Papua New Guinea
2010 Article IV Consultation: Staff Report and Public Information Notice
Author:
International Monetary Fund
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Publication Date:
10 Jun 2010
eISBN:
9781455204649
Language:
English
Keywords:
ISCR; CR; article IV consultation; GDP; exchange rate; resource revenue; LNG revenue; windfall revenue; commodity export revenue; financing fund
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This 2010 Article IV Consultation highlights that real activity in Papua New Guinea was relatively unaffected by the global downturn, with growth easing to roughly 5 percent in 2009 from 7 percent in 2008. A number of factors contributed to this favorable outcome. The country’s financial sector was insulated from the turmoil in global capital markets and domestic credit continued to grow, albeit at a slower pace than in the preceding few years. Export demand also held up, as stimulus measures in other Asian countries supported demand for commodities, the country’s main export.

Abstract

This 2010 Article IV Consultation highlights that real activity in Papua New Guinea was relatively unaffected by the global downturn, with growth easing to roughly 5 percent in 2009 from 7 percent in 2008. A number of factors contributed to this favorable outcome. The country’s financial sector was insulated from the turmoil in global capital markets and domestic credit continued to grow, albeit at a slower pace than in the preceding few years. Export demand also held up, as stimulus measures in other Asian countries supported demand for commodities, the country’s main export.

I. Macroeconomic Backdrop

A. Context

1. The global financial crisis had only a mild impact on Papua New Guinea, but improving living standards remains a challenge. Prior to the global downturn, moderate economic growth was generated by buoyant commodity export revenues and effective macroeconomic policy implementation. During the downturn, growth in Papua New Guinea was supported by an insulated financial sector, still strong terms of trade, and a sound fiscal position that allowed for an increase in public expenditure. However, GDP per capita remains low and improvements in living standards have lagged those in other regional low-income countries. The challenge is to improve the environment for nonmineral-sector investment which remains unattractive due to high crime and weak infrastructure and governance. LNG revenue will provide an opportunity to address long-term challenges and significantly raise living standards; however, unless managed properly it will also raise the economy’s vulnerability to swings in commodity prices.

Figure 1.
Figure 1.

Papua New Guinea: Macro Performance

Citation: IMF Staff Country Reports 2010, 164; 10.5089/9781455204649.002.A001

Sources: Bank of Papua New Guinea; International Financial Statistics, World Economic Outlook; and IMF staff calculations.

B. Current Economic Setting

2. Growth eased modestly and inflation fell in 2009. After expanding by almost 7 percent in 2008, GDP is estimated to have grown by just under 5 percent in 2009. While the mineral sector contracted slightly due to production delays and depletion of oil reserves, nonmineral sector growth remained buoyant. Continued expansion in domestic credit, still strong export incomes (as export demand held up relatively well), an increase in public expenditure, and the positive confidence effects of the LNG projects all helped support domestic demand. After peaking above 13 percent in the third quarter of 2008, CPI inflation fell steadily to under 6 percent at end-2009. The improved inflation performance primarily reflects moderation in food price inflation and a decline in energy prices. However, non-tradable inflation pressures appear to have intensified.

Figure 2.
Figure 2.

Papua New Guinea: Growth and Inflation

Citation: IMF Staff Country Reports 2010, 164; 10.5089/9781455204649.002.A001

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

3. Following several years of surpluses, the fiscal balance shifted into a large deficit in 2009. During the period of rising commodity prices, windfall revenues were largely saved and public debt reduced. In addition to funding debt reduction, windfall revenues were also accumulated in public trust accounts to address development needs. In 2008, the government relaxed constraints on trust account spending and spending from trusts exploded in 2009. Trust spending was the main factor shifting the fiscal balance from a surplus of 2.5 percent of GDP in 2008 to a deficit of almost 8 percent of GDP in 2009. The result was a fiscal impulse of almost 13 percent of GDP.

Figure 3.
Figure 3.

Papua New Guinea: Fiscal Performance

Citation: IMF Staff Country Reports 2010, 164; 10.5089/9781455204649.002.A001

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

4. The tight monetary policy stance in place since mid-2008 was eased slightly at end-2009. The run-up in inflation over the course of 2008 prompted an increase in the policy rate from 6 to 8 percent. In addition, the Bank of Papua New Guinea (BPNG) relied heavily on bank bills to contain banking system liquidity, which expanded partly because of government trust account. Both the BPNG’s liquidity control measures and declining inflation contributed to a rise in real bank lending rates in late-2008 and 2009. Consequently, credit growth eased from the high rates posted in 2007 and 2008. The BPNG lowered the policy rate by 100 basis points in December 2009.

Figure 4.
Figure 4.

Papua New Guinea: The Monetary Stance

Citation: IMF Staff Country Reports 2010, 164; 10.5089/9781455204649.002.A001

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

5. The financial sector has been a source of strength. The three large banks are primarily deposit funded with no significant links to global capital markets. Balance sheets are liquid with most lending going to the business sector. Although non-performing loans rose to 0.8 percent of total assets from a trough of 0.4 percent, provisioning is high and banks remain profitable. The other major financial institutions, pension funds, are also performing well, although profitability has suffered given lower returns from some investments.

Figure 5.
Figure 5.

