A. Economic Activity, Inflation, and Balance of Payments

1. Papua New Guinea (PNG), notwithstanding great natural resource wealth, remains a low-income country with significant vulnerability to shocks. Since 2014, PNG became an exporter of liquified natural gas (LNG), but has been hit by large shocks, including lower commodity prices, a severe drought in 2015–16 and a major earthquake in 2018, which cut growth, boosted inflation, and undermined public finances and the balance of payments. The end of the gas project boom in 2014 and lower commodity prices resulted in lower fiscal revenues, significant fiscal deficits and a shortage of foreign exchange (FX). Cuts in capital spending, to cover current spending slippages, and import compression from FX shortages, have inhibited investment and growth in the non-resource sector.

2. The economy is estimated to have rebounded in 2019 following the contraction triggered by the large earthquake in 2018. Real GDP is projected to have grown by 5.0 percent in 2019, underpinned by recovery in energy and mineral production following the earthquake. In the absence of major new resource projects, real GDP growth is projected at 2 percent in 2020 and an average of 3 percent in the medium term, largely driven by the non-resource sector, and supported by easing exchange restrictions. The prospects for major new gas and mining projects remain upside risks to the outlook.

3. Inflation is projected to fall in 2019 but to pick up temporarily thereafter. At end-2018, inflation was 4.8 percent, little changed from 2017, as pass-through from kina depreciation offset the impact of lower betelnut prices. In 2019, inflation is projected to have slowed further to 3.5 percent by year-end, reflecting limited exchange rate depreciation, lower commodity prices and trading-partner inflation. Going forward, and assuming a gradual adjustment in the kina to eliminate overvaluation, inflation is expected to pick up temporarily to 6.3 percent between 2020 to 2022 before tapering off to 3.9 percent by 2024.

4. Despite a large current account surplus, PNG’s non-resource sector continues to face a shortage of foreign exchange (FX). In 2019, PNG’s large exports of LNG and minerals are estimated to have generated a current account surplus of 24 percent of GDP, down slightly from 2018. However, as in the past, the current account surplus has been almost entirely offset by financial outflows associated with resource sector investments. As a result, the non-resource sector faces a chronic shortage of FX. Going forward, some improvement in FX inflows is projected, associated with external loans and a pickup in foreign investments around less uncertainty. This is expected to be reflected in some increase in imports as the foreign exchange orders backlog is gradually cleared, as well as an increase in international reserves that diminishes gradually over the projection horizon.

B. Fiscal Policies and Financing

5. Fiscal consolidation has stalled, and debt has been revised upwards. Despite higher-than-expected revenues in 2018, the fiscal deficit widened to 2.6 percent of GDP from 2.5 percent in 2017, largely reflecting personnel cost over-runs and higher spending on goods and services for the hosting of the APEC summit. The public debt-to-GDP ratio rose from 33 percent in 2017 to 38 percent in 2018, above the government’s long-term target of 30 percent of GDP. This increase partly reflects revisions to public debt in line with the Fiscal Responsibility Act (FRA), which require the central government to recognize three SOE project loans for which it has taken over the servicing (Solwara, Motu-Kea Port, and NCD Roads), adding debt of about 1.4 percent of GDP. The authorities have also taken IMF advice to revalue foreign currency debt at current exchange rates, in line with best international practice, which raises the debt ratio by about 1.8 percent of GDP.

6. The budget deficit for 2019 is projected to have deteriorated significantly. This reflects a disappointing outcome for revenues, as well as significant spending over-runs. Tax revenues are well below 2018 levels, reflecting a subdued economy in 2018 and lower commodity prices. Non-tax revenue is also underperforming as dividends and Public Monies Management Regularization (PMMR) revenues are projected to come in below budget.¹ On the expenditure side, the main overruns are due to personal emoluments, which are expected to come in at around 1 percent of GDP over the budget. In response, the authorities passed a Supplementary Budget in November 2019 including cuts in current spending, savings in the public investment program, and cuts in Service Improvement Program grants (SIPs), and additional payments on arrears in current and capital spending. The net effect is that the budget deficit for 2019 is expected to come in at 4.1 percent of GDP, significantly higher than the 2.3 percent in the original Budget. This larger deficit was financed through domestic borrowing, and multilateral and bilateral external loans.

