Papua New Guinea
2011 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Papua New Guinea

Papua New Guinea showed solid economic growth, supported by greater political stability, fiscal framework, and a healthy banking sector. Executive Directors encouraged the authorities to consider tighter macroeconomic policies in the face of rising inflation pressures and also stressed the need of a tight fiscal policy. They welcomed the Sovereign Wealth Funds (SWF), and considered it important to integrate the use of resources in the SWF into the budget and macroeconomic framework, supported by strong fiscal institutions. Directors observed that Liquefied Natural Gas (LNG) and other resource projects provide an opportunity to raise long-term growth and living standards.

Abstract

Papua New Guinea showed solid economic growth, supported by greater political stability, fiscal framework, and a healthy banking sector. Executive Directors encouraged the authorities to consider tighter macroeconomic policies in the face of rising inflation pressures and also stressed the need of a tight fiscal policy. They welcomed the Sovereign Wealth Funds (SWF), and considered it important to integrate the use of resources in the SWF into the budget and macroeconomic framework, supported by strong fiscal institutions. Directors observed that Liquefied Natural Gas (LNG) and other resource projects provide an opportunity to raise long-term growth and living standards.

INTRODUCTION

1. Papua New Guinea has enjoyed 10 years of positive economic growth. This unprecedented achievement for the country owes much to greater political stability, sound macroeconomic policies, and improved public finances. Higher commodity prices and the construction of a liquefied natural gas (LNG) project—a 190 percent of GDP investment—are boosting an economy facing capacity constraints. As a result, rising consumer and asset price inflation is threatening macroeconomic stability. To lower the risk of overheating, firm fiscal and monetary policies are required. This may be challenging with elections upcoming in 2012.

2. Rich natural resources provide an opportunity to raise long-term growth and living standards. To ensure that the opportunity is not wasted, sound policy frameworks and implementation will be essential. In particular, strict adherence to the allocations in the 2011 budget, close coordination of monetary and fiscal policies, and the integration of a sovereign wealth fund (SWF) into the macro framework should help maintain macroeconomic stability. Improvements in public financial management and structural reforms are needed to ensure that development objectives are achieved.

RECENT ECONOMIC DEVELOPMENTS AND OUTLOOK

3. Economic growth increased in 2010. The economy has weathered the global recession relatively well and real GDP growth is estimated to have picked up from 5½ percent in 2009 to 7 percent in 2010. The turnaround in the mineral sector was due to the start of production at new mines and slower-than-expected decline in oil and gas extraction on the back of higher commodity prices. Banks continued to finance a dynamic nonmineral economy, which got an additional boost from construction, transport, and communication related to the LNG project. Responding to high demand and rising food prices, agriculture production rebounded. However, the country’s infrastructure—roads, ports, and utilities—shows signs of capacity constraints, and bottlenecks have appeared in the markets for skilled labor and land (Figure 1).

Figure 1.
Figure 1.

Papua New Guinea—Macro Performance

Citation: IMF Staff Country Reports 2011, 117; 10.5089/9781455281589.002.A001

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

4. Strong domestic demand, the pick-up in international food prices, and the depreciation of the kina fuelled inflation in 2010. Headline inflation reached 7.8 percent in December. Underlying inflation has been trending upward since mid-2009 to 6 percent and is increasingly driven by domestic demand and higher labor costs. Moreover, inflation is likely to be underestimated in official data, which take inadequate account of rental increases and are based on an outdated consumption basket.

Staff’s Views

5. Near-term growth is projected to remain strong. Staff expects real GDP growth of 9 percent in 2011 as activity is boosted by the construction of the large LNG project, buoyant commodity exports, the start of production at the Ramu Nickel and Hidden Valley mines, and strong investor confidence. In 2013/14, real GDP growth is projected to slow down sharply as LNG construction and extraction from maturing oil fields and from the largest copper mine wind down. LNG production starts in 2015, leading to a 20 percent level jump in GDP. In the absence of further LNG plants and new mines, GDP growth is expected to converge to a 3–4 percent long-run trend rate. Nonmineral GDP growth per head is projected to continue at a moderate pace (Table 6).

Table 1

Papua New Guinea: Selected Economic and Financial Indicators, 2007–11

Nominal GDP (2009):

US$8 billion 1/

Population (2009):

6.3 million

GDP per capita (2009):

US$1,272

Quota: SDR 131.6 million

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

Based on period average exchange rate.

Measured from above 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, 2008–16

(In percent of GDP)

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

Includes spending from trust accounts.