Papua New Guinea: The Banking Sector

Citation: IMF Staff Country Reports 2010, 164; 10.5089/9781455204649.002.A001

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

6. Although volatile during the period of global market instability, effective exchange rates have returned close to averages over the previous 5 years. Prior to the global crisis, exchange rate stability and rising commodity prices delivered a sequence of current account surpluses and declines in external debt. However, owing partly to lower commodity prices, the current account shifted into deficit in 2009. After appreciating in 2008, primarily against the Australian dollar, the currency depreciated by 12 percent in nominal effective terms in 2009. This depreciation was the main factor driving the small increase in external debt to 27 percent of GDP at end-2009. Reserves, which declined slightly over the last half of 2008, were rebuilt during 2009 and now cover almost 12 months of non-mining imports. Foreign direct investment inflows, associated with ongoing mineral sector projects, provided foreign currency to bolster reserve accumulation.

Figure 6.
Figure 6.

Papua New Guinea: The External Position

Citation: IMF Staff Country Reports 2010, 164; 10.5089/9781455204649.002.A001

Sources: Bank of Papua New Guinea; Bloomberg; Information Notice System; and IMF staff calculations.

The Impact of the Financial Crisis on PNG Relative to Other Pacific Island Countries1

uA01bx1fig01
Source: IMF APDLISC database.

In contrast to many other pacific island countries (PICS), growth in PNG held up relatively well during the global crisis. This was partly due to the financial sector’s insulation from global capital markets, which allowed credit growth to continue. Also, demand for PNG’s exports remained quite strong as PNG relies less heavily on remittances and tourism income than other PICs, which were significantly impacted by the crisis. Furthermore, domestic demand was supported by the confidence effects from the proposed LNG projects and increased public expenditure enabled by the prudent fiscal policies of the preceding years. However, the associated decline in commodity prices took its toll on the external and fiscal positions of the resource rich economy.

uA01bx1fig02
Source: APDLISC database.
uA01bx1fig03
Source: IMF APDLISC database.
uA01bx1fig04
Source: IMF APDLISC database.
uA01bx1fig05
Source: IMF APDLISC database.
1 See accompanying Selected Issues Paper, Chapter II.

II. Policy Discussions

7. The near-term challenge will be to maintain macroeconomic stability during the construction phase of the LNG projects. In the medium term, the priority is to ensure that windfall revenues from exhaustible resources are used effectively to raise living standards, while reducing the economy’s vulnerability to commodity price drops. Accordingly, discussion focused on:

  • guarding against a resurgence in high inflation;

  • strengthening the implementation of the fiscal strategy; and

  • incorporating a sovereign wealth fund into the macroeconomic framework.

A. Outlook—Expansion with Upside Risks

8. There was agreement that growth and inflation would accelerate. Both staff and the authorities saw GDP growth rebounding to roughly 8 percent in 2010. Continued buoyant commodity export demand and the LNG construction phase are expected to stimulate growth and strain domestic capacity. Domestic demand pressures combined with the recovery in international commodity prices and the depreciation of the kina against the Australian dollar in 2009 were seen to fuel a pickup in inflation in 2010. Although, growth was expected to slow somewhat in 2011 this was largely due to resource depletion and domestic capacity in the nonmineral sector was expected to remain strained. Given this, staff saw a greater risk than the authorities that high inflation could become entrenched in expectations. Although the current account deficit was forecast to widen over the next few years with LNG related imports, it was expected to be financed with foreign direct investment.

9. Staff and the authorities saw risks skewed to the upside. Although a weaker than expected recovery in the world economy presented some downside risk, overall the risks were seen as tilted to the upside on both activity and inflation. It was recognized that the direct and indirect impacts from the LNG construction phase could be larger than expected and public spending, particularly from trust accounts held outside the budget, could add more demand and inflation pressures than forecast in 2010.

B. Fiscal Policy—Strengthening Implementation

10. Staff commended the authorities for the period of adherence to the Medium-Term Fiscal Strategy (MTFS), but raised concerns about the slippages in 2009. During the commodity price boom, adherence to the MTFS (Box 2) resulted in fiscal surpluses, declining public debt, and the accumulation of public resources in trust accounts. However, in 2009, roughly 8 percent of GDP was spent from trust accounts, twice the amount allowed under the MTFS. Staff stressed that adherence to the MTFS was required to provide a credible fiscal anchor, maintain macroeconomic stability, and ensure that development objectives were achieved. The authorities indicated that trust account spending in 2009 exceeded their expectation. While acknowledging that a relaxation of constraints on trust spending was a factor, they noted that the international endorsement of fiscal stimulus encouraged Ministers to accelerate trust spending. The authorities did point out that at least the spending was from accumulated savings and not debt financed.

The Medium-Term Fiscal Strategy

In July 2008, the Government approved a 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. Staff endorsed the 2010 Budget target of balance, but raised a number of concerns. Targeting a balanced budget and thereby withdrawing the large stimulus in place in 2009 was acknowledged as appropriate. However, staff noted that additional spending was likely from trust accounts held outside the budget. Staff’s projection, which forecasts some under spending from the development budget but assumes that half of the remaining trust fund balances are spent in 2010, contains a fiscal deficit of roughly 1 percent of GDP. Consequently, staff discussed the possibility of delaying some planned infrastructure spending. Staff reasoned that public infrastructure spending could butt up against capacity constraints, drive up prices, and yield poor value. Domestic capacity will be largely exhausted by the LNG projects and construction sector capacity is unlikely to be forthcoming from Australia because it is being absorbed by the demands from the resource sector and public infrastructure projects. The authorities stressed that achieving Ministers’ agreement on a balanced budget for 2010 had been an enormous challenge. However, they noted that a large portion of the spending increase was in the development budget where there was flexibility for delay and they would consider staff’s suggestion. Staff also noted that the 2010 Budget undermined fiscal credibility by directing all above-normal mineral revenue to public investment (according to the MTFS, 30 percent should have been for debt reduction) and failing to fully fund the government’s pension obligations as legislated.