C. Monetary and Foreign Exchange Policies

7. Progress on monetary and exchange rate policy reforms has been mixed. In 2018, the Bank of Papua New Guinea (BPNG) began to restore exchange rate flexibility, including by eliminating guidance to banks on the allocation of FX, allowing some depreciation of the kina, and supplying FX to banks to reduce the large backlog of unfilled FX orders. Since late 2018, however, the pace of depreciation has slowed and the kina remains overvalued. PNG’s net international reserves rose to $2.3 billion (5.6 months of imports) at end-2018, owing to a successful sovereign bond placement of $500 million, commercial loans of $180 million, and World Bank and ADB loans of $250 million. Some of the external borrowings have been used to reduce the backlog of FX orders. This contributed to some reduction in the backlog and waiting times for FX orders in early 2019, but the backlog has increased again in recent months, to an estimated K1.2–1.3 billion for trade-related orders. Progress in strengthening liquidity management and the effectiveness of domestic interest rate transmission has been slow. Liquidity forecasting has been hampered by lack of information on prospective government spending, and liquidity management has also been complicated by maldistribution of liquidity across institutions.

8. On current policies, the PNG financial system is likely to continue to see FX shortages, weak credit growth, and excess liquidity. Recent political turmoil, as well as uncertainties in the global trading environment, appear to have dampened local business confidence and reduced the likelihood of significant resource project-related investment inflows. In view of this, and the limited movement in the exchange rate, the shortage of FX is likely to continue, with adverse effects on investment and growth.² The FX shortage also contributes to the buildup of excess liquidity, as bank deposits have been bolstered by funds intended for imports or dividend payments abroad. In such circumstances, the BPNG’s ability to affect monetary conditions is likely to remain very limited.

D. Risks

9. Risks surrounding the outlook are identified in Appendix I.

• Near-term risks are predominantly on the downside, stemming from possible declines in commodity export prices, a deterioration in the investment climate stemming from domestic or external political developments, or a deterioration in domestic or external financing conditions. Spread of the Corona virus to PNG would also have a large negative impact.

• Over the medium-term risks are mainly on the upside, reflecting the potential impact, from 2021, of major new natural resource project investments, and the beneficial effects of exchange rate adjustment and revenue reforms.

A. Staff-Monitored Program (SMP)

12. In view of the deterioration in the fiscal situation, the authorities requested an SMP to help guide their policy response and catalyze financing. The SMP provides a broad macroeconomic framework within which to pursue reforms. It also allows the PNG authorities to build a track record of success in implementing reforms and laying the foundation for a Fund-supported program. To this end, the SMP includes a large number of structural benchmarks which reflect the authorities’ reform priorities and their sense of urgency to begin cementing the reform process. The draft outline of the SMP was endorsed by the National Executive Council in late November. The text of the SMP is appended to this Report for information only.

B. Fiscal Policy

13. A sustained program of fiscal consolidation is needed to put the deficit on a downward path and reduce the public debt ratio, while protecting social spending and much needed public investment. The authorities’ program aims to bring the core deficit down gradually from 4 percent of GDP in 2019 to 2 percent of GDP in 2023–24. The core deficit excludes expenditure in 2020 and 2021 to clear payments arrears from previous years, including separation payments for retirees still on the government payroll (see below), and additional capital investment projects in 2020 financed by international development partners (Text Table 1). The authorities consider these contingency expenditures important for reinvigorating growth, as they restore private sector liquidity, improve confidence in public finances, and allow space for well managed infrastructure investments. However, they will implement them only if arrears can be verified carefully and transparently, and if these expenditures can be appropriately financed at relatively low cost.³ Under the scenario with all contingent spending on arrears and capital investments, the public debt ratio is projected to rise to 45.4 percent of GDP in 2021 and then fall back to 44 percent of GDP by 2024. Continued fiscal consolidation will be required in the medium-term to reach their intermediate debt target of 35 percent under the revised Fiscal Responsibility Act (FRA) (see below).

^{Text Table 1.}

Papua New Guinea, Core and Non-core Fiscal Deficit

(In percent of GDP)

Sources: PNG authorities and IMF staff calculations.

