Papua New Guinea
2010 Article IV Consultation: Staff Report and Public Information Notice

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

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.

uA01bx1fig03
uA01bx1fig04
uA01bx1fig05
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

article image
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)

article image
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)

article image
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

article image
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

article image
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)

article image
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

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

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

article image
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 stabili