12. Discussion of mechanism to strengthen the implementation of the MTFS yielded few tangible suggestions. Staff suggested that the authorities consider mechanisms used in other countries, such as including MTFS rules in the Fiscal Responsibility Legislation or compelling the Treasurer to explain to Parliament why budgets deviated from the MTFS, to strengthen implementation. The authorities were not convinced that such mechanisms would be effective. There was general agreement that there needed to be an underlying political will to build a reputation for maintaining a credible fiscal framework. The authorities lamented the absence of an informed public debate which meant that reputation effects could provide little incentive for Ministers to adhere to the MTFS.

13. There was agreement that public liability risks would increase during the LNG construction phase. The government has taken on significant liabilities associated with the landowner agreements that have not yet been funded and landowner demands could increase.1 Because the government has taken on a completion guarantee for one of the projects, it has an incentive to meet landowner demands. As a buffer against these liabilities, staff suggested that public savings should increase. Given uncertainty regarding commodity prices and production, staff recommended that when the MTFS normal mineral revenue assumption came up for review this year, that it be reduced to 3 percent of GDP from 4 percent. This would reduce the nonmineral deficit, related to ongoing-spending, to 3 percent of GDP, a level that staff sees as sustainable until LNG project revenues are realized. This would reduce the overall fiscal spending envelope, which would help ease demand pressures at a time when private spending is expected to be strong. The increased savings could then be used to address LNG related liabilities. The authorities indicated that the suggestion would be considered.

14. There was considerable discussion of a Sovereign Wealth Fund (SWF) to augment the macro framework to help manage resource revenue. With the LNG projects expected to eventually deliver a large increase in public revenue, the authorities were interested in the advantages of establishing an SWF. Staff provided an assessment of what type of SWF would best address their needs (Box 3). Staff agreed to work closely with a joint Treasury/BPNG working group tasked with preparing an SWF proposal for the National Executive Council by end-June 2010. Staff noted that an SWF properly incorporated into their framework would provide a more effective vehicle for saving windfall resource revenue than the current practice of using trust accounts and that they need not wait for LNG revenue to establish one.

Lessons from International Experience with SWFS1

Natural resource revenues pose macroeconomic management challenges. In particular, the new LNG projects will bring substantial windfall revenues, which are volatile, uncertain, exhaustible, and could lead to Dutch disease. Consequently, smoothing government expenditure and decoupling it from the short-term volatility of natural resource revenues is a challenge. Against this background, PNG may find it helpful to incorporate an SWF within a sound fiscal policy framework.

A financing fund, featuring both stabilization and saving objectives, would serve best. A financing fund would be directly linked to the budget’s non-mineral deficit and integrated within the budget process, providing an explicit and transparent link between fiscal policy and asset accumulation. Extrabudgetary spending, revenue earmarking, and rigid SWF’s operational rules should be avoided. Importantly, an SWF must be well integrated in the overall macroeconomic framework, which will likely need to be redesigned in light of the magnitude of expected LNG revenues.

Accumulated resources should be invested abroad with stringent transparency and accountability provisions. Investing abroad could avoid imparting volatility to the domestic economy and help minimize Dutch disease. Transparent rules, disclosure of information about fund financial assets, and clearly specified roles in the authority for managing financial assets are also important aspects and should be in line with international best practice, summarized in IMF and OECD guidelines.

1 See accompanying Selected Issues Paper, Chapter I.

C. Monetary Policy—The Appropriate Degree of Tightness

15. The authorities agreed with staff assessment of the inflation outlook, but were more sanguine than staff about the need to contain pressures. Staff noted that although real interest rates had risen with the decline in inflation and credit growth had slowed, inflation was still forecasted to rise notably. Staff pointed out that unlike the recent episode of high inflation that was driven by food and energy prices, the projected increase in inflation had a large domestic demand component, increasing the risk of high inflation becoming entrenched in expectations. Staff reasoned that containing this type of inflation early would reduce the net output cost relative to reducing it once entrenched. While agreeing with staff about the likely pickup in inflation, the authorities noted that their ability to act preemptively was impaired. They expressed concern that using both the policy rate and central bank bills to contain credit growth and domestic demand risked undermining their capital base and thus their credibility. In part this reflected the BPNG’s recent experience using bank bills to remove excess market liquidity partially generated by government trust deposits.

16. Given the experience with government trust accounts, there was agreement that monetary and fiscal policy needed to be better coordinated. In 2009, bank bills yielding between 6 and 7 percent were used to mop up liquidity in the system from trust deposits yielding returns to the government between ½ to 1 percent. This resulted in a large net loss for the public sector. Previously staff had advised that government trust accounts be held at the central bank and although some attempts over the course of 2009 were made to execute this, no progress was made. The authorities agreed that it would be preferable to transfer remaining trust accounts to the BPNG and hold future above-normal mineral revenue at the central bank. Further, the authorities saw merit in staff’s suggestion that the Treasury and the BPNG work together to determine how much above-normal mineral revenue could be spent each year based on the capacity constraints in the economy.

D. Financial Sector—Maintaining Stability

17. There was agreement that the financial sector remained sound. The only sign of stress from the global turmoil was a doubling of non-performing loans. However, because this was from a low base and loan-loss provisions were substantial, capital buffers remain large. Further, it was noted that a significant portion of the increase was from a single loan at one of the banks and expectations were that the net loss was likely to be quite small.