^1/Includes K430 million in separation arrears, K200 million in goods and services arrears in 2020 and 2021, and K300 million in capital spending arrears in 2020.

^2/Includes K500 million of IFI-financed capital project expenditures.

^{Text Table 1.}

Papua New Guinea, Core and Non-core Fiscal Deficit

(In percent of GDP)

		2019	2020	2021	2022	2023	2024
Core fiscal deficit		-4.1	-3.3	-3.1	-2.2	-1.9	-1.9
	Public debt	38.3	40.8	42.4	42.2	41.7	41.1
Planned arrears clearance 1/		0.0	1.1	0.6	0.0	0.0	0.0
Planned additional capital expenditure 2/		0.0	0.5	0.3	0.0	0.0	0.0
Overall fiscal deficit		-4.1	-5.0	-4.1	-2.2	-1.9	-1.9

Sources: PNG authorities and IMF staff calculations.

^1/Includes K430 million in separation arrears, K200 million in goods and services arrears in 2020 and 2021, and K300 million in capital spending arrears in 2020.

^2/Includes K500 million of IFI-financed capital project expenditures.

View Table

^{Text Table 1.}

Papua New Guinea, Core and Non-core Fiscal Deficit

(In percent of GDP)

		2019	2020	2021	2022	2023	2024
Core fiscal deficit		-4.1	-3.3	-3.1	-2.2	-1.9	-1.9
	Public debt	38.3	40.8	42.4	42.2	41.7	41.1
Planned arrears clearance 1/		0.0	1.1	0.6	0.0	0.0	0.0
Planned additional capital expenditure 2/		0.0	0.5	0.3	0.0	0.0	0.0
Overall fiscal deficit		-4.1	-5.0	-4.1	-2.2	-1.9	-1.9

Sources: PNG authorities and IMF staff calculations.

^1/Includes K430 million in separation arrears, K200 million in goods and services arrears in 2020 and 2021, and K300 million in capital spending arrears in 2020.

^2/Includes K500 million of IFI-financed capital project expenditures.

14. There is some uncertainty as to the total stock of arrears outstanding. To this end, the authorities have established an interagency office in the Treasury dedicated to identification, verification and clearance of central government payments arrears (Memorandum on Economic and Financial Policies (MEFP) paragraph 8 bullet 3). Estimates of the overall envelope of arrears and their distribution are presented in Text Table 2. Arrears on compensation of employees consist of payments of previous year’s salary increases and separation payments (retirement costs) for personnel over 65 (see below). Remaining arrears are on goods and services, and represent unpaid utility and rent bills, and arrears on capital expenditure.

^{Text Table 2.}

Estimated Stock of Arrears Outside the Core Program

(In millions of kina)

Sources: PNG Authorities and IMF Staff calculations.

^{Text Table 2.}

Estimated Stock of Arrears Outside the Core Program

(In millions of kina)

		2019	2020	2021
		est.	est.	est.
Compensation of Employees		120	552	430
of which:
	Previous year’s salary increase	120	122	0
	Separation payments	0	430	430
Goods and Services (Utilities and Rent)		200	200	200
Capital Expenditure		321	300	0
Total		641	1,052	630
in percent of GDP		0.8	1.1	0.6

Sources: PNG Authorities and IMF Staff calculations.

View Table

^{Text Table 2.}

Estimated Stock of Arrears Outside the Core Program

(In millions of kina)

		2019	2020	2021
		est.	est.	est.
Compensation of Employees		120	552	430
of which:
	Previous year’s salary increase	120	122	0
	Separation payments	0	430	430
Goods and Services (Utilities and Rent)		200	200	200
Capital Expenditure		321	300	0
Total		641	1,052	630
in percent of GDP		0.8	1.1	0.6

Sources: PNG Authorities and IMF Staff calculations.

15. As the benefits of the MTRS will be small in the near term, fiscal adjustment will require bringing current expenditure under better control. In particular, this includes measures to limit the growth of the compensation of employees and expenditure on goods and services:

• Limiting the growth of compensation of employees (MEFP paragraph 8 bullet 4). This will be achieved by linking the payroll process to the issuance of warrants in the Integrated Financial Management System (IFMS) to better control personal emoluments, including by placing a ceiling on payments for essential new staff, and the better control of non-salary payments, particularly supplements and allowances (Text Table 3). Reduction of overall personnel payments (and expenditure on goods and services) will also be achieved through the amalgamation/elimination of a number of agencies (MEFP paragraph 8 bullet 4).

