Papua New Guinea
2012 Article IV Consultation: Staff Report; Public Information Notice

Papua New Guinea has seen solid economic growth over the past decade, supported by sound macroeconomic policies. This 2012 Article IV Consultation discusses that the financial sector in Papua New Guinea remains profitable and well capitalized, but vulnerabilities have increased. Executive Directors have commended the authorities for achieving macroeconomic stability and a sustainable fiscal position. To preserve these achievements and promote inclusive development, it will be important to combine steady, affordable growth in government spending with improvements in public financial management and expenditure effectiveness.

Abstract

Papua New Guinea has seen solid economic growth over the past decade, supported by sound macroeconomic policies. This 2012 Article IV Consultation discusses that the financial sector in Papua New Guinea remains profitable and well capitalized, but vulnerabilities have increased. Executive Directors have commended the authorities for achieving macroeconomic stability and a sustainable fiscal position. To preserve these achievements and promote inclusive development, it will be important to combine steady, affordable growth in government spending with improvements in public financial management and expenditure effectiveness.

INTRODUCTION

1. Papua New Guinea (PNG) has seen solid GDP growth over the past decade. This owes much to sound macroeconomic policies, improved public finances, moderate inflation, and attractive conditions for foreign investors in the mining and petroleum industries.

2. PNG must manage its current resource investment boom and prospective resource revenues in ways that benefit the whole country. This is a challenging adjustment task, and will require structural and other policies to assist the required transition in the economy. Prudent fiscal and monetary policies have achieved macroeconomic stability. To preserve these achievements and promote inclusive development, it will be important to combine steady, affordable growth in government spending with improvements in public financial management and expenditure effectiveness, as well as structural reforms.

RECENT ECONOMIC DEVELOPMENTS AND OUTLOOK

3. Real GDP is estimated to have expanded by about 9 percent in 2011. Elevated commodity prices, the construction of a liquefied natural gas (LNG) project, and government spending are boosting the economy and generating inflation pressures (Box 1). The temporary closure of key mines, caused by natural disasters, and dwindling oil production dampened overall output growth. Headline inflation peaked just below 10 percent in the second quarter of 2011, but subsequently eased to 7 percent at year-end in line with declining international food prices and a 21 percent appreciation of the kina in nominal effective terms, although the full effects of the exchange rate appreciation may not have been fully passed through to consumers. Capacity pressures and sector-specific skilled labor shortages have increased underlying inflation (Figure 1).

Figure 1.
Figure 1.

Papua New Guinea: Macro Performance

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

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

Papua New Guinea: Liquefied Natural Gas Projects

PNG LNG Project (ExxonMobil)

Project construction began in 2010 and the first liquefied natural gas (LNG) shipment is scheduled for 2014. Esso Highlands, a subsidiary of ExxonMobil, is operating the project. Building work accelerated in 2011 and is expected to peak in the second quarter of 2012. The main components of the project include:

  • Natural gas wells in the Southern Highlands. The first of two drilling rigs has been delivered and earthworks at some sites have been completed.

  • Construction of a gas conditioning plant at Hides. Delivery of supplies was complicated by a mudslide in January, and landowner unrest in March led to temporary suspension of work.

  • Construction of the main LNG plant site outside Port Moresby. Construction is ahead of schedule and the jetty is more than 50 percent complete.

  • Offshore and onshore pipelines connecting the plants. The offshore portion is ahead of schedule, while the onshore portion has been delayed by weather disruption and landowner protests.

More than 14,300 workers are employed by the project, with PNG nationals accounting for 60 percent. Two thousand nationals have been trained through the National Training College. LNG-related goods imports amounted to US$2 billion in 2011. Mineral sector service and income payments to foreign workers increased by US$3½ billion between 2008 and 2011.

The US$15.7 billion construction costs are financed by a mix of 30 percent equity and 70 percent debt, with the government responsible for funding its share of costs (including cost increases). The largest private sector equity participants are ExxonMobil affiliates (33.2 percent) and Oil Search (29 percent). The PNG government owns a 16.8 percent stake, mostly through the Independent Public Business Corporation, and landowners own 2.8 percent. The government also owns shares amounting to 15 percent of Oil Search. To fund initially estimated construction costs, these shares were pledged to Abu Dhabi’s International Petroleum Investment Company through an exchangeable bond. They are due to be transferred in 2014, with additional compensation required if the shares are worth less than the initial borrowing of $A 1.68 billion. The government’s share of cost increases in 2011 was financed through domestic debt issuance.

LNG production will reach full capacity in 2015 and boost real GDP by about 20 percent. The annual output of 6.6 million tons is fully contracted to buyers from Japan, mainland China and Taiwan POC. The LNG price is linked to the oil price (Japan Crude Cocktail). Production costs will include goods imports and payments to foreign workers, projected at about US$1 billion annually. The expected operational life of the project is 30 years.

Fiscal revenues from the LNG project are projected to begin in 2018 and peak in 2024. LNG-related government revenues are projected to grow to around 10 percent of non-mineral GDP by 2024 as extended depreciation allowances are used up.