18. Maintaining asset quality was seen by staff and the authorities as the key challenge. It was noted that during the financial crisis, banks had tightened lending standards, shortening loan maturity. With local companies’ credit demand likely to increase to take advantage of opportunities afforded by the LNG projects, there was agreement that lending standards could ease. There was an expectation of a property-price boom in the capital region from the increase in LNG associated demand given relatively inelastic supply owing to land-availability constraints. In fact, anecdotal evidence suggested that it was under way. Because of limited domestic investment opportunities, there was agreement that overexposure to an inflated property market was a risk for financial institutions. The authorities indicated that prudential guidelines constrained financial institutions’ property market exposures and they recognized the need to monitor and enforce these closely.2

19. The authorities indicated that the Bank of South Pacific (BSP) would operate recently-purchased Colonial Bank of Fiji (CBF) as a branch. The BPNG had reached an agreement with the Fijian authorities to receive adequate information to effectively supervise the branch. It was noted that CBF was profitable, but with a lower rate of return than BSP was earning.

E. The Equilibrium Exchange Rate and External Stability

20. Staff estimates suggest that the exchange rate is broadly in line with fundamentals. Since last year’s assessment of mild overvaluation, depreciation in the Kina and a projected improvement in the terms of trade have brought the currency back in line with fundamentals (Box 4)

21. A large projected widening in the current account deficit is not expected to undermine external stability, but stress tests indicate a moderate risk of debt distress. Because they are associated with the LNG projects, the large projected current account deficits are expected to be FDI financed. Consequently, public external debt is anticipated to increase only mildly and reflect concessional borrowing from international institutions. However, under the most extreme stress tests, the debt sustainability analysis (Appendix 1) indicates a moderate risk of debt distress with threshold levels being violated for the present value of debt relative to GDP. Further, with the government’s LNG completion guarantee and commitments to landowners, the risk of unfavorable medium-term debt dynamics has increased. Staff stressed that fiscal discipline needs to be enhanced to maintain external debt sustainability during the LNG construction period.

F. Fostering Sustainable Broad-Based Growth

22. Structural reform implementation has slowed. The new Development Strategic Plan (DSP) 2010-2030 correctly recognizes the need to shift the sources of growth to the private nonmineral sector. The strategy stresses that to increase the exports of nonminerals and manufactures, improvements are required in transportation, private micro-credit facilities, basic utilities, human capital, and law and order. However, decisive actions have been lacking with the exception of the communications sector, international air travel, and power.

23. Reinvigoration of structural reforms that increase the efficiency of state-owned enterprises (SOEs) would contribute to a more vibrant private sector. Inefficient SOEs are driving up the cost of doing business and constraining growth in the nonmineral sector. Staff welcomed the Government’s commitment to developing a community service obligation (CSO) framework, an important step towards the commercialization of SOEs. Staff expressed encouragement in the progress towards implementing a national public-private partnership (PPP) policy that potentially facilitates much needed private infrastructure investment (Box 5). Successful SOE reform will contribute towards a more enabling business environment, which is essential for the attainment of more broad-based economic growth.

Equilibrium Real Exchange Rate1

Staff estimates show the exchange rate is broadly in line with fundamentals. The macro balance (MB) approach indicates the kina is not significantly different from its estimated equilibrium level and the equilibrium real exchange rate (ERER) approach points to a mild overvaluation of 3.4 percent. The decomposition of the fitted values into time-varying contributions of the explanatory variables suggests that demographic factors and the oil trade balance are the main factors in determination of the equilibrium current account balance under the MB approach. In the ERER approach, the terms of trade and government consumption are the key factors.

Exchange Rate Assessment: Baseline Results 1/

article image

All results are expressed in percent.

Staff projection of the underlying CA/GDP in 2014.

Based on a semi-elasticity of the CA/GDP with respei the REER of -0.42.

Overvaluation is assessed relative to January 2010.

uA01bx4fig03
Sources: Bank of Papua New Guinea; Bloomberg; World Economic Outlook; and IMF staff calculations.
1 See Selected Issues Paper “Determinants of Current Account and Exchange Rate Assessment for Papua New Guinea.” IMF Country Report No. 09/113.

State-Owned Enterprise Reform1

State-owned enterprises (SOEs) continue to impede growth PNG. Some reforms and performance improvements have been achieved, such as the commercialization of the Papua New Guinea Banking Corporation, through a merger with Bank of South Pacific. However, most SOEs continue to operate without budget constraints or profit objectives. Political interference yields conflicting mandates, where SOEs must deliver community service obligations (CSOs) without adequate compensation. While disclosure is improving, audited SOE financial reports are still not public so ascertaining profitability is difficult. Where they do not cover their costs of capital, and many likely do not, they represent an inefficient use of public funds.

Successful reform will require making SOEs independent from political directives, subject to binding budget constraints, exposed to competition, fully compensated for CSOs’ and fully accountable.2 Although competition is gradually being introduced in select infrastructure sectors, it is being approached cautiously, placing substantial emphasis on protecting incumbent SOEs. The introduction of competition enabled private sector investment in the telecommunications, aviation and power sectors. More however needs to be done particularly with those SOEs that will see considerable increases in demand from the LNG projects. The Government is currently committed to the development of a CSO framework which is an important step in SOE commercialization.

