stability

24. In line with the recent deterioration in the terms of trade, staff estimates suggest mild overvaluation of the kina (Box 5). The mission encouraged the authorities to continue to shift toward greater exchange rate flexibility. Allowing the currency to adjust in response to the sharp decline in commodity prices would help offset the impact on export incomes and safeguard foreign reserves. The authorities acknowledged the benefits of allowing the exchange rate to adjust given the decline in commodities prices. However, they noted that given the extraordinary global volatility and high domestic inflation, slowing exchange rate adjustment was key to anchoring inflation expectations.

25. External debt has decreased, but negative terms-of-trade shocks and uncertainties about other liabilities raise concerns about long-term fiscal sustainability. Large current account surpluses in recent years and the early repayment of debt have resulted in a significant improvement in the external debt position. External debt declined to about 27 percent of GDP in 2008. The debt sustainability analysis suggests that the risk of debt distress is moderate (Appendix 1).4 However, the scale of broader public-sector obligations (i.e., borrowing and guarantees associated with the LNG project, the large unfunded pension liability, the uncertain magnitudes of state-owned-enterprise debt, and the government’s commitments under the memorandum of agreement with landowners) combined with vulnerability to deteriorations in the terms of trade suggests that highly unfavorable debt dynamics could arise.

Equilibrium Real Exchange Rate1

Staff estimates points to evidence of mild overvaluation. According to the macro balance (MB) estimates the kina is broadly in line with fundamentals.2 The medium-term estimate of overvaluation implied by the equilibrium real exchange rate (ERER) approach is 16 percent. The decomposition of the point estimates into time-varying contributions of the explanatory variables points to demographic factors and trade oil surpluses as the main determinants of the equilibrium current account under the MB approach, while the change in the terms of trade is the key factor in determining the equilibrium exchange rate.

Exchange Rate Assessment: Baseline Results 1/

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Source: Fund staff estimates.

All results are expressed in percent.

Staff projection of the underlying CA/GDP in 2013.

Based on a semi-elasticity of the CA/GDP with respect to the REER of -0.40.

Overvaluation is assessed relative to January 2009.

uA01fig06

MB Approach: Contributions to CA/GDP Norm

(In percent)

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

uA01fig07

ERER Approach: Baseline Scenario

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

uA01fig08

ERER Approach: Contributions to Equilibrium REER

(Log scale)

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

1Selected Issues Paper “Determinants of Current Account and Exchange Rate Assessment for Papua New Guinea.”2Given the amount of statistical uncertainty, the overvaluation of 3 percent under the MB approach is not significantly different from zero.

F. Fostering Sustainable, Broad-Based Growth

26. The implementation of structural reforms has slowed. The Medium-Term Development Strategy (MTDS), spanning 2005–10, has correctly recognized the need to shift the sources of growth toward the private nonmineral sector. The strategy stresses the importance of increasing exports of nonminerals and manufactures. The required improvements that will enable Papua New Guinea to catch up with its peers include addressing a weak transportation system, encouraging private micro-credit facilities, improving basic utilities such as power and telecommunications services, increasing human capital, and reducing crime. However, decisive actions have been lacking, with the exception of the communication sector. The government plans to undertake a review of the development strategy in late 2009. The extraordinary improvements in communication services, following the introduction of competition in the cellular phone market, illustrate the benefits of continued reform.

uA01fig09

Share of Nominal GDP, 2007

Citation: IMF Staff Country Reports 2009, 112; 10.5089/9781451831764.002.A001

Source: PNG Treasury.

27. The authorities agreed with this assessment. They noted that the political commitment toward accelerating these reforms has been minimal because focus has been almost entirely directed toward the LNG project.

28. Staff underscored that the prospective LNG project could provide a permanent boost to GDP growth, provided the resulting revenues and dividends were directed toward addressing development needs. The mineral sector operates as an “enclave” with limited direct spillovers to other sectors. The key linkage to the nonmineral sector of the economy is via revenues to the public budget. Therefore, while it is crucial to directly encourage private activity in the nonmineral industries, nonmineral sector growth will continue to be influenced by growth in the mineral sector and the effective use of the resulting public resources. If the LNG project goes forward, it will result in a large, one-time increase in the level of GDP once production commences. Without significant progress on the reform front, GDP growth will revert to trend in the following years. To permanently raise long-term growth in the nonmineral sector, the resulting revenues and public ownership proceeds must be channeled through the budget and directed toward effectively addressing development needs.

29. The mission stressed that notable improvements to public service delivery and the private investment climate were central to addressing developments needs. Enforcing contracts, dealing with licenses, and obtaining credit are relatively more cumbersome compared to other countries in the region, according to the World Bank ease-of-doing-business database. Further, security issues continue to be a significant barrier to private sector activity.