Future Developments

Esso Highlands plans additional phases of LNG development. The Hides plant will undergo improvements in 2019. New wells are planned at Angore over 2017–18 and Juha over 2021–22.

InterOil and Talisman have independent plans to develop additional gas resources in PNG. InterOil plans to develop the Elk and Antelope gas fields, with estimated construction costs of US$7 billion and annual production of 7.6-10.6 million tons. Talisman Energy found gas reserves at exploratory wells in 2010 and will spend US$800 million on further exploration over 2012-15.

Staff’s Views

4. The medium-term growth outlook is positive. In 2012, real GDP is projected to grow at 8 percent. LNG construction-related activity will continue at peak levels and mining output is expected to recover. In 2013, however, growth is likely to weaken to about 4 percent, as LNG construction winds down and output at maturing mines slows. LNG production is expected to start in 2014, raising real GDP by about 20 percent when LNG production reaches full capacity in 2015, although GNI will rise by less because of dividend outflows. Thereafter, annual GDP growth is projected to average around 5 percent.

5. Inflation pressures are likely to persist. Underlying inflation is driven by elevated election-year public spending and large private sector investments related to the upgrading of mines and mineral exploration activity.

6. The risks to the outlook are broadly balanced. Although the European debt crisis has so far had only a limited impact, it constitutes a major downside risk. Lower commodity prices would reduce government revenue, and tighter financing conditions for multinational companies could deter future FDI. Weaker trading-partner activity could reduce traditional exports and rural incomes. The main domestic downside risks include delays or disruptions to the mining sector and the LNG project. On the upside for growth, the elections could lead to higher-than-planned public spending in 2012, and a number of additional mining and LNG projects may be realized in the medium term.

Authorities’ Views

7. The authorities broadly agreed with staff’s assessment of the economic outlook and inflation. They noted that intensification of the European debt crisis would negatively impact global commodity prices and hurt PNG’s growth. They agreed that inflation pressures are likely to persist in the medium term, and pointed to increased capital inflows and heightened economic activity related to the LNG project. Their tolerance for inflation is higher than in the pre-LNG construction period.

MANAGING ECONOMIC VOLATILITY

A. Fiscal Policy

8. After a large fiscal deficit in 2009, the budget returned to surplus in 2010. Higher-than-expected commodity prices boosted government revenue and greater spending discipline, including on spending out of trust accounts, resulted in a budget surplus (Figure 2).

Figure 2.
Figure 2.

Papua New Guinea—Fiscal Performance

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

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

9. Gross public debt has declined further, and PNG’s risk of debt distress rating has been upgraded from moderate to low (Appendix III). It declined to 25 percent of GDP in 2011 from over 70 percent of GDP in 2002. Taking into account superannuation arrears and financing of the government’s LNG equity stake, gross public debt and non-contingent liabilities amounted to 45 percent of GDP in 2011. The LNG project completion guarantee was another 18 percent of GDP (text table).

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).

Gross public debt and non-contingent liabilities less government assets.

Government completion guarantee for LNG project.

Staff’s Views

10. For 2012, staff projects a fiscal deficit of 2½ percent of GDP. The government targets a balanced budget. However, their revenue projections are based on an optimistic commodity price forecast for 2012 (although projections for 2013 and beyond are conservative). Moreover, unlike staff, the authorities do not include net withdrawals from trust accounts in their calculation of fiscal deficits. One-off administrative expenditures for the 2012 elections amount to 1 percent of GDP, and tax policy measures are estimated to cost 0.3 percent of GDP. Staff recognized that election-related spending is needed, but raised concerns about the inflationary impact of high overall spending growth, and advised a reduction in planned spending growth by 1½ percent of GDP in 2012, for instance by delaying some non-critical infrastructure projects and reducing spending out of trust accounts.

11. The increasing importance of resource revenues warrants an adaptation of the fiscal framework. The 2008-2012 Medium-Term Fiscal Strategy (MTFS) helped reduce public debt but was less successful in insulating public spending from volatility in commodity prices. Real public spending per head has fluctuated substantially (text figure), with negative implications for stability in public service provision and investment. To address expenditure volatility, the authorities plan to introduce medium-term budgeting and a sovereign wealth fund (SWF). The 2013–17 MTFS is currently being discussed and should outline guiding principles for future spending.

12. Staff advised moving away from a quasi-balanced budget approach toward a steady real expenditure path. Medium-term projections foresee a temporary slowdown in revenue growth over 2013–17, mainly owing to lower mining and oil production in the period before LNG tax revenues materialize. Over this period, following current budget policy, the authorities plan to implement matching spending reductions, resulting in average annual cuts to real spending per head of about 1½ percent. Staff advised instead to a medium-term strategy that targets a smooth path for real public spending growth commensurate with medium-term revenue projections. This approach, which should be reflected in the new MTFS, would include:

  • Reducing planned spending in 2012 and preserving trust account balances for use in later years.