Increased private infrastructure investment is necessary to enable the business environment. Cabinet’s endorsement of a National Public Private Partnership (PPP) policy in 2008 and ongoing preparation of a legal and institutional framework for implementation will potentially facilitate needed private infrastructure investment. It is anticipated that the greatest potential for PPP investments will be in the utility and transport sectors. Successful implementation of the PPP policy will improve basic service delivery, reduce the costs of doing business and create opportunities for private sector investment and growth, essential ingredients for longer term prosperity in PNG.

1“Making SOEs Work in PNG: Approach for Sustainable Reform”, ADB (2009). 2 Although there are likely to be significant interim fiscal costs associated with restructuring SOEs, these costs have not been quantified, but they would be incurred gradually so as to make reform politically acceptable.

III. STAFF APPRAISAL

24. we commend the authorities for maintaining a medium-term fiscal framework. However, recent slippages in the implementation of the framework have undermined its stabilization objective. Spending from accumulated mineral revenue above the framework’s limit imparted a fiscal stimulus in 2009 larger than warranted. Although the 2010 budget reduces the stimulus, the planned level of spending is likely to be too expansionary given the expected strength in private activity. Further, spending from trust accounts outside the budget will add to demand pressures. Delaying some infrastructure spending would ease overall demand pressures and help ensure that good value is achieved from this spending.

25. The construction phase of the LNG projects will increase the difficulty of maintaining macroeconomic stability and enhancements to the MTFS could be helpful. First, it would be prudent to lower the assumption of normal mineral revenue to 3 percent of GDP between now and 2014, when LNG production should commence. This would reduce pressures from public spending during a period of strong private spending and the increased public savings could be used to finance currently unfunded government liabilities. Second, annual consultation between the monetary and fiscal authorities should determine how much of the 4 percent of GDP limit from above-normal mineral revenue can be spent.

26. The implementation of the MTFS needs to be strengthened. The fiscal credibility built during years of adherence to the framework can be easily lost, reducing long-term growth prospects. Strict adherence to the framework will also help deliver the fiscal prudence required to guard against unfavorable public debt dynamics from vulnerabilities such as those arising from potential LNG project delays, lower commodity prices, and weaker external demand.

27. With LNG projects underway, now is the time to develop an SWF to manage resource revenue. The best way forward is a financing fund that directs all public spending through the budget, thereby enhancing macroeconomic stabilization and helping to ensure high quality spending aligned with development objectives. To maximize the long-run development impact of LNG income, domestic absorption capacity will need to guide the rate of drawdown. Further, to minimize the potential for currency appreciation that would undermine the welfare of rural populations that depends on agriculture exports, the fund’s resources should be invested offshore. To effectively achieve its objectives, the SWF needs to be integrated into the macro framework and thereby supported by other fiscal institutions, such as the MTFS and the Fiscal Responsibility Act.

28. Although inflation declined over 2009, monetary policy needs to be focused on emerging inflation pressures. Compared to the recent episode of high inflation, domestic demand will play a more important role in driving inflation up, which implies a greater risk that high inflation could become entrenched in expectations. The central bank should be tightening monetary policy now with a view to achieving real lending rates of around 6 percent. Further, to contain inflation and manage inflation expectations, they should be prepared to maintain real lending rates around this level, or higher if significant overheating occurs.

29. Closer coordination of monetary and fiscal policy is desirable. Public trust accounts should be moved to the BPNG and procedures to automatically deposit above-normal mineral revenue with the central bank should be introduced. This will give the BPNG better control over domestic liquidity and market interest rates, strengthening the effectiveness of monetary policy. Also, the net cost to the public sector would be reduced by limiting the need to use high-cost central bank bills to remove excess liquidity.

30. Indicators suggest that the financial sector remains sound. However, to safeguard financial health, banks should be encouraged to maintain strict lending standards as credit demand increases in line with opportunities associated with the LNG projects. Furthermore, all financial institutions need to guard against overexposure to the property sector that could become significantly overvalued during the LNG construction phase.

31. The projected widening in the current account deficit is not expected to threaten external stability. The exchange rate is estimated to be broadly in line with fundamentals and reserves remain adequate to address potential balance of payments needs.

32. To achieve the Development Strategic Plan it will be essential to better align development spending with priorities and reinvigorate the reform process. There has been some progress on reform, with increased competition in telecommunications, aviation, and power. However, more needs to be done, particularly with those state-owned enterprises that will see considerable increases in demand for their services from the LNG projects. The government’s commitment to implement a public-private-partnership policy is encouraging and could potentially facilitate significant private investment in infrastructure. Improvements to security and the business environment would also yield significant benefits.

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

Table 1.

Papua New Guinea: Selected Economic and Financial Indicators, 2006–10

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Sources: Papua New Guinea authorities; and IMF staff estimates and projections.

Based on period average exchange rate.

Measured from below the line in the fiscal accounts.

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

Table 2.

Papua New Guinea: Summary of Central Government Operations, 2007–15

(In percent of GDP)

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

Since 2005, this includes transfers to Bougainville.

Table 3.

Papua New Guinea: Balance of Payments, 2008–15

(In millions of U.S. dollars)

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

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

Table 4.

Papua New Guinea: Summary Accounts of the Depository Corporations, 2007–10

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

Papua New Guinea: Medium-Term Scenario, 2007–15

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Sources: Department of Treasury; Bank of Papua New Guinea; and IMF 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.

March 2010 WEO projection.

Table 6.

Papua New Guinea: Indicators of External Vulnerability, 2006–10

(In percent of GDP, unless otherwise indicated)

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Sources: Department of Treasury; Bank of Papua New Guinea; and IMF 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, 1990–2008

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Source: World Development Indicators database, 2010.
Table 8.