• Paying down retirement costs to reduce public employment. Currently there are approximately 4000 public workers over the retirement age still on the payroll because the authorities have not budgeted for the payment of separation costs. Allowing these workers to retire has an immediate budgetary cost (Text Table 1), but will result in savings going forward of about 0.1 percent of GDP in 2021 and 0.2 percent of GDP from 2022 onward.

• A detailed audit of government employment and payroll practices by an independent organization (MEFP paragraph 8 bullet 5) to identify inappropriate hiring practices and payments and to develop a program of reforms to better track and control public service hiring and compensation practices.

• Limiting the growth of expenditure on goods and services. This will be achieved through the amalgamation/elimination of a number of agencies (MEFP paragraph 8 bullet 4), as well as through elimination of waste and better control of current spending.

^{Text Table 3.}

Personnel Emoluments Payments in the Core Program 2019–2022

(In millions of kina)

Sources: PNG authorities and IMF staff calculations.

^1/Includes payments for previous year’s salary increases and superannuation payments.

^{Text Table 3.}

Personnel Emoluments Payments in the Core Program 2019–2022

(In millions of kina)

		2018	2019	2020	2021	2022
		Actual	est.	est.	est.	est.
Compensation of Employees		5,198	5,324	5,487	5,573	5,782
(percent of GDP)		6.6	6.3	6.0	5.5	5.2
Base salary		4,574	4,818	4,818	4,863	4,909
other payments		624	506	669	710	873
of which:
	Supplements and allowances	624	235	236	231	227
	Essential staff onboarding ceiling	n.a.	n.a.	160	320	480
	Arrears 1/	n.a.	271	273	159	166

Sources: PNG authorities and IMF staff calculations.

^1/Includes payments for previous year’s salary increases and superannuation payments.

View Table

^{Text Table 3.}

Personnel Emoluments Payments in the Core Program 2019–2022

(In millions of kina)

		2018	2019	2020	2021	2022
		Actual	est.	est.	est.	est.
Compensation of Employees		5,198	5,324	5,487	5,573	5,782
(percent of GDP)		6.6	6.3	6.0	5.5	5.2
Base salary		4,574	4,818	4,818	4,863	4,909
other payments		624	506	669	710	873
of which:
	Supplements and allowances	624	235	236	231	227
	Essential staff onboarding ceiling	n.a.	n.a.	160	320	480
	Arrears 1/	n.a.	271	273	159	166

Sources: PNG authorities and IMF staff calculations.

^1/Includes payments for previous year’s salary increases and superannuation payments.

16. The authorities will redouble efforts to implement the updated MTRS. Measures include organizational and institutional arrangements for the Internal Revenue Commission (IRC), and the implementation of the new Tax Administration Act (TAA) which was passed in 2018 (MEFP paragraph 10). However, these measures may take some time to bear fruit, and to ensure that the revenue targets for 2020 under the program are met, the authorities will introduce the following measures (MEFP paragraph 8 bullet 7), which are expected to provide about 0.3 percent of GDP in revenue:

• A one-off increase in cigarette excise taxes and for alcohol and social drinks;

• Increased compliance for international taxes (imports) from the introduction of container examination facilities at the main Port of Lae;

• Capturing resource rents on export of unprocessed old-growth logs by increasing the progressive duty rate from the current average of 32 percent to an average of 50 percent;

• Compliance efforts in collecting fees and services, including rent due the central government.

17. Revising the fiscal framework to include an expenditure rule will help achieve the fiscal targets. The medium-term fiscal strategy is anchored by a debt target in the Fiscal Responsibility Act (FRA) of 30 percent of GDP over the long term. The recent amendment to the FRA raises the upper limit on debt temporarily to 45 percent of GDP to accommodate the absorption of recent contingent liabilities, but targets an intermediate debt ratio of 35 percent to be achieved in no more than ten years. To reduce the pro-cyclicality of fiscal policy, reconcile the debt target with revenue objectives under the MTRS, and encourage an integrated approach to development spending, the authorities have introduced a rule to limit current expenditure calibrated in terms of non-resource GDP in the 2020 Budget (MEFP paragraph 12). This rule will also serve as a guide in budget formulation.