  • Increasing real spending per head at a steady rate until 2020 to provide stable financing for essential services and delivery of development targets, and to help smooth domestic consumption. Staff assesses that increasing real spending per head by about 1½ percent per year is consistent with stabilization of gross public debt and non-contingent liabilities. The spending increase can be financed by limited borrowing should revenues be insufficient during 2013–17, without hurting PNG’s debt sustainability.

  • Revising the planned medium-term expenditure path periodically in future MTFSs in line with updated estimates of government revenues, in particular when there is more certainty on LNG revenues.

Papua New Guinea: Medium-Term Fiscal Outlook

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

Development expenditure follows the authorities’ classification and includes capital spending, aid, and trust account spending.

A01ufig01

Fiscal Impulse 1/

(In percent of nonmineral GDP)

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

1/ Adjusted for cycle and mineral revenues.
A01ufig02

Real per Capita Spending

(In Kina)

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

A01ufig03

Overall Fiscal Deficit

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

A01ufig04

Gross public debt and non-contingent liabilities

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

13. The authorities could generate additional revenue by streamlining existing tax concessions, which are currently on a case-by-case contract basis. Preliminary findings by staff suggest that the average effective tax take in the resource sector corresponds to the low side of fiscal regimes in the world1. Since the issuance of the 2003 Oil and Gas Policy regulation, the Additional Profits Tax (APT) has not been payable for oil and gas activities, except for specific arrangements made for activities in the gas sector, such as the LNG project. Similarly, the APT is not applicable for the mining sector. Significant tax revenues from the LNG project are not expected before 2021–22, largely owing to accelerated depreciation allowances.

Authorities’ Views

14. The authorities pointed out that the commodity price assumptions were based on consensus forecasts2. The past use of conservative assumptions triggered questions by Parliament about the ability of the government to make accurate budget projections, since revenue under-projections had led to supplementary budget submissions in each of the last four years. Nonetheless, the government remains mindful of commodity price volatility, in particular given the substantial risk of a commodity downturn in the current global environment.

15. The authorities broadly agreed with staff’s advice to move toward steady and affordable real expenditure increases. However, they noted that containing public spending in an election year is a challenge. They will monitor closely the implementation of public investment projects and, if required, consider ways to control expenditure. This will include oversight and careful management of trust accounts funds, including district improvement funds. Looking forward, the authorities believe that moving toward more sustainable and effective medium-term budgeting will enable better planning and smoothing of public spending.

16. The authorities agreed that the resource sector could make a larger contribution to public revenues. In that regard, the authorities expressed their interest in Fund technical assistance to review their current resource taxation regime and, if necessary, present reform proposals.

B. Monetary Policy

17. Inflation slowed down following the Bank of PNG’s monetary tightening in 2011. The Bank of PNG raised its KFR policy rate by 75 basis points to 7¾ percent, increased commercial banks’ cash reserve requirements (CRR) by 200 basis points to 6 percent, and issued central bank bills (CBBs) to mop up banking sector liquidity (Figure 3). Most importantly, the kina appreciated by 21 percent in nominal effective terms throughout 2011. The stronger kina, combined with the decline in global food prices in late 2011, dampened import price inflation. As a result, annual headline CPI inflation declined to about 7 percent at the end of the year from near 10 percent in the second quarter.

Figure 3.
Figure 3.

Papua New Guinea—The Monetary Stance

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

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

18. Over the medium term, in the absence of further tightening, inflation is projected to remain above the Bank of PNG’s 5 percent reference value. During 2012, election-year government spending and continued LNG construction will generate inflation pressures. Staff projects that entrenched expectations will keep inflation at about 7 percent over the medium term.

19. Inflation expectations should be anchored at the Bank of PNG’s reference value. Anchoring expectations would help reduce the cost of fighting future inflationary shocks, and could be achieved by continuing the Bank of PNG’s tight policy stance. In the short term, the authorities can raise the CRR for commercial banks. This measure is less costly for taxpayers than the issuance of CBBs, and has been used to sterilize capital inflow-driven liquidity growth in other countries (Box 2).

Papua New Guinea and China: Similarities in Quantitative Monetary Policies

Over the past decade, both Papua New Guinea (PNG) and China have seen large capital inflows. Although PNG experienced a temporary capital outflow in 2008, capital inflows resumed afterwards and were over 5 percent of GDP in most years. As in the case of the Chinese renminbi, inflows caused persistent appreciation pressure for the kina.

Both central banks opted for foreign exchange intervention. As central banks were the sole market clearers, they accumulated large amounts of foreign exchange reserves and injected the equivalent amount of liquidity in local currency into domestic financial markets. The Bank of PNG allowed more flexibility of the kina in 2011, and the kina appreciated 22 percent against the U.S. dollar, but reserve accumulation remained high.