Papua New Guinea: Authorities’ Response to Recent Fund Policy Advice 1/

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Source: IMF Staff.

Advice from the 2008 Article IV Consultation.

Appendix I: Papua New Guinea: Debt Sustainability Analysis1

Based on the low-income country debt sustainability analysis (LIC DSA), Papua New Guinea is rated to be at a moderate risk of debt distress. The baseline public DSA suggests that Papua New Guinea’s overall public sector debt dynamics are sustainable in light of the current size and the evolution of the domestic stock. However, stress tests of both external and public DSA suggest that vulnerabilities rise against shocks from slower export and economic growth, which are related with uncertainties of the global economic recovery and the construction phase of the LNG projects. Moreover, the inclusion of the LNG contingent liabilities as well as other domestic liabilities would also undermine long-term fiscal sustainability, addressing requirements for adherence to the authorities’ Medium-Term Fiscal Strategy and the needs to establish a Sovereign Wealth Fund (SWF) for more efficient revenue management.

I. Background

Papua New Guinea has been effectively reducing its public and external debt burden over past years.2 Public debt indicators improved dramatically, with the public sector debt ratio declining from 62 percent of GDP at end-2004 to an estimated 32 percent of GDP at end-2009 (Table 1). The public and publicly guaranteed (PPG) external debt also decreased from the peak of over 50 percent of GDP in 2001 to the current 13 percent of GDP (Table 2). Over 90 percent of public external debt is with multilateral institutions such as the AsDB and World Bank, with the rest mainly from Japan and Australia. Private sector external debt is estimated at about 14 percent of GDP by end-2009.

II. Economic Outlook and Underlying DSA Assumptions

The impact of the global financial crisis on Papua New Guinea is limited due to a relatively segmented financial market and strong recovery of commodity prices. Real GDP growth slowed to 4.5 percent in 2009 accompanied by eased inflation. External demand also weakened in 2009 and led to a current account deficit for the first time since 2002. Consequently, the currency has depreciated in both nominal and real terms by end 2009. As indicated in the 2008 DSA, Papua New Guinea is vulnerable to terms of trade shocks.3 However, unfavorable public debt dynamics did not materialize in 2009 as its terms of trade deteriorated during the first half of 2009 but recovered quickly with rising commodity prices.

The economic outlook of Papua New Guinea is expected to improve with the approval of two Liquefied Natural Gas (LNG) projects in December 2009. During the construction phase of the projects from 2010 to 2014, there will be increasing economic activities with rising imports mostly financed by FDI inflows. The near-term challenge will be to maintain macroeconomic stability with limited economic capacity. The LNG project is therefore included in the baseline scenario and Box 1 summarizes the medium-term macroeconomic framework underlying the DSA.

III. External Debt Sustainability Analysis

The baseline scenario indicates that all PPG external debt and debt service ratios stay well below the policy-dependent debt burden thresholds. However, the vulnerability of the external debt sustainability remains if export value growth slows down in combination with other shocks. The main results of the external DSA are the following:

  • The baseline scenario shows a slight increase in external debt burden in the medium term before declining in the long run (Table 3 and the text table). This is due to expected increase in disbursements of approved AsDB loans in the pipeline. Since additional financing needs for the LNG project and the current account deficit would be met with projected large FDI inflows, the PV of PPG external debt over GDP would remain around 11 percent in the medium term, which is below the 30 percent of threshold. The PVs of PPG external debt-to-exports and debt-to-revenue ratios are expected to stay well below the indicative threshold levels over the projection period.

  • However, the debt burden is expected to breach the indicative thresholds under some stress tests (Table 4 and Figure 1). External debt sustainability is most vulnerable to shocks from lower export growth (Table 4). A decline in export value growth in 2010–11, by one standard deviation below its historical average, would raise the PV of public external debt-to-GDP ratio to 37 percentage points over the medium term, and only fall below the 30 percent threshold after 2018. Other stress tests including lower FDI inflows and a combination of several shocks above also generate similar debt patterns which move to alarming levels.4

  • The scenarios indicated by stress tests on external debt burden are not trivial and cannot be ruled out given the uncertainty ahead. Export demand could remain weak if the recovery of the global economy is sluggish and a “double-dip” of commodity prices happens. Moreover, the negotiation between the government and local communities on land issues is ongoing and the construction of the LNG project would not be fully launched before these issues are settled.

Text Table: Policy-based PPG External Debt Burden Thresholds for PNG

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IV. Public Debt Sustainability Analysis5

With a prudent fiscal policy and improved economic outlook, the overall public debt dynamics for Papua New Guinea is favorable. During previous years of rising commodity prices, windfall revenues were largely saved and public debt reduced. The public debt burden is forecasted to decrease over the projection period under the baseline. Meanwhile, compared to the 2008 Article IV DSA, given the LNG project now included in the baseline, it indicates Papua New Guinea remains vulnerable to external shocks as well as domestic ones during the construction period of the project. In addition, the inclusion of several contingent domestic liabilities shows potential risks to long-run fiscal sustainability.

  • The baseline scenario projects a gradual decline in the public sector debt ratio over the medium term. The public debt ratio is projected to decline to 23.8 percent of GDP by 2015 (Table 1). The projected improvement results mainly from projected rapid economic growth, large FDI inflows associated with the LNG project, a continued prudent fiscal policy. The public debt is projected to decline further to about 14 percent by 2030.