Table 3

Papua New Guinea: Balance of Payments, 2008–16

(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, 2008–11

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

Papua New Guinea: Indicators of External Vulnerability, 2007–11

(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.

Table 6.

Papua New Guinea: Medium-Term Scenario, 2008–16

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.

Measured from above the line in the fiscal accounts.

Includes changes in check float.

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

March 2011 WEO projections.

6. Inflation is expected to accelerate in 2011. Domestic demand is increasingly becoming a major driver of core inflation, and headline inflation could temporarily rise into double-digits pushed by international food and energy prices. Inflationary pressures are exacerbated by increases in public spending, higher wage costs—resulting from a shortage of skilled labor—and rapidly increasing prices associated with the use and development of land. Moreover, staff sees a risk that high inflation becomes entrenched in expectations. However, the impact of recent increases in international food prices on consumers is likely muted by a strong domestic supply response by peri-urban food producers (Box 1).

7. Risks to growth and inflation are tilted to the upside. Upside risks include an increase in mining activity related to high commodity prices, an early start of a second LNG project, stronger-than-expected private sector investment, and additional fiscal spending from trust accounts. Downside risks include possible disruptions in mining and delays in the LNG project, mainly related to land disputes, social tension that may be created by rising income inequality, and a possible correction of very high real estate prices in Port Moresby and Lae.

Authorities’ Views

8. The authorities broadly agreed with staff’s assessment of the economic outlook and inflation. Reflecting high volatility and uncertainties surrounding projections of commodity prices and production, their outlook is based on conservative assumptions. Like staff, their projections include only new mining and LNG projects with an approved development plan, but unlike staff, the authorities assume commodity prices to return gradually to recent lows. They agreed that official CPI measures are understating inflation. The 2010 household income and expenditure survey will be used to improve the quality of data, including the CPI basket. Real estate prices are about to peak, but any correction is likely to be muted.

The Impact of Food Price Movements on the Poor in PNG

Food price increases over the past year were moderate. In 2010, the prices of imported foods increased faster than those of domestically produced items. Nonetheless, urban households, in particular the landless urban poor, benefited from low-priced rice imports. Rural households living near major cities such as Port Moresby have become important food suppliers to the urban population.1 Their incomes increased moderately in 2010 and less than they had done during the food price surges of 2008. They cut back on imported foods, which represent a small portion of their diet, but an important source of protein.2 Subsistence farmers, and households further away from urban centers, were largely unaffected by increases in urban prices of domestically produced items.

A01ufig02

Growth in Food Price Indices

(In percent)

Citation: IMF Staff Country Reports 2011, 117; 10.5089/9781455281589.002.A001

Sources: IMF staff calculations using BPNG CPI data, 1996 HIES weights.

Percentage of Change in Import Prices Passed Through to Domestic Prices

article image
Source: Mellor (2009).

Higher world demand for agricultural commodities has benefited rural regions, which export these products. Coffee price increases have increased cash income of the Eastern and Western Highlands, while high cocoa prices have benefited East New Britain and Bougainville. Oil palm production areas, such as the Hoskins project in New Britain, have enjoyed a price boom.

An elastic domestic supply response by substitute foods producers will mitigate the effect of projected increases in international food prices. Econometric analysis by Mellor (2009) suggests a weak and temporary pass-through from import prices to domestically produced goods prices in the major cities apart from Goroka.3 The likely channel is a high propensity for peri-urban farmers to substitute between subsistence and market production in response to price changes.

1 “Feeding Port Moresby Study,” Fresh Produce Development Agency (FPDA, 2008).2 “Food and Agriculture in Papua New Guinea,” Bourke and Harwood (2009).3 “Social Impact of Commodity Price Volatility in Papua New Guinea,” Mellor (2009).

POLICY THEME #1—MANAGING THE RISK OF OVERHEATING

A. Fiscal Policy

9. The large fiscal stimulus in place in 2009 was unwound in 2010. Windfall mineral revenues during the commodity price boom in earlier years were largely saved in trust accounts to pre-finance development expenditure or used to reduce public debt. However, in 2009 when the global financial crisis hit and commodity prices were low, the government relaxed restrictions on spending from trust accounts, and the fiscal balance moved into a deficit of 9½ percent of GDP. In 2010, global commodity prices rebounded and mineral revenue recovered, at the same time trust-account spending slowed. As a result, budget balance was almost achieved and the fiscal stance tightened.

10. Over the past 8 years, gross public debt fell from about 70 percent of GDP to below 30 percent of GDP. Public debt is approaching a sustainable level and is below the average of low income countries in the Asian-Pacific region. Moreover, for the first time the government has allocated funding to meet its annual obligations with superannuation funds and settled some of its arrears.