Cash reserve requirements (CRR) and central bank bills (CBBs) were used to absorb excessive liquidity. China used CRRs aggressively, raising the CRR ratio from 7.5 percent in September 2004 to 20.5 percent in December 2011, while outstanding CBBs were raised by a factor of 3 during the same period. PNG relied more on expensive CBBs, the outstanding amount of which grew by a factor of 32, while the CRR ratio was only increased from 3 percent to 6 percent. The sterilization ratios, calculated as the percentage of liquidity absorbed by the CRR and CBBs, stayed at around 70 percent in both countries in 2011.

The Bank of PNG can achieve the same sterilization effect by further raising the CRR ratio. At the same time, the amount of CBBs can be reduced, so as to lower the cost of liquidity management.

A01bx02ufig01

Capital Inflow 1/

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

1/ Capital inflow=current account + capital and financial account.Source: WEO.
A01bx02ufig02

Quantitative Monetary Policies

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

Sources: International Financial Statistics, and IMF staff calculations.
A01bx02ufig03

Exchange Rate and Reserve Accumulation

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

Source: International Financial Statistics.
A01bx02ufig04

Sterilization ratio 2/

(In percent)

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

2/ Central bank sterilization as a percentage of total foreign reserves.Sources: International Financial Statistics, and IMF staff calculations.

20. The authorities should pursue measures to enhance the effectiveness of interest rate-based monetary policy. Current interest rate policy has only limited sway on market rates as long as liquidity remains abundant. A more flexible exchange rate, appropriate combination of quantitative tools including the CRR and CBBs to mop up domestic liquidity, and a SWF that reduces liquidity build-up in the banking system, would help achieve an effective interest-rate transmission channel over the medium term.

21. Greater exchange rate flexibility would provide a buffer against external and domestic demand shocks. While some intervention may be appropriate to limit short-term exchange rate volatility, a more flexible exchange rate can be an important shock absorber, for instance when sustained global commodity price rises and capital inflows cause inflationary pressures, as has recently been the case.

22. Coordination between fiscal and monetary policy is crucial to reduce the cost of inflation control. Maintaining expenditure discipline in 2012 would reduce excess demand, while holding trust accounts at the Bank of PNG instead of commercial banks, and rationalizing the use of government working accounts in banks, would facilitate liquidity management. The authorities’ plans to issue guidelines for cash management of trust-account holdings at commercial banks are a positive step.

Authorities’ Views

23. The Bank of PNG agreed that inflation is likely to remain above the 5 percent reference value, but is concerned that allowing the exchange rate to appreciate further would hurt traditional exporters. The Bank of PNG sees a risk of elements of Dutch disease developing, because LNG construction-driven exchange rate appreciation may hurt the rural sector if agricultural prices are unable to keep up. This could develop into a bigger problem in the future and the Bank of PNG is of the view that monetary policy should help alleviate the adjustment, at least temporarily. Moreover, the Bank of PNG is comfortable with an inflation rate below 10 percent at a time of high economic growth.

24. The Bank of PNG projects banking sector liquidity to remain elevated. Foreign exchange inflows will continue to be high as LNG construction continues and commodity tax revenues accrue to the government.

25. The authorities have instructed commercial banks to transfer all trust accounts to the Bank of PNG. However, they noted that transferring funds from committed projects’ accounts at commercial banks to the central bank is difficult. To improve coordination, the authorities are developing a finance instruction to guide the use and management of trust accounts, particularly working accounts (under current rules, government departments have opened trust accounts at the central bank but then swiftly moved funds to working accounts at commercial banks). These procedural guidelines are short-term solutions, and trust accounts will cease to exist once the SWF is established.

C. Exchange Rate Assessment and External Stability

26. The current account deficit widened to 36 percent of GDP in 2011. The rise in imports of LNG construction materials worsened the trade balance, and the compensation of foreign workers led to large negative balances for services and income.

27. The kina appreciated by 27 percent in real effective terms during 2011, despite some reserve accumulation by the Bank of PNG. This was helped by a 15 percent appreciation in PNG’s terms of trade driven by a spike in the prices of gold, copper, and agricultural commodities. LNG construction-related inflows kept the exchange rate appreciating even during late 2011, when global uncertainty related to the European debt crisis generated volatility, and eventually a decline, in commodity prices. The Bank of PNG allowed the kina to appreciate while continuing to accumulate foreign exchange reserves. Its reserves rose by 40 percent to US$ 4.3bn by end-2011.

28. Private external debt grew to 82 percent of GDP in 2011. As LNG project partners and subcontractors drew down on loans to finance construction inputs, the level of private external debt has jumped by 70 percent of GDP since 2008.

Staff’s Views

29. The current account deficit is projected to remain high at 28 percent in 2012 and then fall as the LNG construction phase comes to an end. The mineral balance will turn positive in 2014, and LNG production will generate an overall current account surplus from the following year, although dividend outflows will also increase.

30. The real exchange rate is assessed to be on the weak side relative to medium-term fundamentals (Box 3). The external assessment for PNG is complicated by the lack of reliable data on real wages and non-tradables. Staff’s judgment of a modest undervaluation is based on the assessment that the increase in LNG-related exports will dominate the reversal in construction-related capital inflows over the medium-term. This assessment is sensitive to commodity price assumptions and fiscal policy – the current exchange rate is even more undervalued relative to a medium-term scenario where the authorities implement staff’s recommended expenditure profile.