  • The alternative scenarios and bound tests for public debt sustainability show that the projected debt path is particularly sensitive to changes in real GDP growth (Table 2 and Figure 2). A negative shock to real GDP growth6 in 2011–12 would increase the present value (PV) of the public debt-to-GDP ratio close to 80 percent in 2030. This shock can be again related with the progress of the LNG construction given its significant contribution to the economic growth over the medium term. Moreover, if a primary deficit of 5.8 percent in 2009 is assumed to maintain for the projection period, the PV of the public debt-to-GDP ratio would be above 200 percent in 2030. While the case of a persistent primary deficit is unlikely to happen (in view of the unusual spending from the government trust account in 2009), this highlights the need for the government to ensure the project is moving forward as planned while protecting the priority spending in the event of a growth slowdown. In addition, as discussed in the previous section, a decline in the export growth would also exacerbate public debt burden.

  • Other country-specific liabilities from several potential sources may also undermine fiscal sustainability. Government unfunded superannuation liabilities, estimated to be about 9 percent of GDP by end-2009, will remain sizable though the government has made partial repayment recently. The contingent liabilities related with the LNG project are estimated to be, in PV term, about 20 percent of GDP in 2014.7 Other liabilities, including borrowings by SOEs8 and the government’s commitments under the memorandum of agreement with landowners, are also estimated to be significant though detailed information on the magnitude and timing is limited. These factors, as shown in the alternative scenario9 (Table 2 and Figure 2), would result in unfavorable debt dynamics and add additional risks to public debt sustainability.

Macroeconomic Assumptions Underlying the DSA

  • Real GDP growth is projected to be at 5.2 percent on average over the medium term, above the historical average of 2.9 percent, and slow to 3 percent in the long run. In the medium term rapid growth in the nonmineral sector, including in agriculture, as well as several mining projects coming on stream will offset the decline in petroleum and copper production and exports.

  • inflation is projected to rise in the medium term due to increasing domestic demand and near-term capacity constraints, while stabilizing at around 3 percent in the long run.

  • The two LNG projects have a construction period of 5 years each, from 2010/11 to 2014/15. Production and exports are expected to commence in the second half of 2014, with a maximum capacity of about 60 million barrels of oil equivalent. The peak impact of the projects is estimated to be an increase of 25 to 30 percent in annual GDP growth. These 30-year projects are estimated to increase annual GDP growth, through both direct and indirect channels, by about 15 to 20 percent on average. Accounting for the substantial income outflows, the projects are expected to increase annual GNI by about 9 percent.

  • The current account (including grants) is estimated to be in deficit in 2009 and the deficit is projected to remain over the medium term until 2013, primarily reflecting the strong import growth related with the construction phase of the LNG project. FDI inflows from foreign shareholders are projected to increase substantially given the financing scheme of the project.

  • The grant element of loans is expected to decline. As per capita income rises, the share of external financing provided on concessional terms is expected to decline gradually over the projection period.1

  • The fiscal balance is estimated to turn into a deficit2 in 2009 due to falling mineral revenues and the spending of preceding years’ mineral windfall revenues. The deficit is financed by a rundown of resources held in trust accounts. Over the medium term it is projected to remain balanced.

1 Grant-equivalent financing (in percent of GDP) increases slightly in the near term before it declines in the long run, due to the expected large disbursement from the AsDB in the pipeline. 2 The deficit is estimated by Fund staff. The official 2009 budget outcome does not include the large amount of spending from the government trust account held outside the budget. The trust accounts consist of saving from mineral windfall revenues in past years to address development and debt reduction needs. However, since 2008 the government has relaxed constraints on trust account spending. Trust spending was the main factor shifting the fiscal balance from a surplus of 2.5 percent of GDP in 2008 to a deficit of almost 8 percent of GDP in 2009. The result was a fiscal impulse of almost 13 percent of GDP.

V. Conclusion

It is the staffs’ view that Papua New Guinea should be considered at moderate risk of debt stress based on both external debt burden indicators and stress tests on public debt pattern. Although the baseline scenario indicates that all external PPG debt burden indicators are below their indicative thresholds, the projected PPG debt paths shows significant vulnerability against shocks from slower export and economic growth. The inclusion of the LNG contingent liability as well as other domestic liabilities would also add concerns to long-term fiscal sustainability.

Enhanced debt management with adherence to the Medium-Term Fiscal Strategy (MTFS) would be required to offset the underlying risks in public debt sustainability. The staff encourages the authorities to improve implementation of the MTFS during the construction phase of the LNG project to guard against unfavorable public debt dynamics from vulnerabilities such as those arising from potential LNG project delays, lower commodity prices, and weaker external demand. The staff also encourages the authorities to consider the establishment of a Sovereign Wealth Fund (SWF) to manage revenues from those projects more efficiently and to further strengthen debt management capacity.

Table 1.

Papua New Guinea: Public Sector Debt Sustainability Framework, Baseline Scenario, 2007–2030

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Public sector includes central government and nonfinancial public sector. Gross debt is used.

Gross financing need is defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period.

Revenues excluding grants.

Debt service is defined as the sum of interest and amortization of medium and long-term debt.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Table 2.

Papua New Guinea: Sensitivity Analysis for Key Indicators of Public Debt 2010–2030

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Sources: Country authorities; and staff estimates and projections.

Assumes that real GDP growth is at baseline minus one standard deviation divided by the square root of the length of the projection period.

Revenues are defined inclusive of grants.

Table 3.

External Debt Sustainability Framework, Baseline Scenario, 2007–2030 1/

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Sources: Country authorities; and staff estimates and projections.