18. An update of the debt sustainability analysis (DSA) to end-2018 indicates that PNG remains at moderate risk of debt distress. Nevertheless, risks have risen related to the large increase in debt in 2018, and the shift in debt towards external lending, without a proportionate reduction in domestic short-term debt. The main risks stem from significant increases in the ratio of debt servicing costs to revenue, the concentration of domestic debt in short-term instruments, unfunded superannuation liabilities, and government guarantees of SOE debt. This further underscores the need for the authorities to pursue sustained fiscal consolidation and, in particular, rein in current spending) to reduce the debt ratio and debt-servicing costs over the medium term. The authorities also need to improve their capacity for medium-term financial planning and debt management to lengthen maturities and lower interest rates to help reach their debt targets.

C. Monetary and Exchange Rate Policies

20. The main challenges are to restore exchange rate flexibility and move towards money market operations to implement monetary policy. In parallel with measures to re-establish an interbank FX market, steps should be taken to enhance the effectiveness of BPNG money market operations. IMF technical assistance (TA) has been provided on these issues, but additional TA will be needed, preferably including a resident advisor. The mission recommends actions in the following areas:

• Restoring exchange rate flexibility and eliminating overvaluation of the kina (MEFP paragraph 14 and Table 2). The External Sector Assessment (Box 1) suggests that PNG’s external is moderately weaker than implied by fundamentals and desirable policies, and that the kina is overvalued by around 11 to 18 percent. This overvaluation could be largely eliminated over the next three years without boosting inflation excessively.⁴

• Continuing an orderly reduction in the FX orders backlog (MEFP paragraph 14 and Table 1). Although the backlog in FX orders declined in early 2019, more recently it has been growing. BPNG should continue to provide monthly injections of FX until the backlog is substantially cleared, and consider introducing auctions of FX.

• Strengthening liquidity and debt management (MEFP paragraphs 14 and 15, and Table 2). To enhance functioning of the domestic interbank market and liquidity management, Treasury should improve its cooperation with BPNG on liquidity forecasting. In addition, BPNG should encourage banks to use the interbank market as their preferred source for meeting liquidity needs, by raising the spread between the rate on its overnight lending facility and the policy rate.

D. Financial Supervision and AML/CFT issues

22. The financial system appears to be adequately capitalized, and non-performing loans moderate, but banks may be vulnerable (MEFP paragraph 16). As BPNG moves towards greater exchange rate flexibility, it is important to ensure that the banking system is able to manage exchange rate risks. Recent stress-testing by BPNG of banks’ balance sheets suggests that they can manage significant exchange rate adjustment. A larger concern is with the financial health of large SOE clients of banks. Several SOEs are essentially bankrupt, and banks will need to be adequately provisioned to deal with insolvencies.

23. PNG has made substantial progress in strengthening its AML/CFT framework, but challenges remain (MEFP paragraph 17). In particular implementation of measures to mitigate money laundering (ML) and terrorism financing (TF) risks and maintain robust correspondent banking needs to be strengthened. Recent progress focused on upgrading the legislative and institutional framework through the establishment of the Financial Analysis and Supervision Unit (FASU) and improving domestic coordination through the National Coordinating Committee. The FASU should continue enhancing its risk-based supervision of banks to improve AML/CFT compliance. Law enforcement agencies should step up their efforts in prosecuting and sanctioning ML cases and confiscating ill-gotten proceeds.

Authorities’ Views

25. The authorities agreed with the Staff’s main recommendations. Both Treasury and IRC agreed that a reinvigorated implementation of a revenue strategy is needed, and that stronger IRC accountability will help in achieving this. With regard to addressing SOE performance issues, the authorities agreed and indicated that they have a very ambitious reform agenda including not only governance reforms, but divestiture of assets. With respect to governance issues, the authorities indicated that this is a high priority area and that they will be enunciating a comprehensive governance strategy.