G. Other Issues

30. There has been only limited progress on improving the quality and timeliness of macroeconomic data. The authorities reported that the department of National Planning and Monitoring, currently responsible for the National Statistic Office (NSO), has been unwilling to transfer the compilation and dissemination of economic statistics from the NSO to the BPNG, as advised by the December 2007 STA mission. Staff reiterated that intensive efforts are needed to address shortcomings in the quality and timeliness of the macroeconomic data. The authorities agreed, but offered no indication of when or how the impasse might be resolved.

III. Staff Appraisal

31. Papua New Guinea was in a relatively favorable position at the onset of the global financial crisis. Windfall mineral revenues had been largely saved. Large current account surpluses and the early repayment of public debt had improved the external debt position. Exchange rate flexibility had increased and the banking system had only limited exposure to global financial markets.

32. Yet, the deterioration in international economic conditions is having an impact, albeit milder than in many other countries. The global slowdown is taking its toll mainly through lower export revenues, owing to the collapse in commodity prices, worsening both domestic and external balances. However, despite the highly synchronized nature of the global downturn, some idiosyncratic factors such as the prospective LNG project and the relative insulation of the banks from global financial markets are buffering the impact on Papua New Guinea.

33. The monetary stance is appropriate, but caution is needed moving ahead. Despite the decline in food and energy prices, there are risks that domestic price pressures could prevent a rapid decline in inflation. However, with the balance of risks to inflation on the downside because of the deteriorating external environment, the central bank should be prepared to loosen quickly if a larger-than expected negative domestic impact materializes.

34. The new Medium-Term Fiscal Strategy, if fully implemented, will help maintain macroeconomic stability. Insulating recurrent spending from abnormal fluctuations in mineral revenues will facilitate both public and private planning and help guard against procyclical fiscal policy. However, macroeconomic stability would be enhanced if the monetary and fiscal authorities cooperated to ensure that the cyclical position of the economy determined the magnitude of annual spending from trust accounts.

35. A looser fiscal policy seems warranted in 2009, but concerns remain about the magnitude and the quality of spending. Although inflation is forecast to moderate over 2009, capacity pressures could still keep it uncomfortably high. Therefore, to ensure that public demand does not stimulate inflation, it would be prudent to reduce public spending in 2009 so as to achieve a balanced budget by staff definition. In addition, should the planned level of expenditure be maintained over the medium term, fiscal sustainability will be threatened. Moreover, with acute capacity constraints and almost no oversight or accountability mechanism in place, the expected increase in spending at the district level raises concern about achieving appropriate value for money.

36. More discipline is needed in spending the mineral windfall accumulated over the last few years. The windfall should be safeguarded and directed toward achieving the Medium-Term Development Strategy objectives and be available to support growth should the impact of the global slowdown be larger than expected.

37. Indicators suggest that the currency is mildly overvalued. Given the sharp decline in commodity prices, the currency should be allowed to adjust to help offset the impact on export incomes. This policy would also help to safeguard foreign currency reserves.

38. The financial sector has been relatively immune to the global financial crisis. With banks funded primarily via domestic deposits, the tight conditions in international capital markets are not affecting their liquidity. However, the impact of declining commodity prices on export incomes could stress debt-servicing capabilities, driving up nonperforming loans. Therefore, banks should maintain strict lending standards and monitor borrowers’ servicing abilities carefully.

39. The pace of structural reform must accelerate. To make meaningful progress toward achieving development objectives, the public-sector reform program on health, education, and law and order needs to be reinvigorated. Complete transparency of the financial conditions of state-owned enterprises and full transfer of their returns to general government revenue will be necessary to ensure that the government has the resources to implement the reform agenda. If the LNG project proceeds, to permanently raise long-term growth in the nonmineral sector, the resulting revenues and public ownership proceeds must be channeled through the budget and directed toward effectively addressing development needs.

40. Macroeconomic data needs to improve. The government must press ahead with Fund recommendations on the compilation and dissemination of economic data as they form the cornerstone for sound macroeconomic policy.

41. Staff recommends the next Article IV consultation be on the standard 12-month cycle.

Table 1.

Papua New Guinea: Selected Economic Indicators, 2005–09

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

Measured from above the line in the fiscal accounts.

Measured from below the line in the fiscal accounts.

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

Table 2.

Papua New Guinea: Balance of Payments, 2007–13

(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.

Table 3.

Papua New Guinea: Medium-Term Scenario, 2007–13

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

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

Includes changes in check float.

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

January 2009 WEO projection.

Table 4.

Papua New Guinea: Summary Accounts of the Banking System, 2005–09

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

Papua New Guinea: Summary of Central Government Operations, 2007–09

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Sources: Data provided by the Papua New Guinea authorities; and Fund staff estimates and projections.
Table 6.

Papua New Guinea: Indicators of External Vulnerability, 2005–09

(In percent of GDP, unless otherwise indicated)

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

End of period.

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

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.

Table 7.

Papua New Guinea: Millennium Development Goals Progress, 1990–2007

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Source: World Development Indicators database, September 2008.