Staff’s Views

11. For 2011, the government targets a balanced budget. However, the government’s target does not include spending from trust accounts. Staff includes additional spending out of trust accounts, and assumes that trust-account spending remains just below the Medium-Term Fiscal Strategy (MTFS) ceiling of 4 percent of GDP— though with national elections in the offing, this assumption might be optimistic. In addition, it is unclear how much of the 2009 withdrawals from trust accounts has actually been spent or is still in the banking system, waiting to be spent during the election period. On the other hand, staff assumes higher commodity prices than the authorities, leading to higher-than-budgeted mineral revenue. As a result, staff expects a budget surplus of 1 percent of GDP.

12. Despite the surplus, the pace of overall public spending risks exacerbating inflationary pressures at a time when LNG construction peaks. Staff expects no further fiscal tightening to materialize and total public expenditure to increase faster than nominal GDP in 2011, resulting in a fiscal stimulus of about 3 percent of nonmineral GDP.

13. Tight budget implementation is needed to reduce demand pressure. Budget allocations should be strictly adhered to. Moreover, savings opportunities should be rigorously exploited and the typical year-end spending rush avoided. Instead, under-spent resources could be reallocated next year if needed. Some development projects are currently facing inflated prices as they are competing for scarce resources with private sector construction activities. Delaying these projects until the LNG construction phase is over, would lower demand pressures, raise value for money, and help achieve better service delivery.

14. Further reductions in public debt would reduce PNG’s vulnerability to shocks. The steady reduction in public debt over the past decade is commendable. However, none of the windfall revenues was used for debt reduction in 2010, in contrast to the previous MTFS rule to use 30 percent of above-normal mineral revenues for this purpose. Instead the government modified the MTFS rule to allow 100 percent of above-normal revenues to be devoted to public investment in future budgets, as long as debt stays below 30 percent of GDP. In light of falling oil and copper production over the medium term and the high uncertainties about the timing of future LNG revenues, staff noted it would be prudent to lower this threshold to 25 percent of GDP (around current levels) and include contingent liabilities in the calculation of the debt ceiling. Moreover, with mineral output falling, normal revenues from minerals should decline until LNG revenues commence.

Figure 2
Figure 2

Papua New Guinea—Fiscal Performance

Citation: IMF Staff Country Reports 2011, 117; 10.5089/9781455281589.002.A001

Sources: Papua New Guinea authorities; APDLISC, and IMF staff calculations.

15. Staff advised that further net debt reductions below the current level can be achieved by:

  • Saving any windfall revenues that may accrue, should market expectations of higher-than-budgeted mineral prices be realized, and setting aside some of these savings for debt reduction or to cover future liabilities related to participation in the LNG project.

  • Developing a payment schedule for the remaining unfunded superannuation liabilities.

16. Expectations about future mineral income need to be well managed. Once public revenues from LNG are affirmed, there may be some limited room for additional borrowing for well-identified development projects. To avoid excessive lending, gross and net public debt-to-GDP ratios of below 25 percent could serve as medium-term fiscal anchors.

Table:

Public Debt and Liabilities (In percent of GDP)

article image
Sources: PNG authorities and IMF staff calculations.

Does not include guarantees to state-owned enterprises (SOE), which were estimated at 2.5 percent of GDP in 2008 (no updates available).

Includes government equity stake in the LNG project.

Gross public debt and liabilities less government financial assets.

Authorities’ Views

17. The authorities noted that the 2011 budget strikes a balance between fiscal restraint in an economy that faces capacity constraints, pre-commitments, and development needs. For Ministers to agree on a balanced budget in a pre-election year was challenging. Moreover, there are many developing needs and funding of public services has been eroded in recent years, including for security, education, health, and maintenance and rehabilitation of infrastructure. Prudent revenue assumptions are appropriate, given PNG’s past experience with commodity price booms and uncertainties surrounding new LNG and mining projects.

B. Monetary Policy

18. The BPNG has kept its policy rate constant at 7 percent since end-2009. In 2010, the BPNG issued new central bank bills (CBB) totaling about 2 percent of GDP and increased the cash reserve requirement in October from 3 to 4 percent to absorb excess liquidity and reduce credit expansion by the banking system. Nonetheless, total liquidity in the banking system increased by almost 12 percent, mainly due to foreign exchange inflows, including mineral taxes and dividends. As a result, net foreign reserves increased by 19 percent and CBB and Treasury bill rates fell by about 3 percentage points. A weaker exchange rate and falling treasury rates indicate that monetary conditions have eased while excess liquidity in the banking system continues to reduce monetary-policy effectiveness.