Includes both public and private sector external debt.

Derived as [r - g - p(1+g)]/(1+g+p+gp) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and p = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

Assumes that PV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the PV of new debt).

Table 4a.

Papua New Guinea: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2010–2030

(In percent)

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Sources: Country authorities; and staff estimates and projections.

Variables include real GDP growth, growth of GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows.

Assumes that the interest rate on new borrowing is by 2 percentage points higher than in the baseline., while grace and maturity periods are the same as in the baseline.

Exports values are assumed to remain permanently at the lower level, but the current account as a share of GDP is assumed to return to its baseline level after the shock (implicitly assuming an offsetting adjustment in import levels).

Includes official and private transfers and FDI.

Depreciation is defined as percentage decline in dollar/local currency rate, such that it never exceeds 100 percent.

Applies to all stress scenarios except for A2 (less favorable financing) in which the terms on all new financing are as specified in footnote 2.

Figure 1.
Figure 1.

Papua New Guinea: Indicators of Public and Publicly Guaranteed External Debt under Alternatives Scenarios, 2010–2030 1/

Citation: IMF Staff Country Reports 2010, 164; 10.5089/9781455204649.002.A001

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2020. In figure b. it corresponds to a Exports shock; in c. to a Exports shock; in d. to a Exports shock; in e. to a Exports shock and in figure f. to a Exports shock
Figure 2.
Figure 2.

Papua New Guinea: Indicators of Public Debt Under Alternative Scenarios, 2010–2030 1/

Citation: IMF Staff Country Reports 2010, 164; 10.5089/9781455204649.002.A001

Sources: Country authorities; and staff estimates and projections.1/ Revenues are defined inclusive of grants.
1

Currently the unfunded liabilities associated with the landowner agreements represent about 8 percent of GDP.

2

Papua New Guinea will have its first Financial Sector Assessment Program during May 2010. Staff will await the outcome to make detailed recommendations on regulatory and supervisory issues.

1

As Papua New Guinea is an IBRD/IDA blend country, this DSA is prepared by Fund staff in close consultation with the World Bank and the Asian Development Bank (AsDB) under the IMF-WB DSA framework for Low-Income Countries. The fiscal year of Papua New Guinea is the calendar year. An IMF country team visited Papua New Guinea for Article IV consultation in February 2010.

2

Papua New Guinea is rated as a weak performer for its policies and institutions for the purposes of the IMFWB low-income country DSA framework. Consequently, the applicable thresholds for this category for external public debt are: 30 percent for the present value (PV) of debt-to-GDP ratio; 100 percent for the PV of debt-toexports ratio, 200 percent for the PV of debt-to-revenue ratio, 15 percent for the debt service-to-exports ratio, and 25 percent for the debt service-to-revenue ratio.

3

See Papua New Guinea: 2008 Article IV Consultation, IMF Staff Report 09/112.

4

Bound test B5, which combines four different shocks with smaller standard deviations than those shocks in tests B1–B4, also shows the similar pattern of the debt dynamics with the shock from the export growth dominates.

5

Public debt includes domestic central government debt and external public and publicly guaranteed debt.

6

The GDP growth shock in 2011–12 is defined as the historical average of GDP growth rate minus one standard deviation. Another permanent GDP growth shock, which will bring the Debt-to-GDP ratio above 70 percent in 2030, is defined as the baseline GDP growth rate minus one standard deviation divided by the square root of the length of the projection period.

7

These liabilities are arising from the issue of exchangeable bonds to finance the state’s equity participation (in 2009) and the state’s completion guarantee for debt financing (by 2014). Under this scheme, the creditor acquires exchangeable bonds, amounting to US$1.1 billion, with the option to exchange the bonds for equitiesin the Oil Search company. Under the completion guarantee, if the project fails, the government may have to pay up to US$2 billion to the creditor. Other liabilities including the settlements with landowners (negotiation is ongoing) may also be significant.

8

From 2008 Article IV DSA estimates, SOEs related contingent liabilities are about 2.5 percent of GDP when we consider borrowings, various provisions, and other liabilities based on end-2007 financial statements of nine SOEs. However, there is no information on the off-balance sheet liabilities which also may be significant.

9

The alternative scenario (All Other Liabilities: Pension, SOEs, and LNG contingent liabilities) assumes that pension and SOEs liabilities are to be covered in the 2011 budget (total about 10 percent of GDP) and all LNG contingent liabilities will materialize in 2014 (about 20 percent of GDP).

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Cover IMF Staff Country Reports
Papua New Guinea: 2010 Article IV Consultation: Staff Report and Public Information Notice
Author:
International Monetary Fund
Volume/Issue:
Volume 2010: Issue 164
Publisher:
International Monetary Fund
ISBN:
9781455204649
ISSN:
1934-7685
Pages:
59
DOI:
https://doi.org/10.5089/9781455204649.002
Figure 1.

Papua New Guinea: Macro Performance
Figure 2.

Papua New Guinea: Growth and Inflation
Figure 3.

Papua New Guinea: Fiscal Performance
Figure 4.

Papua New Guinea: The Monetary Stance
Figure 5.

Papua New Guinea: The Banking Sector
Figure 6.

Papua New Guinea: The External Position
Figure 1.

Papua New Guinea: Indicators of Public and Publicly Guaranteed External Debt under Alternatives Scenarios, 2010–2030 1/
Figure 2.

Papua New Guinea: Indicators of Public Debt Under Alternative Scenarios, 2010–2030 1/