Papua New Guinea: Exchange Rate Assessment

Papua New Guinea’s real effective exchange rate appreciated by 27 percent during 2011. The kina appreciated by 22 percent against the U.S. dollar and 24 percent against the Australian dollar.

Owing to the projected structural change in the PNG economy, standard CGER methodologies disagree on the exchange rate assessment, with an average overvaluation assessed around zero. For the MB approach, staff used coefficients estimated from a standard CGER regression, but to account for the importance of mineral exports for PNG (including LNG production from 2015), the norm was calculated by substituting PNG’s entire mineral balance (export revenues less wage and dividend payments) in place of the traditional oil trade balance variable. This method indicates an 8½ percent undervaluation. The ERER approach predicts the exchange rate directly from movements in the terms of trade and net foreign assets, and estimates an overvaluation of 13 percent, reflecting the large appreciation over 2011.

Over the medium term, the equilibrium real exchange rate will depend on the precise balance between large trade surpluses and a reversal of LNG investment-related capital inflows, and fiscal policy. Neither of the CGER approaches captures all the details of this specific trade-off (which is sensitive to commodity price assumptions). Staff’s external sector analysis (Table 3) projects a medium-term buildup of reserves at the 2012 real exchange rate, indicating undervaluation. If authorities follow staff’s advice of higher medium-term fiscal spending, the current account norm would decline, pushing toward further undervaluation of the kina today. However, this assessment is tempered by the fact that the real appreciation has pushed up rents and other non-tradable input costs relative to other countries, damaging the competitiveness of the non-mineral sector. This calls for structural reform and infrastructure improvements to raise efficiency and ease structural adjustment.

Exchange Rate Assessment: Baseline Results 1/

article image

All results are expressed in percent.

Based on a semi-elasticity of the CA/GDP with respect to the REER of -0.25.

Overvaluation is assessed relative to April 2012.

A01bx03ufig01

Papua New Guinea: MB Approach

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

A01bx03ufig02

Papua New Guinea: ERER Approach

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

A01bx03ufig03

ERER Approach: Contributions to Equilibrium REER

(Log scale)

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

31. Staff’s public external debt sustainability assessment for PNG has improved (Appendix 3). This is the result of sustained progress in developing fiscal institutions and public debt reduction over the past decade. Regarding the private sector, the recent increase in external debt is related to operations by large multi-national companies (construction is being undertaken by an ExxonMobil subsidiary), and staff projects that it will be repaid steadily once LNG production begins in 2014.

Authorities’ Views

32. The authorities agreed that the current account deficit will remain substantial until LNG construction is completed. For the medium-term, they use more conservative price assumptions than staff and project that the current account will remain in deficit owing to substantial income outflows in the form of mineral company dividends.

33. The authorities agreed that there is low risk of debt distress from the declining ratio of public external debt to GDP, or from the recent growth in private external debt. LNG project completion should result in paydown of private sector debt from 2014, and it should accelerate public debt reduction after 2020, when substantial LNG revenues materialize.

USING RESOURCE REVENUES TO SUPPORT BROAD-BASED DEVELOPMENT

A. Managing Resource Revenue

34. The establishment of the SWF will help manage resource revenue volatility. Implementation details are still to be determined, in particular the relationship between the SWF withdrawal rules and the new MTFS. However, the institutional framework is guided by international best practice adapted to the PNG context: a single governance framework, offshore investment and onshore management, integration with the fiscal framework and the budget, and accountability and transparency rules based on the Santiago principles (Box 5).

Papua New Guinea: Medium-Term Fiscal Strategies and the Sovereign Wealth Fund 1/

Over the past 10 years, fiscal policies were guided by Medium-Term Fiscal Strategies (MTFS). The 2002–07 MTFS was a stabilization and structural reform program. Its balanced budget target was achieved in 2004, three years ahead of schedule, but progress on structural reforms was slow. The 2008–12 MTFS added rules to limit the fiscal impact of volatility in resource revenue. It required that resource revenue above a ‘normal’ level (4 percent of GDP) be used for infrastructure development (70 percent) and debt reduction (30 percent). Annual spending out of trust accounts was capped at 4 percent of GDP. Together these rules imposed an 8 percent of GDP limit on the non-mineral budget deficit.

To address the challenge of smoothing government expenditure and decoupling it from the short-term volatility of natural resource revenues, the authorities decided to establish a Sovereign Wealth Fund (SWF). The Parliament approved the Organic Law on the SWF in late February 2012. The law envisages a consolidated pool of two offshore funds, stabilization (SF) and development (DF). The SWF model, design, and institutional framework were guided by international best practice with consideration of domestic features: a single governance framework to manage the two funds, offshore investment and onshore management, integration with the fiscal framework and the budget, and accountability and transparency rules based on the Santiago principles.