Staff’s Views

19. High inflation rates are costly and difficult to reduce. Staff expects headline inflation to approach 10 percent in the short run and to stay elevated in the medium run. Moreover, measured inflation is likely to substantially underestimate true inflation. Such high inflation harms households on fixed incomes (e.g., retirees and minimum wage workers), distorts price signals, and reduces savings incentives. Over the medium term, higher inflation rates may be associated with greater inflation volatility and weakened central bank credibility. Once embedded in expectations, high inflation is difficult to reverse.

20. Monetary policy needs to be tightened to contain inflationary pressures and reduce the risk of higher inflation becoming entrenched in expectations. Monetary policy would work through three main channels:

  • Interest rates. Raising the Kina Facility Rate (KFR) 3 to 4 percentage points above expected core inflation would provide an important signal. However, the policy interest rate seems to have only limited sway over market rates as long as liquidity remains abundant.

  • Liquidity. The increase in the cash reserve requirement to 4 percent goes in the right direction and further increases should be considered. Liquidity could be reduced further by raising the CBB rate gradually back to just below the KFR.

  • Exchange rate. Tighter macroeconomic policies would help mitigate real appreciation. Raising the KFR and letting markets determine the Kina exchange rate could shift the real exchange rate adjustment from inflation to nominal exchange rate appreciation. The pass-through of exchange rates to domestic prices is strong in PNG (see last year’s Selected Issues, Chapter III).

Figure 3.
Figure 3.

Papua New Guinea—The Monetary Stance

Citation: IMF Staff Country Reports 2011, 117; 10.5089/9781455281589.002.A001

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

21. The decision to move all new trust accounts to the Bank of Papua New Guinea (BPNG) facilitates fiscal and monetary policy coordination. It gives the BPNG better control over liquidity in the banking sector and market interest rates. Monetary policy will become more effective and the net cost to the public reduced by limiting the need to use high-cost central bank bills to mop up excess liquidity.

Authorities’ Views

22. The BPNG broadly shared staff’s inflation forecast. They agreed that inflation risks are on the upside and pointed to the need for fiscal restraint to reduce demand pressures. However, they were reluctant to increase interest rates because this could restrain private sector growth. The BPNG considered inflation below 10 percent tolerable at a time of high economic growth. With underlying inflation seen as stable, they considered the current monetary policy stance appropriate. However, the BPNG indicated they stood ready to tighten, should inflation exceed their comfort zone.

23. The authorities shared concerns about excess liquidity. The BPNG welcomed the decision to move new trust accounts to the central bank and suggested to manage them in offshore bank accounts. Further increases in the cash reserve requirement were also being considered.

C. Exchange Rate Assessment and External Stability

24. Following several years of surpluses, the current account shifted into deficit amidst weak commodity prices in 2009. Despite the recovery in commodity prices and exports, staff estimates the deficit to have widened to 24 percent of GDP in 2010, reflecting LNG-related goods and services imports and income deficits, mainly due to higher compensation of foreign employees, and higher dividend payments associated with increased mining profits from strong commodity prices (Table 3). However, current account deficits are largely financed by FDI and equity investments of the LNG partners. Foreign reserves are estimated to be around US$3.2 billion by March 2011 and cover almost five months of imports of goods and nonfactor services. The increase in reserves reflects strong inflows associated with mineral taxes and foreign investment.

25. The nominal effective exchange rate (NEER) depreciated by more than 7 percent in 2010. PNG is classified as a floating exchange rate regime. Over a longer horizon, the NEER remained roughly flat, while a positive inflation differential with main trading partners led to an appreciation of the real effective exchange rate by 20 percent since early 2008.

Staff’s Views

26. Due to a fall in oil and copper production, current account deficits will continue until 2015 when LNG production is expected to start. From 2015, LNG production and current-account surpluses are likely long-lasting. Nevertheless, a debt sustainability analysis shows a moderate risk of debt distress under a combination of negative shocks. This strengthens the case for a prudent approach to borrowing and enhanced fiscal discipline.

27. The real exchange rate is broadly in line with macroeconomic conditions in 2010, but moderately undervalued when projected LNG exports are factored in (Box 2). Uncertainties surrounding the estimation of equilibrium exchange rates imply, however, that the standard exchange rate assessment provides only rough guidance, in particular given uncertainties about the timing and scale of future LNG production and the lack of reliable data on local wages and prices of non-tradables.