The law provides guidelines for contributions to, and withdrawals from, the funds. It stipulates that contributions to the SF will include all mineral and petroleum revenues, earnings from its investments, and other government contributions. Withdrawals from the SF will go through the budget process and should not exceed 15-year moving average of mineral and petroleum revenues as a share of non-mining revenues. Annual contributions to the DF will be no less than the guaranteed minimum allocation based on the expected average of the LNG project dividends determined by the parliament, earnings from its investments, and other government contributions. There is no clear rule defining withdrawals from the DF except that funds are to be made available to support the development plans of the government in accordance with an act of parliament. Implementation details are still to be determined, in particular the relationship between the SWF withdrawal rules and the new MTFS.

The authorities intend to publish a new MTFS in late 2012 in connection with the planned SWF. Based on the SF withdrawal rule, the drawdown of funds would be equal to about 6 percent of non-mineral GDP in 2011, largely corresponding to the lower revenue scenario in the 2011 FAD TA report. This report assumes a decline in non-LNG natural resource revenue to a long-run level of 3 percent of non-mineral GDP. On top of this, LNG revenue are projected to average about 3½ percent of non-mineral GDP over 2015–30 in the low revenue scenario, yielding a ‘new normal’ of about 6½ percent of non-mineral GDP. In a higher revenue scenario the new normal could reach 14 percent of non-mineral GDP.

1/ Fiscal Advice on Establishing a Sovereign Wealth Fund, FAD TA report August 2011.

Staff’s Views

35. Staff support the setting up of an SWF. Staff recommend setting withdrawal rules in conjunction with the new MTFS. Moreover, the integration of the development fund with the budget process should be clarified and the risk of creating a “parallel budget” minimized. Once the SWF is established, all existing trust accounts should be consolidated with the fund.

36. Medium-term resource revenues may not be substantially higher than in the recent past. Moreover, the SWF in itself will not solve all long-standing problems of expenditure management. Expenditures need to be better aligned with development priorities.

Authorities’ Views

37. The authorities emphasized that the SWF should address economic and social development in line with the development goals of the government. They noted that withdrawals would finance specific projects instead of providing cash hand-outs.

B. Structural Reforms and Public Service Delivery

38. PNG’s consumers suffer from continued monopolies in staple products such as petroleum and sugar, and the business environment for small- and medium-sized enterprises (SMEs) is poor. PNG was ranked 101 out of 183 countries regarding the ease of doing business by the World Bank’s Doing Business 2012, with particularly negative performance regarding the enforcement of contracts and obtaining construction permits.

39. Revenues from LNG production provide an opportunity for development but direct employment effects will be small. To generate a broad-based improvement in the living standards of PNG citizens, the government needs to spend more effectively, and structural reforms to improve the efficiency of the private sector and state-owned enterprises (SOEs) should be accelerated. It will also be important to continue with initiatives to address long-running allegations of corruption.

Staff’s Views

40. The government initiated critical SOE reforms. Measures to strengthen the Independent Public Business Corporation and its mandate are important for improving professional management, commercial orientation, accountability and transparency of SOEs. Moreover, the authorities plan to introduce a robust framework for public-private partnerships (PPPs), with a potential application to electricity generation.

41. Staff recommends further steps to improve competition in sectors with established monopolies, within both the private and public sectors. A more competitive environment would improve consumer welfare by lowering prices and enhancing product variety, while improved infrastructure and lower production costs would enhance the competitiveness of the non-mineral sector and encourage export diversification. In particular, plans to improve competition in broadband services by replacing PNG Telikom’s monopoly with an updated regulatory framework are positive and can build on successes in the deregulation of the telecommunications industry. Staff also supports the government’s tariff reduction program. A better-resourced Independent Consumer Competition Commission is instrumental to enforcing competitive behavior, especially in sectors with long-established dominant firms.

42. However, the rice project currently under consideration is concerning, as it is anti-competitive and detrimental to the welfare of consumers. While staff has no objection to supporting rice-growing in PNG, for example by providing transportation infrastructure, the introduction of exclusive production rights and the proposed import levy are counter-productive and run the risk of replicating inefficient arrangements in other sectors of PNG’s economy.

Authorities’ Views

43. The authorities are committed to reforming SOEs, improving their administration, enhancing competitiveness and removing corruption. Their package of initiatives to combat graft, for example Taskforce Sweep, should help improve the functioning of public enterprises.

44. The authorities agreed that the proposed rice project has substantial flaws, but intended to get involved in making rice production viable in PNG. They are of the view that rice exports to East Asia could provide jobs for PNG, and that the government should facilitate such large-scale projects. They would welcome advice from development partners regarding more efficient ways to foster such sectors in PNG.

State Owned Enterprise Reform1,2

The government of Papua New Guinea (PNG) owns nine State Owned Enterprises (SOEs) which are managed by the Independent Public Business Corporation (IPBC) and vested in the General Business Trust (GBT)3. These SOEs play a significant role in the domestic economy, with a total net asset value of $US 870 million and responsibility for providing essential public services such as power, water, postal services, banking, telecommunications, air travel, and seaports.

Yet the performance of SOEs in providing services to the people of PNG continues to be poor. Just 12% of households have access to power, and only 15% of schools are connected to the electricity grid. Moreover, while about 47% of the population had access to improved water and sanitation facilities in 1990, only 45% had access in 2008. In 2007, the Port Traffic League ranked the Moresby port 313th out of 365 world ports in terms of efficiency and cost. In 2010, only 12 of PNG’s 22 national airports met the International Civil Aviation Organization safety and security standards.

A01bx05fig01

SOE Net Asset Value and Dividends

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

List includes only 100% government-owned

PNG’s SOEs impose a significant fiscal burden. Between 2002 and 2010, public investments are estimated to have more than doubled SOEs’ asset value, but they paid just $US 17 million in dividends to the government.

Improving the performance of SOEs has been a policy goal for governments over the last decade. However, with deeply entrenched interest groups and changing government ideologies, progress has been mixed.

Significant SOE reforms were initiated during 1999-2002, including a privatization program, establishment of the Independent Consumer and Competition Commission and implementation of a policy introducing competition into sectors previously reserved for SOEs. However, with a change of government in 2002 came a new policy focused on the consolidation and growth of the SOE portfolio. While progress was made in introducing competition for the telecommunications and airlines sectors, privatization activities were halted and in some cases reversed, and accountability and transparency gradually eroded. During the subsequent period from 2002 to 2010, PNG’s SOE portfolio grew rapidly in asset size while generating steadily declining returns.

In the past six months the SOE policy framework has again shifted, with the 2012 National Budget identifying a number of reform priorities. These include setting out the government’s dividend expectation for the SOEs, a Community Service Obligation (CSO) policy to ensure SOEs identify and deliver CSOs on a commercial basis, the development of Public Private Partnership (PPP) legislation to complement existing arrangements, and an on-lending policy to ensure a level playing field between SOEs and the private sector.

In addition, a number of initiatives have also been identified to strengthen the role of the IPBC as an independent and transparent manager of SOEs. These initiatives include amending the IPBC Act to clarify IPBC’s governance and accountability frameworks; and developing a long-term SOE strategy which identifies opportunities for public-private partnerships, and strengthened SOE monitoring mechanisms.

1/ This box was contributed by Aaron Batten, Asian Development Bank.2/ Asian Development Bank. 2011. ‘Papua New Guinea: Critical Development Constraints’, Growth Diagnostics Studies Series, Manila, Philippines.3/ In 2010, SOEs had a net asset value equivalent to 30% of GDP and comprised between 10-15% of total fixed assets in the economy.

C. Financial Stability and Development

45. The financial sector remains profitable, but vulnerabilities have increased. Returns on equity exceed 100 percent and the capital adequacy ratio is over 20 percent of total assets (Figure 5), while exposure to the heated real estate sector continues to fall. However, the non-performing loans (NPL) ratio increased to 2.3 percent in September 2011 from 1.8 percent in September 2010, and provisioning of commercial banks dropped to around 130 percent from over 230 percent in the same period. Foreign investment positions of the Authorized Superannuation Funds (ASFs)—the largest non-bank financial institutions—were hit by the kina appreciation and global stock market downturn in 2011, and the ASFs are likely to record a net loss for the first time since 2006. Growth in bank credit decreased in 2011 after several years of rapid expansion, in line with limited demand for domestic loans as enterprises opted for cheaper internal financing and overseas borrowing.

Figure 4.
Figure 4.

Papua New Guinea—The External Position

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

Sources: Bank of Papua New Guinea; Bloomberg; Information Notice System; and IMF staff calculations.
Figure 5.
Figure 5.

Papua New Guinea—The Banking Sector

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

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

Staff’s Views

45. The Bank of PNG has strengthened its supervision framework. The Bank imposed stricter limits on financial institutions’ exposure to risk (particularly to the heated property sector), increased on-site inspections, carried out stress tests, and took the initiative in improving coordination with supervisory authorities for life and general insurance products. The aim is to conduct regular meetings with all relevant authorities so they can update one another and obtain an overview of systemic risks.

46. The government has taken several initiatives to support inclusive financial development. They include development of a regulatory environment for mobile banking, capital injection into the National Development Bank, tax incentives for banks to invest in regional branches, setting up a program to improve access to credit for small and medium sized enterprises, and expanding microfinance projects. The government also released draft legislation to facilitate loans secured by personal property.

47. The authorities are making progress in implementing Fund’s 2011 FSSA recommendations. The Bank of PNG’s Strategic Plan aims to improve financial supervision and develop financial infrastructure. The introduction of a real-time settlement system is a step toward improving the efficiency of the clearance and settlement infrastructure. Legislation to update the payment system law will be presented to Parliament in 2012. Staff encourages implementation of the recommendations made in the July 2011 Asia-Pacific Group on Money Laundering assessment report on anti-money laundering and combating the financing of terrorism (AML/CFT). The Financial Intelligence Unit indicated having issued guidelines on customer due diligence.

Authorities’ Views

48. The authorities considered systemic risks to the financial sector to be low. The NPL ratio increased owing to one large enterprise, which temporarily fell back on debt-servicing. Moreover, banks were able to absorb a moderate increase in non-performing loans given their provisioning. The loss of the ASFs was judged to be a one-off event, and the Bank of PNG has been working with ASFs on reviewing overseas investment risks. The authorities also welcomed the slowdown in credit growth from high rates in past years. The Bank of PNG is reviewing new applications for bank licenses to promote competition and financial inclusiveness.

STAFF APPRAISAL3

49. We commend the authorities for achieving macroeconomic stability and a sustainable fiscal position. To preserve these achievements and promote inclusive development, it will be important to combine steady, affordable growth in government spending with improvements in public financial management and expenditure effectiveness. This should be accompanied by structural reforms and a flexible monetary policy.

50. After 10 years of uninterrupted economic growth, the medium-term outlook remains positive. Risks to the outlook are broadly balanced and predominantly related to the resource sector.

51. Further monetary tightening would likely be needed to anchor inflation expectations at the Bank of PNG’s 5 percent reference value. Reducing excess liquidity by raising banks’ cash reserve requirements and limiting reserve accumulation would be the most effective ways to achieve tighter monetary conditions. Going forward, greater exchange rate flexibility would provide an important buffer against external shocks.

52. Fiscal policy should target a smooth expenditure path. Such a policy would help sustain solid economic growth with moderate inflation, and provide reliable funding for essential public services. It could be implemented through tighter control of expenditure growth in the current election year, and steady increases in real spending per capita over the medium term.

53. PNG’s resource sector could make a larger contribution to public revenues. Efforts to promote this could include strengthening revenue collection, reinforcing the internal revenue and customs services, streamlining existing tax concessions, and applying the Additional Profits Tax to mining activities, given that the average effective tax take from resources appears to be on the low side of fiscal regimes across the world.

54. The SWF provides a strong framework for insulating public expenditure from volatility in resource revenue, and for improving transparency, accountability, and good governance. Withdrawal rules should be set in accordance with the new Medium-Term Fiscal Strategy. Once the SWF is established, all existing trust accounts should be consolidated with the fund.

55. We welcome the government’s agenda for better public services. Plans to increase the expenditure share of key development priorities—education, health, law and order, and infrastructure—go in the right direction. However, to deliver better public services marked gains in the effectiveness of public spending are needed. Therefore we encourage the authorities to develop a multi-year budget for selected expenditures and invest in the reform of key ministries responsible for planning and service delivery.

56. More competition would benefit consumers and raise efficiency. We encourage the authorities to strengthen enforcement of competitive behavior and replace existing monopolies. The introduction of exclusive production rights and import protection for rice would go in the wrong direction and hurt consumers. The authorities should proceed with SOE reforms.

57. The current account deficit is largely financed by FDI and is not expected to threaten external stability. The exchange rate is estimated to be modestly undervalued and reserves are adequate to address potential balance-of-payments needs.

58. The financial sector remains sound. Banks have high capital adequacy ratios and should be resilient to contagion from the Euro area, but need to maintain appropriate lending standards and further reduce exposure to the real estate sector. Financial supervision has been of high quality, and the planned enhanced cooperation among supervisors is welcome. The authorities should implement the remaining 2011 FSAP recommendations.

59. The authorities need to urgently tackle structural deficiencies in the provision of national statistics. Gaps in macroeconomic data provision complicate PNG’s public policy-making and Fund surveillance. This requires immediate reform and strengthening of the relevant government agencies.

60. It is recommended that the next Article IV consultation be held on the standard 12-month cycle.

Papua New Guinea—Key Risks and Policy Responses1

Box 6.
Box 6.
1/ Risk of event (high = red, medium = orange, low = yellow) indicated by color of oval; magnitude of projected impact on each sector indicated by thickness of arrows; recommended policy responses are indicated, with most important policies underlined.
Figure 6.
Figure 6.

Papua New Guinea—The Cross-Country Context

Citation: IMF Staff Country Reports 2012, 126; 10.5089/9781475504033.002.A001

Sources: Bank of Papua New Guinea; International Financial Statistics, World Economic Outlook; and IMF staff calculations.
Table 1.

Papua New Guinea: Selected Economic and Financial Indicators, 2008–12

Nominal GDP (2010): US$10 billion 1/

Population (2010): 6.5 million

GDP per capita (2010): US$1,521

Quota: SDR 131.6 million

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

Based on period average exchange rate.

Includes central government external debt.

Table 2.

Papua New Guinea: Summary Operations of the Central Government, 2008-17

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

Gross public debt and non-contingent liabilities less government assets including LNG equity stake.

Table 3.

Papua New Guinea: Balance of Payments, 2008–17

(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 external debt.

Table 4.

Papua New Guinea: Summary Accounts of the Depository Corporations, 2008–12

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

Papua New Guinea: Indicators of External Vulnerability, 2008–12

(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 external debt.

Covers only banking system short-term external debt.